Robinhood, co-founded by Baiju Bhatt, faces controversies yet attracts major investors
Over the past few months, stocks selling for under $1 on American exchanges, including of bankrupt companies, have been spiking higher even though they have little or no intrinsic value.
On May 22, for instance, Hertz Global filed for bankruptcy and the stock fell 98% to 40 cents, from $21 in February. The car rental company’s business is being crushed by the collapse in travel, following COVID-19. Also, Hertz has over $21 billion in debt and other liabilities and only $1.5 billion in shareholder equity. So, with a collapsed business and huge debt, it seems apparent that those owning the stock will very likely get nothing for it. Yet, during the month after its bankruptcy, Hertz’s stock gained more than 1,400%, jumping to over $6 in June. Now the stock trades at $1.40.
When stock markets rise sharply, as markets in the U.S. have done since late March, speculators take to gambling on penny stocks, betting they will rise sharply and quickly. In the case of Hertz and other recent, similar bubble stocks, Wall Street analysts and media commentators blame the speculative mania on novice investors trading aggressively on Robinhood and other mobile stock trading platforms.
A tragedy
In June, Alex Kearns, a 20-year-old college student in Nebraska, committed suicide, after his Robinhood account showed a negative $750,000 balance. He was trading options where the use of leverage can be as high as 100 to 1. The New York Times reported that, in a note to his family before killing himself, Kearns wrote, “There was no intention to be assigned this much and take this much risk.”
Kearns “…left a note citing confusion with our product…We are personally devastated by this tragedy,” Baiju Prafalkumar Bhatt and Vlad Tenev, co-founders of Robinhood, wrote in a blog on their website. They announced changes to their trading processes and additional training for customers.
No fee trades but other costs
In 2013, Bhatt and Tenev founded Robinhood, which is based in Menlo Park near San Francisco. It has over 13 million customers, more than double that of a long-established competitor E*Trade, which was founded in 1982, also in the Silicon Valley, and is now owned by Morgan Stanley.
“We are on a mission to democratize finance,” says Robinhood. It has grown rapidly since customers can trade stocks on the platform without paying a commission fee. But customers do incur a cost for each trade though that is invisible to them.
Robinhood, E*Trade and other retail trading platforms are legally allowed to collect a “payment for order flow” they send to Wall Street firms. This payment is a portion of the profit the firms make on the price at which they buy or sell stocks of Robinhood clients. The more a client trades the bigger the overall payment Wall Street firms make to Robinhood.
A premium service with fees
Young clients are also attracted to Robinhood since they can trade fractional shares. For instance, they do not have to come up with $3,100 to buy one share of Amazon. Instead, they can buy 1/10th of a share for $310 or 1/100th for $31.
Besides payment for order flows, Robinhood gets revenues from fees for a premium service which allows customers to trade after the stock exchanges are closed. The service also allows clients to borrow money to buy leveraged products like options or to buy more stocks than the value of the cash they hold at the brokerage. There is a $5 monthly fee per account and 5% annual interest charged on borrowed funds.
Like other financial services companies, Robinhood also earns interest on the cash deposited by clients and does not pay them any interest. Its mobile and digital trading platforms are easy to use. Some critics say they are too easy without adequate warnings, including when debt rises to risky levels, and an absence of automatic stop loss trading mechanisms that limit losses, like those in-built in trading systems of E*Trade and other brokers.
A New York Times investigation found that “part of Robinhood’s success appears to have been built on a Silicon Valley playbook of behavioral nudges and push notifications, which has drawn inexperienced investors into the riskiest trading…”
Financial services ripe for disruption
Visa, the credit card processor, has a stock market value of $430 billion. Mastercard, the other major company in the business, is valued at $310 billion. American Express, the high-end credit card issuer, is valued at $76 billion. Charles Schwab, a discount stock broker founded in 1971 and with 14 million customers, is valued at $45 billion.
For more than a decade, these big valuations of financial services firms have been eyed hungrily by venture capitalists in the Silicon Valley and elsewhere. One of them is Richard Branson, the Brit who founded Virgin Airlines and other multi-billion-dollar companies. In 2014 he wrote that the financial services “market is ripe for disruption, with incumbent banks, insurance, payments and investment management companies no longer able to bamboozle consumers with jargon, hidden costs and arcane language. The time is right for entrepreneurs and new technology to shake up these industries.”
Branson and other investors have funded hundreds of start-ups in financial services in the U.S. and Western Europe. But most of them failed in large part due to being unable to overcome the expensive, time-consuming and complex legal, regulatory and political hurdles which protect the incumbents. A few of them succeeded like Square in the payment area, SoFi in education loans and Robinhood.
In July, Robinhood announced that it had raised $600 million in its latest funding round, valuing the company at $8.3 billion. Funding came from existing investors including Sequoia Capital, which was an early investor in Google and Instagram. In operation since 1972, today the companies Sequoia funded have a total public market value of $3.3 trillion.
From physics to online enterprise
While in high school, Bhatt wanted to be a physicist. He was influenced by Surely You’re Joking, Mr Feynman! by Richard Feynman and Brighter Than a Thousand Suns by Robert Jungk. These books, about science and creative scientists, were birthday gifts from his dad, who worked at NASA, Bhatt told Entrepreneur.
Bhatt earned a B.S. in physics and M.S. in mathematics from Stanford University. He and Tenev were classmates and roommates. After graduation, they built two finance companies in New York which sold trading software to hedge funds.
The experience made them realize that big Wall Street firms pay effectively nothing to trade stocks, while most Americans were charged $10 or more in commission for every trade. They decided to build products that would provide everyone with access to the financial markets, not just the wealthy.
“We had this crazy idea: If we make it free and make it really easy to use on mobile [devices], we would see a new generation of customers,” Bhatt told the TechCrunch Disrupt conference in 2018 in San Francisco.
Robinhood appears to be named after the English outlaw Robin Hood who stole from the rich to help the poor. Bhatt and Tenev each have an estimated net worth of over $1 billion,.according to Bloomberg.
In June, after Axel Kearns suicide, they announced a donation of $250,000 to the American Foundation for Suicide Prevention.
PHOTO: from Baiju Bhatt’s Twitter account - https://twitter.com/bprafulkumar?lang=en