Will Robinhood’s rocky IPO cast doubt on online brokerages?

Robinhood, the trading app which had rocked Wall Street, was itself treated to a rocky start on NASDAQ. It had aimed for a US$35 billion valuation, cut that number to US$29 billion right before its debut, experienced one of the worst IPO debuts in history before surging by almost 50 percent. And that’s just the past two days.

Some of the possible reasons behind this shaky debut are unique to Robinhood as a company. True to its vision of democratizing finance for all, the company had reserved as much as 35 percent of shares for retail investors– most IPOs usually set this percentage at around 10 percent. This unusual step left many institutional investors expecting its IPO to be volatile, and reluctant to back Robinhood (at first).

There was also uncertainty because of the regulatory oversight surrounding Robinhood. The payment for order flow (PFOF) practice–which contributed to 75% of Robinhood’s revenues in 2020– has come under growing scrutiny by the SEC. Critics accuse it of failing to provide investors with the best prices, and it is possible for PFOF to be banned.

Yet, if we look at Futu Holdings, a company with a similar business model as Robinhood, we see that its stock price has also experienced wide swings in the past year. This volatility that both companies have experienced, therefore, point to the hurdles that trading apps (including Ajaib in Indonesia) may face in the road ahead.

Robinhood and Futu are consumer internet companies first

Robinhood and Futu may position themselves as brokerages, but they are still consumer internet companies first. By centering their wealth management services on an easy-to-use app, these companies ultimately want to drive traffic to their platforms.

In the short run, higher traffic equals higher revenues. Whether it’s brokerage commissions (Futu) or PFOF (Robinhood), these companies generate higher revenues when more people– and more trades– are made on their platforms. 

In the long run, higher traffic also translates to more data points of their users. This information enables them to create a full-fledged financial services platform, which these companies envision as the end goal for their apps.

In fact, these trading apps are in a unique position to achieve this goal because of their user stickiness. The average Robinhood user visited the app seven times a day in 2020. Can you imagine a digital bank user checking their account that many times each day?

Walking the tightrope between increasing traffic and managing risk

Given the importance of traffic, these apps will prioritize increasing user numbers and encouraging more trades. Their current target audience–young and inexperienced investors who are more emotionally driven and more likely to make frequent trades– suits this objective.

Robinhood has sought to further incentivise trading activity by gamifying investment. The company has repackaged investing as an online social activity, which does encourage more trades, but also contributes to a jesting attitude towards it.

Dogecoin to the moon?

However, after the tragic death of Alexander Kearns, regulators have called for these trading apps to take greater responsibility for its users. They are expected to not only provide access to stock markets, but also protect its users from the sharp end of the markets.

At present, Robinhood and Futu have fulfilled this unspoken responsibility by performing due diligence and educating their investors (Moomoo Courses, Robinhood Learn). A wider “safety net” may (or may not) be introduced in the future. 

Either way, as these apps try to rein in their users, it will be unlikely for these retail investors to trade as frequently as before. Can these trading apps still maintain the same volume of trading activity? Or would they inadvertently hit a bottleneck?

Democratizing finance in a bearish market

The other major challenge that these trading apps will face in the future are changes in market sentiments. So far, these online brokerages have piggybacked on a bull market– novice investors are more enticed by investing if they believe that they can “grow their wealth”. It will be much more difficult to draw the same number of retail investors in a bearish market.

Have you noticed that when the tech stocks had a correction during the first half of this year, all the YouTube ads of expert stockpickers suddenly disappeared?

This quote from Patrick Krizan, a senior economist at Allianz, sums it up quite nicely.

“It’s easy to make positive speeches about democratizing finance when everything is going up. It will be more interesting to see how people behave when we democratise the downturn.”

How will Robinhood and Futu evolve?

Online brokerages such as Futu and Robinhood have steadily grown their user numbers and trading volume in the past few years, but can they maintain such impressive numbers in the future?

Whether regulatory authorities will impose more restrictions on these companies adds another layer of complexity to this already difficult question.

Unlike the US stock market, the stock market in China feature a significantly higher percentage of retail investors. The potential for online brokerages, which democratize access to investing, to disrupt these markets is stronger in the latter. Will Futu, which operates in China, face future regulatory challenges? We don’t know.

These companies are, however, run by capable, determined and experienced entrepreneurs. With the backing of the public market (more than just retail investors), I am sure that they will figure out a viable and prosperous path.