GameStop Hearing Reveals Key Insights into Robinhood’s Revenue Model

The recent House Financial Services Committee hearing concerning GameStop and Robinhood yielded limited genuinely new information, though Reuters provided a useful overview. A notable exchange involved lawmakers questioning Robinhood CEO Vlad Tenev about the necessity of securing additional capital during the GameStop events; TechCrunch has consistently covered this topic, and further clarification proved beneficial.

During the hearing, legislators also obtained a significant data point: over half of the company’s revenue originates from payment for order flow (PFOF), a practice that remains a subject of debate.

Understanding Payment for Order Flow (PFOF)

Critics of PFOF argue that it effectively treats users of neo-trading platforms as the product, potentially exposing retail investors to unfavorable trade execution prices. Robinhood has faced scrutiny regarding trade pricing previously. Conversely, proponents maintain that PFOF enables affordable access to equity markets.

Regardless of one’s perspective on PFOF, its potential for significant disruption appears limited. Regulatory changes threatening its existence seem unlikely, and Robinhood’s utilization of this model fueled substantial growth in 2020. Specifically, Robinhood’s PFOF revenue increased from just over $90 million in Q1 2020 to approximately $220 million in Q4.

The Role of Options Trading in Robinhood’s Revenue

How many users contributed to these PFOF earnings? Tenev’s congressional testimony indicated that Robinhood has over 13 million “customers,” though the precise definition of a “customer” remains unclear. However, not all users contribute equally to revenue.

To better understand this, let’s examine the proportion of Robinhood users who engage in options trading. Tenev stated the following in his testimony:

This, coupled with the fact that PFOF income constitutes the majority of its revenue, leads to a compelling conclusion: a relatively small segment of Robinhood’s user base generates the majority of its income.

This is evident when considering that revenue from trades in S&P 500 stocks is modest, revenue from non-S&P 500 stocks is somewhat higher, and revenue from options order flow comprises the largest portion of recent revenue.

For instance, TechCrunch calculated that options-derived PFOF revenues accounted for approximately 67%, 64%, and 63% of Robinhood’s total PFOF revenue in October, November, and December, respectively.

Approximately 13% of Robinhood’s 13 million users, or 1.69 million, are estimated to have traded options. The number of users engaging in multileg options trading is even smaller, at 260,000.

These high-volume traders, akin to “whales” in the casino industry, are the primary drivers of the company’s revenue.

Growth and Potential Challenges

It’s important to note that Robinhood’s impressive growth last year has attracted significant investment, and this revenue concentration isn’t necessarily a cause for immediate concern.

However, the company faces potential challenges due to the disparity between its large base of lower-value customers and its smaller group of highly profitable users.

Consider this further insight from Tenev’s testimony:

This indicates that a significant portion of users trade infrequently in securities that generate less PFOF revenue.

For example, in December, PFOF income from Citadel for S&P 500 shares was 20.126 cents per hundred shares, non-S&P stocks yielded 27.8964 cents per hundred shares, while options trades generated 65.8218 cents per 100 shares. Increased options trading directly benefits Robinhood’s business.

Previous reporting has highlighted Robinhood’s reliance on options-related income, but confirmation that PFOF accounts for more than 50% of its revenue is new. With this clarification – and a likely figure closer to 65% – the extent of Robinhood’s dependence on active options traders becomes clearer.

Data Illustrating Options Revenue

Further data supports this point. In December, Citadel generated $154,508.58 in PFOF for S&P 500 stock market orders, $4,780,624.90 for non-S&P 500 stock market orders, and $9,360.52 from options market orders.

However, Citadel also paid Robinhood $11,304,200.90 for options PFOF for marketable limit orders and $16,661,113.10 for nonmarketable limit orders in the same month. This demonstrates the critical importance of options income – and this data represents only December.

This analysis reveals Robinhood’s core strength: a business model that generates hundreds of millions of dollars quarterly while minimizing costs for end users. Its weakness, as with companies like TikTok at Fastly or Uber at Twilio, lies in revenue concentration and the risk of losing a key user base.

Acquiring a portion of Robinhood’s options-trading user base would require a competitor to attract a substantial number of users engaging in more conventional investing activities to offset the revenue loss.

Ultimately, the anticipation now centers on the release of Robinhood’s S-1 filing.