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Commission-Free Brokerage Truths, as Revolut Follows Robinhood

 11 min read / 

It turns out that Andy Murray is a savvy investor. The tennis star joined more than 40,000 investors last August in committing to a crowdfunding round for London-based fintech firm, Revolut, valuing it at $350m. The company has since smashed that valuation following its giant Series C fundraising round led by DST Global this April, that served up a valuation almost fivefold Andy’s entrance price at $1.7bn, ace! I’ll stop now.

Revolut is one of an emerging cohort of challenger banks and fintech firms capitalising on a millennial demographic increasingly dissatisfied with the services, charges and latency of legacy financial institutions. Founded in 2015, the company originally focused on frictionless, minimal-fee foreign exchange services for the retail market before expanding into other consumer banking verticals. That evolution and a continuing ability to raise funds have made Revolut a force to be reckoned with in the world’s financial capital, home to the many of the company’s competitors in TransferWise, Monzo, WorldRemit and more. Indeed, London’s transaction-focused startups are in good company on the continent too, including Sweden’s at-checkout lender Klarna, Berlin-based challenger bank N26 and the Netherlands-based multichannel payment provider, Adyen. Adyen debuted this June on the Euronext Amsterdam and its shares jumped 90% in its first day, which gave it a market capitalisation nearly seven times greater than its last private valuation.

Source: AlicornCo

Revolut is beginning to stand out from the pack. The company’s mission to disrupt what it views as an array of gratuitously-priced retail banking products has led its expansion into current accounts, personal loans and as of February even the purchase, storage and exchange of three cryptocurrencies. This April, the firm launched a savings tool, Vaults, that assists users in achieving financial goals by enabling them to round up the spare change on transactions and save it as cryptocurrency. If that wasn’t innovative enough, Revolut offers the globetrotting millennial ‘geolocated’ travel insurance, meaning it tracks when the user is abroad by their mobile phone and charges them only for those days. Following in its now safely-insured users’ footsteps, its most recent fundraising of $250m is largely designated for its international expansion into the US, Canada, Hong Kong and Australia, a process that is already underway. The relentless evolution of the firm is idiosyncratic of its get-shit-done culture and working environment embodied by CEO, co-founder and former investment banker, Nikolay Storonsky, that stands the fintech firm even further abreast of its start-up peers.

A wider offering has a downside though. To heavily borrow from the Notorious B.I.G, “mo’ products, mo’ competitors”. Revolut’s current and savings accounts compete with both the mainstays of high street banking as well as their rising challenger-bank competitors. That list includes RBS, Lloyd, Barclays, HSBC with Atom, Metro, Aldermore and TSB thrown in. Its mobile-only products, differentiated by tech-enablement and versatile access, are vying for the same estranged millennial population as Monzo, Tandem, Starling and N26 in Europe alone. Even its original niche in low-fee foreign exchange transfers is now a crowded space, with rivalry in consumer transactions from fellow unicorn TransferWise, in global remittances by WorldRemit and everything in between by century-old behemoth, Western Union. Savings platform Vaults, even in its infancy, competes with a new age of robo-advisors including Nutmeg, MoneyFarm and Wealthify, equally infamous for their unashamed domination of the London underground’s available advertising space.

Source: Revolut Press Kit

It is in the true, unfased style of Revolut and Storonsky that the company announced in June that it’s pursuing the addition of commission-free brokerage to its platform, for implementation in 2019. Given the speed of Revolut’s product expansion, it is surprising to some it took this long to see the opportunity for disruption. Brokerage as a services industry is notorious for cosmetic and undynamic fees. Legacy institutions such as Charles Schwab and eTrade in the US, or Redmayne-Bentley and Hargreaves Lansdowne in the UK, commonly charge flat trading fees of $5 or more per trade. That’s often a high proportional cost for the little guy, an addressable market Revolut hopes it can take a slice of.

Despite the incumbent operators, Revolut’s path into share brokerage has largely been carved by another firm already at the forefront of disrupting the industry, Robinhood. The US-based firm focused primarily on providing commission-free brokerage of listed stocks, cryptocurrencies and exchange-traded funds to its users. Like Revolut, its user base is comprised largely of the same millennial demographic annoyed at having to pay $5 for a $100 trade through legacy operators. Take up has been so strong that users number more than 4 million for Robinhood after the firm doubled active accounts in the 12 months prior to May this year, surpassing listed rival eTrade’s 3.7 million users. Of even closer comparison, is Robinhood’s enormous fourfold uplift in valuation to $5.6bn following its most recent round of funding in March, led by none other than DST Global. Revenue figures aren’t publicly available for the firm, but based on total users, invested capital and listed comparables like eTrade, it’s a valuation some of the market believes Robinhood will have to grow into. Revolut, following its own valuation uplift, is trading above its London peers based on the latest available metrics, but some way from the multiples commanded by its soon to be US-rival. Assuming market share for commission-free brokerage in Europe may be Revolut’s road to changing that.

Source: AlicornCo

Charging minimal forex fees and the lowest interest rate on the high street is one game, but charging zilch for brokerage services is not quite price competition so much as an entirely different model. How do you generate money from transactional services without charging someone? That’s a question the market’s been asking of Robinhood’s business model since it roared onto the venture scene, and after four years, it’s still getting it comically wrong. In fairness, it’s not the market’s fault.

Robinhood answers this exact question on their website, indicating the firm receives revenue from Robinhood Gold subscriptions, their premium trading account and interest on non-invested deposits; imagine placing $200 in a trading account but only trade $100, the other $100 is placed in an interest-bearing account, generating interest revenue for the brokerage provider. Those revenue streams are straightforward, especially since Robinhood confirmed in 2017 that some 75% of its trading volume was from Gold subscriptions. They are, however, a little slim for a company valued on a 1,400x user multiple that still has to deal with the transaction fees of the client’s order. Well, that’s because Robinhood doesn’t have any transactional fees, in fact, the complete opposite occurs as Robinhood’s filing with the SEC for Q1 2018 explains more clearly:

Source: SEC

If you’ve read Flashboys by Michael Lewis, it’s likely the above reference to Citadel Securities has caught your attention. A Briton may even be voicing a silent and drawn out ‘wait a minute’, usually found at the conclusion of a Scooby Doo mystery. In fact, all four names demand pricked ears given these particular routing venues are US exchanges well-known for their active high-frequency trading arms. A non-directed order simply means the client has not instructed the broker as to which exchange they would like their trade to be executed via, leaving that decision to the brokerage firm. In Robinhood’s website attestation, it seems they’ve omitted one key revenue line: Robinhood receives a fee for routing orders to these particular exchanges.

That’s important. For those unfamiliar, high-frequency trading largely came into the limelight after the publication of Lewis’ book in 2014. It told the story of how Brad Katsuyama, had come to uncover the co-operative practices of certain firms and stock exchanges to the detriment of the market participant. High-frequency trading (HFT) firms, in simplistic terms, use speed to beat market orders to their desired execution, acquiring the stock in demand before ransoming it back to its prospective owner at a higher price; this is known as front-running. (Imagine an investor decides to buy IBM stock and the market shows there is enough liquidity to meet his order at $146.90. They place an order with their broker who, assuming no commission, routes the purchase order to an exchange and the trade executes at the price $146.90, and the investor would walk away satisfied with his purchase of a blue-chip stock. In an exchange with active HFT firms, however, the traders can arrive first, purchase the stock at $146.90 and force the market to their new sell order of $147 or higher, depending on the remainder of the order book.) Until Katsuyama’s campaign to combat these trading practices, and ultimately the launch of his own exchange, it appeared to investors like the market was simply moving away from them at the wrong time. (IEX, The Investors Exchange, is a US stock exchange founded by Brad Katsuyama that attained regulatory approval in October 2017.)

So, are trades from Robinhood users under attack from HFT firms as well? In short, no. Front-running Margaret from Louisiana’s $250 gamble on Chipotle stock, based implicitly on her lifelong, soft-flour taco love affair, is unlikely to be a profitable business for high-frequency traders. Robinhood is, however, avoiding transaction fees and generating revenue by routing user orders to these exchanges, a relationship that underpins their ability to offer brokerage commission-free to the user.

The relationship also underscores the fact that there must be some value for HFT firms in receiving these orders to their exchanges. What may be useful, some analysts posit, is knowing which orders in the book are retail investors just like Margaret and which are in fact the iceberg orders of institutional buyers seeking material blocks of stock. (An iceberg order is a type of order to purchase shares in a market. It involves placing an order for a small proportion of the overall shares a client wishes to purchase in order not to reveal the total size of their desired block, which in doing so may alert the market to the increased demand for the stock, creating price pressure to their detriment.) In other words, Margaret and co. would be handing high-frequency traders information on which orders were theirs, in return for trading commission-free. The key to arriving first for HFT firms has always been information, specifically regarding large, institutional demand. Being able to mark trades in the book as retail would help them identify just that, and they’re willing to pay for it. The above would be based on Robinhood allowing the exchanges access to their API, which is unclear.

It is not something app users are likely to consider immediately, but how much does Margaret care? Her privacy has been priced, and the cost of retaining it is a $5-$7 brokerage fee with eTrade or counterparts. If the order is indeed being front-run, which seems a leap for trades of immaterial value, the slippage cost need only be below $5 and the investor is still financially better-off. If instead, the trade information is up for auction to these exchanges, then one should ask themselves this – how bad would one feel taking advantage of commission-free trading if one knew it was being used to the disadvantage of larger, institutional investors in their own pursuit of profit? Given the public’s general sentiment towards the latter, and that of income inequality more generally, one wouldn’t think Maggie gives two flying tacos.

What is clear is that the business model is extremely innovative. Customers, although increasingly concerned with their privacy, are more than ever focused on unjustifiable margins. What’s more, Robinhood and Revolut, across both their product offerings, target the growing dissent of the masses at lack of access to financial services available to the 1%, and never more so than when the barrier to entry is monetary. Exchanges with active high-frequency trading units will be incentivised to pay Robinhood as its user base gains scale, as their ability to piece together an accurate picture of the market improves with each retail investor routed to them. It’s no surprise Revolut, whose co-founder and CTO Vlad Yatsenko spent a decade building technology systems at tier one investment banks, believes following Robinhood is a profitable path. DST Global clearly agrees, having led both Series C and D for Robinhood and now Revolut’s Series C. Robinhood has a material head start in the US, but the race to build Europe’s counterpart appears to be in full flight

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1 Comment

1 Comment

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  1. Geert

    June 19, 2018 at 5:35 PM

    Good article!

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