Is Robinhood Shooting Itself in the Foot?

Robinhood continues to make headlines. The free online stock trading platform was forced to raise billions of dollars over the past several weeks to meet increasing capital requirements as the result of trading highly volatile stocks including GameStop and AMC Entertainment Holdings. However, some feel Robinhood is undermining its own mission, "To democratize finance for all."

On this clip from Motley Fool Live, recorded on Feb. 1, "The Wrap" host Jason Hall and Fool.com contributors Danny Vena and Keith Speights talk about an apparent conflict of interest that may hinder the company from achieving its ambitious goals.

Jason Hall: Everybody knows this. If you're watching us, then you know what's happened with WallStreetBets, the Reddit subreddit, and Robinhood, and GameStop, and hedge funds, all this stuff. It's just been absolutely crazy what's happened.

Just a little bit of the insider baseball here. The way Robinhood makes money, its business model is selling its trading flow to hedge funds. The majority of its revenues actually come from that source. The company just had to raise a bunch of money. They raised $1 billion last Thursday, I think. They just announced they raised another $2.4 billion, so $3.4 billion in cash raised in like four or five days here, more than the company has raised in its entire existence before the past few days.

What happens here, guys? Keith, here's a question that I'm going to ask and I want us to pontificate on. Can Robinhood's business model really reach their goal of "democratizing finance for all" if the company has to sell trading flow to hedge funds to cover its costs?

Keith Speights: My answer is no. I don't think they can. I saw someone tweet this, and I think it's true. Robinhood's product is its users.

Hall: Yeah.

Speights: The users aren't Robinhood's customers, it's the hedge funds that are their customers. You can't fundamentally change the way finance works when that's your business model, in my view.

Hall: Because you follow the money and you know where a company's interests have to be aligned.

Speights: Exactly.

Hall: That's just how it works. Danny, what are your thoughts here?

Danny Vena: I think Robinhood is in trouble and the trouble just keeps getting deeper. I was reading something earlier today. We know that Robinhood used to be the upstart, the little guy empowering young investors, and now the very people that made Robinhood the up-and-coming trading platform are abandoning that platform and talking bad about Robinhood on the way out the door. Robinhood has become the bad guy.

I don't think it's completely deserved. Some of what these investors are saying is that, Robinhood is cutting these trades because it's in bed with the hedge funds and trying to keep them from making money. What it really is is the fact that with the volatility of those shares, the people that process those trades for Robinhood are making Robinhood come up with a ton of money to back the three days between the trade actually executes and the day the trade settles. They're stuck between a rock in a hard place, and right now, I don't see that ending anytime soon. It's only going to get worse before it gets better.

Hall: I would agree. Go ahead Keith.

Speights: Just really quickly. I think Danny is exactly right. I don't think it's that Robinhood is just inherently evil, it's just that their interest aren't fully aligned with their users, and we're seeing that.

Hall: I think it's a little bit of the law of unintended consequences. I think at some point the folks that founded it, they had this great idea, this great idea that they could build a platform that would give something to users, would support the idea of free trades, release free trades for the trader, and that they would be able to do it by selling the deal float, the trading volume, to a hedge fund, so it could make a little bit of money. You buy a stock for $10 through the hedge fund, the hedge fund actually buys a stock for $9.995. They do so much volume that that little tiny fraction of a penny adds up and they make a little bit of money, and it's so small but the value is still created for the investor. Because it's cheaper than it would be to pay $5 or $10 or $15.

Then the law of unintended consequences kicks in, and this great idea completely blows up in this way that nobody could have possibly even come close to imagining that it would.