Robinhood's Fate Now Rests With Dogecoin

Commission-free stock trading platform Robinhood Markets (HOOD +0.98%) became a public company in July, finally giving people the chance to own a piece of the trading revolution driven by young, first-time investors. 

But the stock appears to have cooled off after an initial wave of enthusiasm. The company's second-quarter earnings report highlighted an accelerating shift away from the roaring options and equity trading businesses Robinhood is best known for, and into cryptocurrencies -- especially one highly controversial joke coin. 

In the face of ongoing regulatory questions about its business model, investors might be concerned that this sharp pivot will add fuel to the fire, as crypto is the subject of hot debate among lawmakers. Let's explore the size of this potential risk. 

Image source: Getty Images

Is Robinhood now a cryptocurrency platform?

It seems to have happened in the blink of an eye: In the second quarter, Robinhood's largest source of revenue stopped being transactions in conventional markets like stocks and options. Instead, cryptocurrency trading led the way amid soaring interest in assets like Dogecoin (DOGE +0.07%), a novelty token that has been heavily promoted by social media personalities.

Data source: Company filings 

Crypto comprised 51% of all transaction-based revenue, but what's concerning is that of the $233.1 million Robinhood generated from digital currency trading, more than 62% came from Dogecoin trades alone. That means Dogecoin accounted for a little more than 30% of transaction-based revenue. Against the backdrop of a decline in stock trading, it signals that Robinhood's customers are forgoing safer investments in favor of pure speculation in the crypto markets. 

This might spell trouble for the platform, which is already under regulatory scrutiny for encouraging risky behavior through its "gamified" features.

But despite accounting for the lion's share of revenue, crypto assets held by Robinhood customers make up just 22% of all assets under custody. This suggests two things. First, its customers might be trading their tokens far more frequently than they traded stocks. Second, crypto may simply be a higher-margin business for the company. 

However, the quantity of crypto assets held by Robinhood customers is growing almost 14 times faster than overall assets.

Data source: Company filings. 1 basis point = 1/100 of a percentage point.

The risks continue to mount

Whether the trades in question involve stocks, stock options, or cryptocurrencies, Robinhood makes about 80% of its money through a controversial practice known as payment for order flow.

Robinhood became famous as a no-fee trading platform, but it still makes money from its customers' trading activity. Users' market orders are sent to third parties known as market makers that execute the trades and pay some of the proceeds back to Robinhood (that is, it takes payments based on the order flow). That's one reason regulators are paying attention -- the market makers, and Robinhood itself, are not exactly incentivized to find traders the very best prices.

The Securities and Exchange Commission found that payment for order flow cost Robinhood customers $34.1 million in hidden fees between 2015 and 2018, after accounting for the savings from the zero-commission model. The practice is banned in other major markets, including the United Kingdom, and deemed counter to the rules in the European Union.

Cryptocurrencies, though, present a whole new dimension of risks not only to Robinhood customers, but also to the company itself. 

In its second-quarter SEC filing, Robinhood warned that because of security risks involved with storing and dealing in cryptocurrencies, it could not obtain insurance to protect all of its customers' crypto holdings. That means if Robinhood were hacked or lost control of the crypto assets in its care, those clients would have virtually no recourse to fully recover their losses.

This risk is not unique to Robinhood. It affects most players in the crypto space. However, investors who bought shares of this company because of its image as a stock-trading platform popular with younger generations now need to consider the potential consequences of Robinhood being the custodian for more than $22 billion in cryptocurrency assets (and growing).

Why I'm not buying it

Robinhood has done what no brokerage has been able to as well before -- capture the business of young people. Stock investing was perceived as an older person's game until technology made it more accessible. Now, Robinhood has 22.5 million customers -- more than twice as many as it had at this time last year. The problem is that its users seem to be straying further and further away from actual investing. 

One of the largest issues I have with Robinhood is that its business will likely be confined to the U.S. It can only offer commission-free trading if it's able to earn revenue through payment for order flow. Since that's banned in many other major markets, global domination appears to be completely off the table. 

The question is whether the U.S. market alone is enough to provide Robinhood with sustainable long-term growth, especially since its stock trades around 25 times trailing-12-month sales -- with revenue growth expected to slow to 18% in 2022, according to analysts. Compare that to competitor Interactive Brokers, which trades at 2 times sales and is highly profitable, whereas Robinhood is still losing money on the bottom line.

Robinhood has faced regulatory challenges to many parts of its business in its short history. It only increases the risk to the business that its users are pivoting so hard into cryptocurrencies at a time when the treatment of these assets is the subject of fierce debate among lawmakers.

But more important, its users appear to have become far less interested in stocks than they were previously. Now, the fate of Robinhood's growth trajectory depends on whether or not crypto has staying power. And for the moment, the company's future is most specifically tied to Dogecoin -- a token that even its founder says is a joke.