Stock broking is a profession as old as the markets themselves, but the practice has evolved over time with the help of technology, which has made investing far more accessible.
With the swipe of a finger on their smartphones, the youngest of investors can now buy and sell an entire suite of financial products, and at the center of it all is app-based broker Robinhood Markets (HOOD +4.87%).
At first, there was much enthusiasm about the innovative nature of Robinhood's business, but it has seemingly come crashing down amid a swathe of regulatory issues, a questionable shift into cryptocurrency markets, and now a significant data breach.
The company's stock is down over 58% from its highs, and here's why it could get even worse.
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A business model under fire
Traditionally, a stock broker's job is to connect clients to other participants in the market. If a client wants to buy stock in a company, the broker finds a willing seller, and for that service the broker earns a commission.
But technology has automated many of these transactions, and they happen in the blink of an eye. As such, brokers like Robinhood have opted to charge their clients zero commissions instead partaking in what's known as payment for order flow (PFOF).
It's a business model at the center of significant controversy, with the U.S. Securities and Exchange Commission (SEC) imposing a $65 million fine on Robinhood in Dec. 2020 when it found that despite paying zero commissions, Robinhood's clients were actually getting charged far more in "hidden" fees as a result of PFOF.
The SEC is now assessing whether payment for order flow should be reformed or barred completely in what would be a crushing blow to Robinhood, which earns 78% of its revenue from the practice.
But the regulator hasn't stopped there. It's also going after brokers like Robinhood for their "gamified" in-app features, which are said to encourage risky behavior and sell the trading experience as something more akin to a digital casino than an investment platform.
The crypto shift, and the big data breach
It's not just the regulators putting pressure on Robinhood. Investors have been exiting the stock for several months, which seemed to coincide (in part) with the company's decision to deviate its focus away from stock and options trading products and into cryptocurrency offerings.
For the first nine months of 2021 (ended Sept. 30), 32% of Robinhood's revenues came from cryptocurrency trading, compared to just 3% in the same period of 2020.
While cryptocurrency trading tends to offer brokers higher fee potential, there are serious questions about the staying power of many of the tokens retail investors are trading. For instance, in the recent third quarter, 40% of Robinhood's crypto-related revenue came from clients who traded Dogecoin -- a joke coin with almost no consumer adoption or merchant uptake.
However, there's a more concerning issue. A problem facing many crypto brokers is their inability to get full and complete insurance coverage for all of their clients' cryptocurrency holdings. Robinhood plainly states that in the event of a hack, they might not be able to insure against losses of their clients' now $22.2 billion in cryptocurrency assets, which the company holds in custody for them.
So what? Well, a few short weeks ago in early November, Robinhood fell victim to a significant data breach that exposed the email addresses of 5 million customers and other personal information of 2 million different customers.
If I were holding a valuable amount of cryptocurrency with a broker who failed to protect even my email address, I might be pondering my options.
A long road back
There's no question Robinhood has changed investing for the better in many ways. The stock market has typically never been a young person's game, but Robinhood helps first-time investors gain valuable experience while they don't have a significant net worth to place at risk.
But at the same time, the regulatory verdicts have been clear in suggesting Robinhood's practices aren't always in their clients' best interests. Yet if the platform is forced to change to suit new rules, it might no longer attract its coveted younger audience.
For me, Robinhood poses far too many risks and hasn't been proactive enough at addressing them -- if anything, things have grown worse recently. From an investment perspective, it might be better to stick with a tried and tested broker instead.
