We're only three years removed from the start of the COVID-19 pandemic, but given the sequence of events, it feels like a lifetime ago. That's even more the case for investors who own shares in Robinhood Markets (HOOD -2.33%), the brokerage platform getting so much Generation Z attention.
The world looks very different now -- social restrictions have greatly eased and U.S. government stimulus is nearly all gone. Elsewhere, the enthusiasm for Robinhood stock has evaporated along with the enthusiasm for the stock market among young people.
To make matters worse for the online trading platform, the Securities and Exchange Commission (SEC) just proposed a major change to the rules surrounding payment for order flow (PFOF), a stock trading practice that helps Robinhood generates most of its revenue. Here's how the company might be affected.
Here's how payment for order flow works
The traditional stock brokerage fee model is simple: A customer buys or sells a stock (or any financial instrument), and the broker takes a commission based on the dollar volume of the transaction. But new-age brokerages like Robinhood have found a way for customers to trade under a zero-commission structure that uses a practice called payment for order flow.
PFOF involves Robinhood partnering with a group of market makers who purchase customer orders from Robinhood for a fee. The market maker then executes the customers' orders at a price that is slightly worse than the live market price and pockets the difference -- this all happens in a matter of seconds. In return, customers pay no commission and are assured their orders will (almost) always be executed.
Technically, though, the customer is paying a fee -- it's just hidden. Hiding the practice was grounds for the SEC to cite Robinhood for misleading advertising back in 2020, levying a $65 million fine.
The SEC this month proposed new rules that would ensure competition in the PFOF space, meaning Robinhood would have to give market makers an opportunity to bid on customer orders. This would likely drive down the amount of fees Robinhood receives. That's great for Robinhood's clients, but it's bad for Robinhood because its PFOF fees are determined based on how much income market makers generate.
If market makers are bringing in less money due to a more competitive landscape, then Robinhood's revenue could be decimated. For context, PFOF accounted for 63% of Robinhood's total revenue through the first nine months of 2022, so these changes would really shake up its business.
Robinhood faces other challenges, too
Robinhood's user base is shrinking. Since the era of ultra-low interest rates and U.S. government stimulus ended in 2021, the exuberance for the stock market evaporated and it took the enthusiasm of retail investors along with it. Robinhood's monthly active user base has now declined for six quarters in a row, dropping 34% in the last 12 months alone.
On the plus side, the amount of revenue Robinhood earns from each user ticked up 3% year over year to $66 in the fourth quarter, resulting in a 5% increase in total revenue, which climbed to $380 million. That certainly isn't blockbuster growth, but it does mark three straight quarters of sequential increases for both metrics.
The company has been riding a strong tailwind from the rapid rise in interest rates recently. Robinhood earns money when customers leave cash sitting in their accounts, and in the fourth quarter, net interest revenue soared 165% to $167 million.
But the company's declining assets under custody are a concern. Customers held just $62 billion in cash and financial assets with Robinhood in the fourth quarter, which was the lowest level since the end of 2020.
There was a 62% decline year over year in the dollar value of customers' cryptocurrency holdings, for example, which is a segment Robinhood bet big on over the last couple of years, yet it appears to be fizzling out.
Robinhood's future appears uncertain
The SEC is giving interested parties until March 31 to provide input on the proposed changes to PFOF. Robinhood's management recently voiced its opposition to the new rules and said it would do everything in its power to avoid transitioning to a commission-based fee structure. After all, no-commission trading is what differentiated Robinhood from most other major brokerage firms.
But the company's long-term growth trajectory has always been limited. Why? Because PFOF is a banned practice in almost every major country except the U.S. As a result, global expansion isn't a straightforward proposition. And with the walls potentially closing in domestically, combined with a retail investor base that is somewhat disengaged relative to two years ago, there are real questions about Robinhood's future.
It's little wonder Robinhood stock is down 88% from its all-time high. Investors value the company at $8.8 billion right now. But it has $6.3 billion in cash on its balance sheet, so they're effectively implying the business itself is worth just $2.5 billion.
Internal struggles aside, this stock might be one to avoid until there's a clear verdict on the future of PFOF. Even then, there are far more attractive growth propositions in the stock market right now.
