Zero-Commission Stock Trading Has Arrived
It happens all the time in a free market…
A new competitor comes along with a product or technology that flips an entire industry on its head.
We call these companies disruptors.
Microsoft (Nasdaq: MSFT) did it in the late ‘80s when it introduced Windows, changing computer operating systems for good.
At the turn of the millennium, Google (Nasdaq: GOOG) revolutionized the search engine business and never looked back.
And Uber, the seamless ride-sharing app, has totally transformed the taxi industry since its debut in 2009. (Investment U contributor Andrew Gordon recently listed the company among his 10 favorite potential IPOs of 2015.)
Now, the planets seem to have aligned for a new startup to completely disrupt the stock brokerage industry.
If you’re interested in trading stocks for free, keep reading…
A Lesson From Wall Street
Let’s step back in time.
The year was 2010. Two Stanford University roommates, Vladimir Tenev and Baiju Bhatt, showed up at Wall Street’s doorstep to help hedge funds and banks build high-frequency software systems.
As they began developing algorithms to lower the cost of trades on the brokerage side, the Occupy Wall Street movement was getting into full swing. This is something that weighed on Tenev’s and Bhatt’s shoulders. To them, they were just helping the rich get richer.
But what they really wanted to do was help the masses.
Luckily, while working on Wall Street they stumbled upon some important information. They learned that the cost of trading for large institutions had fallen to a fraction of a cent. Yet retail investors were still paying $7 to $10 per online transaction.
Tenev and Bhatt wondered if they could they bring the advantages of the rich and powerful institutions to the masses. Could they provide retail investors zero-commission trades and run a profitable business?
Their answer was yes. After all, online brokerages had already brought commission costs down to the single digits over the past two decades. Why not take them all the way down to zero?
So the idea for their zero-trading cost app, Robinhood, was born.
Borrowing From the Rich and Giving to the Poor
Unlike the Robin Hood of English folklore, Tenev and Bhatt aren’t literally stealing from the rich and giving to the poor. They are just taking a large-scale system – that currently only institutions and hedge funds are privy to – and making it work for everyone.
I know what you’re thinking: “If there are no costs, how does the app make money?”
Since it can’t make money off of trade commissions, it generates revenue by earning interest on users’ cash balances and margin lending.
Earning interest on cash balances is already a standard practice by banks, brokerages and financial institutions. So no biggie there.
And margin lending (borrowing to make trades) can be very lucrative. TD Ameritrade and E-Trade charge as much as 8.4% or higher when they lend on margin.
Of course, borrowing money to trade stocks can be a very dangerous game. Although it can boost your returns, it can just as easily magnify your losses. As Alexander Green notes here, it is certainly not something we condone at Investment U.
But we can easily get behind lowering your trading costs to zero. Questions is, will the zero-commission business model work?
Millennials Line Up
Robinhood isn’t the first company to offer zero-commission trading. Between 2006 and 2011, a startup called Zecco provided fee-free trades. But venture capital (VC) funding fell through, forcing it to start charging customers.
Fortunately, Tenev and Bhatt have had great success in funding their app. They have already been backed by big VC firms like Google Ventures, Andreessen Horowitz and Index Venture, along with angel investor Tim Draper and celebrities like Snoop Dogg and Jared Leto.
This funding allowed the company to officially launch its app on March 12. Before the launch, it already had a wait list of 800,000 people. Today, anyone with an iPhone can download Robinhood for free.
Along with no-fee trading, there are no account minimums. This has made the app particularly attractive to millennials, who have less money to invest. In fact, Robinhood users currently have an average age of 26.
I am happy to see younger people taking an interest in investing. Words like “free” and “no fee” undoubtedly help.
And this is just the start. If Robinhood can attract enough users it will force others to adopt zero commissions, in true disruptor style. But we aren’t there yet.
While Robinhood’s initial success is encouraging, we are still in the early stages. It’s hard to tell if the company will be able to operate on cash account interest and margin lending alone.
The good news is that with no human brokers to pay and a high-tech infrastructure running the trades, overhead will be low. Right now, the company has only around 30 employees.
The business model seems viable, but the jury is still out.
In the meantime, I am using the app to trade stocks for free with no complaints. I’ve even convinced some friends who are investing neophytes to try it as well.
Does Robinhood pique your interest? Have another app you’d like us to look into? Let us know in the comments section below.