As the founder and CEO of Cake Financial, one of the first companies to disrupt the brokerage industry by blending social networking with investing in 2007, I was interested to hear about the recent launch of Robinhood.

Robinhood is a startup trying to create a next-generation financial services company by providing free stock trading. The thesis goes like this: a large cohort of young, mobile-first investors is just entering the workforce, earning money for the first time, and is interested in a new-kind of financial services company- one that looks, feels, and acts more like they do. Charles Schwab (with a market cap of $36B and $5B in revenue), the argument continues, was built in the early 1970’s and grew up alongside the 75MM Baby Boomers and, therefore, there is a similarly huge opportunity to do the same with the estimated 80MM-95MM Millennials in the US.

Putting aside whether I believe that buying and selling individual stocks is or is not a smart investing strategy for the average consumer investor, I wanted to look at the current industry context in which Robinhood is trying to operate and to provide some thoughts on how the company could breakthrough and become successful.

It is important to note that just because a concept previously failed does not mean a similar idea cannot succeed now. Spotify was not the first startup to attempt to create a new platform for digital music, but it executed perfectly on the two most critical components to be successful in the new context- negotiating free streaming rights from the labels (with attractive economics) and a near-free distribution channel through Facebook (saving 30% margins)- that enabled them to succeed where so many others failed. Zecco is an example of a first-generation zero commissions brokerage firm that did not succeed.

So what does the current brokerage context look like and why is it different this time?

Brokerage Industry Context in 2014

Stock trading is a commodity product that grows or shrinks a few percentage points each year depending on whether we are in a bear or bull market. Average trades per day across the industry are up 11% since 2010. I looked at the 3 leading consumer investing and trading companies- TD Ameritrade, E*Trade, and Schwab- and found that DART’s (Daily Average Trades) have increased from around 800K per day in 2010 to around 900K per trading day this year. The S&P has nearly doubled over this 5 year time period, so stock trading in an of itself is a mature, slow-growth business.

Trades Per Day (2010-2014)

Average commissions for online trading has similarly remained stable over the past few years- at around $12 per trade, despite the intensity of the competition, marketing campaigns, and young upstarts.

Average Commissions (2010-2014)

The interesting take away here is that, while stock trading is a commodity, once an investor has their capital on a platform, they are captive to that specific trading product. So, since brokerage firms have legacy IT and infrastructure to support, they are able to and incented to maintain pricing power and extract rents all while having little external pressure to improve the underlying trading cost structure.

Revenue from trading still comprises a significant part of the large brokerage businesses, despite a concerted effort to diversify into other banking and lending services.

Brokerage Firms Revenue

Commissions and trading-related revenue is a $1B business for TD Ameritrade and for Schwab and they comprise over 40% of TD Ameritrade’s top line, 25% for E*Trade, and 16% for Schwab. The argument that Charles Schwab could just make stock trading free is not realistic, when non-trading revenues are growing a few percentage points a year.

Non-Trading Revenue

On the cost side, brokerage firms core competency is spending a lot of money on marketing to attract new assets to their platforms and to keep existing customers from moving their assets to other financial institutions. Collectively, Ameritrade, E*Trade and Schwab consistently spend $600MM each year in advertising and marketing- one of the largest line items in their operating budget.

Ad Spend

These firms are largely competing for the same 400,000-600,000 households each year. And the reality is that many investors tend to have multiple accounts- they keep their larger balances at the full service banks like JP Morgan/Chase, Merrill Lynch/Bank of America, Citibank, and Wells Fargo, and their trading money (and smaller balances) at E*Trade, TD Ameritrade, and Schwab.

Net New Accounts

As a result, the industry CAC (customer acquisition cost) is $1,000-$1,500 for a new funded brokerage account.

Spend per Account

For these brokerage firms, its not just about acquiring new customers- it’s about acquiring the right customer, the “mass affluent customer.” Those customers with more than $100,000 in assets, those that will move more of their assets (or “share of wallet”) on to their platforms.

Net New Assets

As you can see, Schwab generally attracts a more affluent customer, followed by TD Ameritrade and then E*Trade.

So what does all of this mean for Robinhood? How could the company break through and become successful? It needs to take a page from Spotify and focus only on the core operating principles from the beginning.

  1. Focus on Right Customer: Robinhood has to be focused on the types of investors that the other brokerage firms do not want- younger investors with small balances who do not trade a lot. The company cannot outspend the large brokerage firms in marketing, it cannot build the kind of trust overnight to warrant large asset movements, it cannot provide the array of services that clientele demands.
  2. Ignore the Active Investor: Corollary to #1, do not build products and services for the active individual investor. This was Zecco’s mistake. The active clientele are demanding, they want an endless supply of expensive real-time tools that are better supplied by others, they are not loyal, and there are not that many of them.
  3. Build lowest cost infrastructure: Negotiate with all of the exchanges for the best transaction fees, embrace the modern tech stack, focus on mobile, limit the kinds of securities that can be traded.
  4. Open Up the Platform: Banks and brokerage firms are closed networks by design. If the company has the lowest cost infrastructure and an open API for other applications to build upon, Robinhood opens up a new revenue stream a la Twilio or AWS.
  5. Find free acquisition channels: By focusing on the Millennial investor, Robinhood has to leverage social in a way that is endemic to the product experience. The key product question is: “Is investing and managing finances a social activity?”

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