Why—And How—Did Robinhood Decide To Clear Its Own Trades?

Robinhood, the startup brokerage, made two huge announcements Wednesday:

• It passed the six million customer mark, more than half the number of active accounts at mainstay retail brokerage TD Ameritrade AMTD.
• It had developed an internal technology for clearing and settling trades on its platform.

One might ask why a rapidly-growing startup would invest in such a massive technological undertaking while supporting growth at scale, so Benzinga sat down with Robinhood co-founder and co-CEO Vlad Tenev and product lead Christine Hall to understand the process of bringing the clearing system online.

In short, Tenev said, the goal is to offer a more comprehensively Robinhood experience to users, and to cut out third parties in order to keep overhead low, which fuels Robinhood’s commission-free trading.

The following interview has been edited for brevity and clarity.

Benzinga: First off, why build your own clearing service? It seems very Silicon Valley to do it yourself.

Vlad Tenev: This is the only clearing system that’s been built from scratch on modern technology in the past decade. It’s basically unprecedented. Clearing is the foundational layer for all brokers, and it will allow us to clear and settle all transactions, as well as custody access for all our customers without depending on any third parties.

It was a huge investment in the future of Robinhood, and it will have a massive impact on our business and the customer experience.

We’ve reached massive scale—we’ve reached six million accounts, and we’re the fastest growing brokerage of all time. [That scale] was pretty clear to us early on. Before we launched, we had a million people on the waitlist. We knew we would quickly reach significant scale.

We started thinking about clearing, and we had to decide whether to build something ourselves, rent a system, or buy a system. When we looked at the clearing space, there hasn’t been a ton of innovation for many decades. Most clearing systems run on mainframes, and don’t have UIs, but terminal interfaces that are many decades old.

Despite that, most brokers don’t build clearing systems themselves. It takes a lot of capital, it requires specialized knowledge and requires interfacing with a lot of regulators, which makes it challenging. The last time a major broker went self-clearing was Vanguard [in 2008], and even they didn’t build their own system from scratch. They rented an off-the-shelf system.

We pride ourselves on being a technology company first, so we decided to build our own system from scratch. In many ways, I’d compare it to Apple Inc. AAPL building their own chips for their model devices, or Amazon investing in its own warehouses and fulfillment centers. It’s a huge investment in the infrastructure that is the foundation of our business, and vertically integrates Robinhood’s core business.

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Can you walk me through the Robinhood order flow? How much testing did you do? What’s the value prop to customers to trade on Robinhood and clear with Robinhood?

Tenev: An important point is that this doesn’t affect order routing or the behavior of customer orders. If you look at the space, there’s three different types of brokers. Robinhood thus far has been an introducing broker. This broker is responsible for the customer relationship. Now, with Clearing by Robinhood, we’re becoming a clearing broker responsible for the back office functions.

There’s actually a third type of broker called an executing broker, and the executing broker is responsible for filling customer orders and fulfilling the best execution obligations. These firms are firms like Citadel and Two Sigma, who are market makers on all the major markets. We’re not our own executing broker. The executing broker space is tangential to the core of the system—we plug into many executing brokers, and they compete to see who can provide the best execution to our customers.

Customers shouldn’t see any differences in the real-time execution quality of their trades.

Christine Hall: The main benefits that we see in going self-clearing is taking clearing, settlement and custody in-house. There will be three major impacts that our customers see.

The first is in fees. Although we’re already zero-commission, we are removing or lowering fees even more. There were about seven fees passed on from our old clearing broker-dealer. Even though those fees only affected a minority of the customers on our platform, they were painful when users did experience them.

An example—if you had a recurring ACH setup and put a few dollars into your Robinhood account every week, and one week your bank account is short, and you overdraft and have to go through an ACH reversal process, we previously charged $30 for that. It’s an industry standard, but when we integrated directly with a bank and started doing the ACH processing ourselves, we read the fine print and the bank was only billing us nine dollars for ACH reversals, which is significantly lower than what users get charged. So we cut the fee to nine dollars.

The second is that now that we have more direct insight into customers’ accounts from the street side, we can offer more support and troubleshooting with a unified picture of the customer’s account.

The last way that this impacts customers is that it’ll over a better overall experience. Previously, things like proxy voting notices weren’t written in plain language and were delivered at suboptimal times. They didn’t look like they were coming from Robinhood. These critical customer notices have been brought in-house and are written well in advance of events like tax day.

A lot of Robinhood users are younger, and have had the gift of a long bull run. If there’s a sustained sell-off in the market and Robinhood has to make good on their trades, what happens? What kind of risk management practices are in place?

Tenev: We’ve seen some corrections in the past five years, and we can point to days with a lot of volatility or significant market corrections where we’ve seen different behavior from our customers than perhaps typical brokerage customers. We actually increased deposit activity, more signups and increased buying activity.

We don’t know how a sustained downturn would affect that since we haven’t been there, but the fact that our customers are younger allows us to weather that storm a little better. These customers are at the beginning of their lifetime earning power. It’s different if you’re five years from retirement or retired as many brokerage customers are and you’re talking about your nest egg declining in value.

We can do more to educate customers about risk to develop a viewpoint and think about risk more, but the mission has always been to democratize the financial system. We view a big part of that as opening up access. If there’s a decision where we have to sacrifice the access and prevent a customer in investing in a product, we err on the side of allowing access and staying true to our mission.

We never want to say “you shouldn’t be investing in a company that has a product you use.”

See Also: From Physics Grad Student To Financial Disruptor: Robinhood's Vlad Tenev

Robinhood has shown its ability to quickly execute with the addition of crypto to the platform—walk me through this process from ideation to execution.

Hall: This process started in late 2016. We went through the build versus buy versus rent decision, and build was the clear winner from our perspective.

A lot of industry experts told us “no one does this,” which possibly made us more convinced we were on the right track.

We had two paths on how to approach this—the first was operational and regulatory-based. To become a clearing broker-dealer, we had to get additional regulatory approvals from FINRA, the DTC for equity settlements and the OCC for options settlements.

Chuck Tennant, who is now head of clearing operations, came onboard to steer that process and introduce the engineering team to the domain expertise they’d need to build this from scratch.

While that was running, we executed on the engineering build itself. A two-year build for a very fast-moving startup signifies how huge this project was. We built 20 different subsystems for accounting, ACH, internal dashboards, and others all run as individual projects.

The industry standard is to rent, so the engineering work of integrating with the technology of the financial industry [was difficult]. It’s no news that the tech is outdated. 92 of 100 banks still run on mainframes. The brokerage industry is in the same boat. It went through a phase of automation in the 1960s, but hasn’t really been touched since. We knew this would be a difficult technical challenge, made more difficult by the fact that no one has done this before. There’s no blueprint, we couldn’t consult a TED Talk [on how to build a modern clearing system].

We ran those two paths in parallel, and that brought us to today.

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How much did you invest in this, both in terms of capital and labor?

Hall: Almost everyone at the company had a hand in launching this, from the engineers who are directly staffed and worked on this for two years to marketing, legal, the frontend team—Vlad even made some code commits when we were up against tough deadlines!

Tenev: We can’t share how much this actually cost, and I feel that’s an imperfect measurement. As a startup that’s growing rapidly, we don’t really think about headcount costs, but instead opportunity costs. This is an investment in the long term of the business. This was a large effort and we had to allocate a lot of resources to do this over the last couple of years, but the goal is to build a long-term business that’s very large. We have a massive mission, and over the long run we feel this will pay huge dividends.

Few other companies are in a position to do this because they’re not at a scale at which it would make sense, and don’t have the business model to require this.

Do you plan to expand this clearing service beyond just Robinhood trades?

Hall: That’s something we thought about early on. The business model for clearing firms is to support multiple brokers—the top five clearing firms support about 1,300 introducing brokers in total. That’s the clear model.

For now, we’ve built this solely for Robinhood users and that is the plan for at least the medium term.

Tenev: The benefit for us as a business isn’t a new revenue line—it’s about owning the functions that we’ve outsourced for so long that will offer massive cost savings. Keeping our overhead super low supports our mission of offering the best pricing.

We’re now no longer dependent on our largest third party, we can control our own destiny. That means we can ship new products and features a lot faster, on timelines without external dependencies.

We don’t have to worry about third parties falling over when we scale to tens of millions of customers and beyond that.