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Robinhood's botched savings account launch could throw IPO into limbo

Robinhood Markets Inc. has weathered a storm of criticism over its attempt at launching a new product marketed as a checking and savings account, but more dark clouds could be gathering over the retail trading startup's plans to run an IPO.

A day after announcing it would launch a checking and savings account backed by the Securities Investor Protection Corp., the SIPC said it does not protect cash held for anything other than purchasing securities. Robinhood pulled the announcement, scrubbed all references to Robinhood Checking & Savings from its website and social media, and rebranded the product as a cash management program.

The furor over what critics called a misleading product announcement has cast doubt over the company's public offering, which co-CEO Baiju Bhatt said Robinhood was preparing for in September. Robinhood has raised at least $542 million, according to S&P Global Market Intelligence data, and it could be one of several high-profile tech companies to hit the market in 2019.

But Robinhood's actions were either "remarkably naive or brazenly cavalier," according to Tyler Gellasch, who is executive director of advocacy group Healthy Markets. The walked-back account also sends mixed signals to investors and investment banks hoping to accurately value Robinhood, others in the industry said.

Robinhood declined to comment on the matter.

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The customer acquisition play

Robinhood was founded in 2013 and rapidly gained users thanks to a free trading app that upended the traditional retail brokerage model, which companies such as E*TRADE Financial Corp. and TD Ameritrade Holding Corp. have built in recent decades by charging a small fee on each trade.

But Robinhood's move into deposits could signal unease at the company about its main revenue stream, a practice known as payment-for-order-flow in which it sells customers' orders to high-frequency trading firms to be executed. Earlier in 2018, it was reported that Robinhood was generating more than 40% of its revenue that way.

Retail brokerages typically get only a small portion of their revenue through payment-for-order-flow, which has come under fire from critics who say it creates conflicts of interest between the brokerage's duty to customers and a source of revenue.

Several industry experts said Robinhood's high revenue from payment-for-order-flow is not a sustainable long-term business strategy unless it keeps growing its trading app's user base. Gathering new clients through what it now calls the money management account and encouraging them to conduct trades could generate a larger order flow pipeline.

Robinhood's valuation

Robinhood's ultimate aims will affect the company's valuation in a potential public offering. Many fintech companies want to offer a day-to-day account, such as a checking account, where the customer becomes core to the everyday business. If Robinhood is launching this service as a play into the digital banking sector, that move would warrant a much higher valuation than if it targets a cash management account, said Alyson Clarke, a banking analyst with Forrester Research.

In a digital banking account, "you know what people are doing, you know where they're spending, and there's value in that data," Clarke said. "You're not getting that primary relationship [and] data through the cash management [account], so that's a different valuation."

Robinhood was valued at $5.6 billion in May 2018 when its Series D raise was completed.

If Robinhood were to launch into banking, its proposed 3% interest rate is considerably higher than even the other digital banks, which have largely been playing a rate-game to attract new customers.

Although Robinhood is not partnering with a bank to issue the new cash management account, it is working with Sutton Bank to launch its debit card. Jeff Lewis, senior vice president of payments at the bank, confirmed that the companies are still moving ahead as planned.

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Lewis was not able to comment on Robinhood's strategy or exact next steps, but he said Sutton was "pleasantly surprised" by Robinhood's approach to regulation while planning the product. He expects the marketing snafu to be resolved "sooner rather than later," he said in an interview.

Enforcement actions possible

While Robinhood took flak for not approaching SIPC before announcing its latest venture, SIPC President and CEO Stephen Harbeck reiterated that his organization is not a regulator.

"We only deal with the wreckage of a defunct firm, so normally [companies] would not reach out to us," he said in an interview.

Still, Robinhood could face enforcement actions from either the SEC or the Financial Industry Regulatory Authority, or both. The regulatory agencies declined to comment. Robinhood is currently hiring a regulatory counsel, according to a job posting on its careers website.

Several experts said a broker/dealer could not fairly call its service a checking and savings account, given that it could lead investors to believe the company is accepting deposits and is regulated like a bank. Instead, a brokerage account like Robinhood's newest product can hold both securities and cash.

Robinhood's recent moves are a "material misrepresentation" of the product, Healthy Market's Gellasch said. Both the SEC and FINRA have rules about advertising and misrepresentation, and they could interpret Robinhood's statements as breaking those rules.

Although more than 500,000 people signed up for the checking and savings account within 24 hours of the announcement, the program was not set to launch until 2019. Because Robinhood likely did not gather any assets, the company may only see a fine, said Larry Tabb, founder and research chairman of the capital markets-focused research firm TABB Group, in an interview.

Another 350,000 people have signed up since Robinhood's rebranding of the product as a cash management account.