Is Square Gearing Up to Challenge E*TRADE and Robinhood?

Square (NYSE: SQ) CFO Sarah Friar recently stated that Square was exploring "lots of ideas" for expanding its fintech ecosystem, including savings products and ways to trade stocks. Those comments, which Friar made at Recode's annual Code Commerce conference, suggest that Square could soon challenge online brokerages like E*TRADE (NASDAQ: ETFC) and Robinhood.

Why would Square enter the brokerage market?

Expanding into the online brokerage market would be the natural next step for Square, which has been growing its high-growth "subscriptions and services" business. That unit's revenue rose 127% annually to $134 million last quarter, and accounted for 16% of Square's GAAP revenues.

The unit's main growth engines are the Cash App (for peer-to-peer payments), the Cash Card (a physical debit card linked to the app), Square Capital (which provides financing to small businesses), the Instant Deposit feature, and the Caviar food delivery service. Those services, with the exception of Caviar, give Square the building blocks for an online bank or brokerage.

Last quarter, Square's Instant Deposit volume hit $4 billion, up from $2 billion in the third quarter of 2017. Square Capital facilitated 60,000 business loans for $390 million, which marked 22% growth from a year earlier. Customers spent $250 million with the Cash Card in June, nearly triple the amount spent last December and representing about $3 billion in annual spending.

Sensor Tower and Nomura Instinet also recently reported that Cash App's cumulative downloads had reached 33.5 million, eclipsing PayPal's (NASDAQ: PYPL) Venmo's 32.9 million downloads. The study also noted that Cash's user base grew three times faster than Venmo's in July, partly due to the app's support for bitcoin transactions. Nomura Instinet analyst Dan Dolev expects the Cash App to contribute up to $40 million (or 3%) of Square's adjusted revenue this year.

Therefore, bundling stock trades into Square's expanding ecosystem of peer-to-peer payments, digital deposits, and small business loans makes perfect sense. But would that move pull users away from entrenched services like E*TRADE and upstarts like Robinhood?

Online brokerages are ripe for disruption

E*TRADE disrupted the traditional brokerage market in the 1990s by popularizing cheap online trades. But over time, cheap online trades became standard as competitors flooded the market. E*TRADE was forced to lower its fees to stay competitive, but continued growing through the aging bull market.

However, the recent arrival of commission-free challengers like Robinhood cast a dark cloud over E*TRADE's long-term prospects. Robinhood, which surpassed E*TRADE by doubling its total accounts annually to 4 million earlier this year, makes money by lending out clients' uninvested cash and keeping the interest. It also sells its clients' orders to market makers like Two Sigma Securities and Citadel Execution Services.

Robinhood also charges clients for "premium" services like margin trades, pre-market and after-hours trades, instant access to brokerage deposits (versus a two-day wait for free members), foreign stock trades, and phone trades with a live broker. It's unclear if Robinhood is profitable, but the company is already gearing up for an IPO.

Robinhood isn't the only commission-free brokerage in town. JPMorgan is offering 100 free trades for the first year on its new investing app for younger clients, and Vanguard is offering a commission-free platform for about 1,800 ETFs.

How would Square enter this market?

Since customer price expectations are rapidly dropping across the online brokerage market, it wouldn't make sense for Square to launch "discount" trades like E*TRADE. Instead, Square will likely offer free stock trades in its Cash App as a loss-leading strategy to gain more users and widen its lead against Venmo.

Once those users are locked into the Cash ecosystem, Square has plenty of ways to recoup its trading expenses -- including fees for customer-to-business transactions, Instant Deposit fees, and bitcoin sales. It could also add premium tier services like Robinhood. Tethering more users to that fintech platform would give Square more room to cross-sell other services like Caviar to consumers, which would feed the growth of enterprise-oriented platforms like Square for Restaurants.

We shouldn't get ahead of ourselves and assume that Square will actually challenge E*TRADE, Robinhood, and other online brokerages. But it's a smart strategy that could help Square disrupt another aging market.

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Leo Sun owns shares of Square. The Motley Fool owns shares of and recommends PayPal Holdings and Square. The Motley Fool has the following options: short January 2019 $80 calls on Square. The Motley Fool has a disclosure policy.