BS READS: Zerodha's run to top is made of more than just 'free' brokerage

The company's tight-aggressive business model has done well so far, but with other players, both traditional and new, smelling an opportunity, there could be a very fascinating game ahead

In just a few years, Bangalore-based online stockbroking firm Zerodha toppled the market leader of the time, which had occupied the top spot for more than a decade. Sitting 600 miles away from Mumbai, a financial powerhouse for all major stockbrokers and other financial service companies, Zerodha in January last year outdid ICICI Securities to become the largest stockbroking firm in India by number of active clients.

However, it was a different world a decade earlier, when Nithin Kamath founded Zerodha along with his brother Nikhil in 2010.

Kamath, who had been an active trader since the age of 16, continued it through his engineering degree and the four years he spent working at a business process outsourcing (BPO) company. His younger sibling Nikhil, a school dropout, joined him in trading. By 2004, Kamath had become a sub-broker at Reliance Money and was also managing portfolios of a few high-networth individuals (HNIs) through another advisory company. This was the germ for Zerodha.

As of April 2020, the platform had 1,598,948 active clients and a market share of over 14 per cent – up from less than one per cent market share, and just 30,000-odd active users in 2015.

The current Covid-19 pandemic has also caused Zerodha some windfall gains. There is a buying opportunity in the market and retail investors are looking to lap it up. Between January and April 2020, the brokerage firm had already added almost 500,000 active clients, many of them preferring Zerodha for its digital-only presence. Zerodha’s market share went up by 2 per cent during this period, further extending its lead in the stockbroking market.

Now, Zerodha is expanding its reach beyond stockbroking and has refashioned itself as a full-stack tech-powered financial services company. It distributes mutual funds, holds a non-banking financial company (NBFC) licence from the Reserve Bank of India (RBI), and has recently applied to the Securities and Exchange Board of India (Sebi) for a licence to operate as an asset management company (AMC).

It’s no surprise then that even the company’s name — a combination of words ‘Zero’ and ‘Rodha’, Sanskrit word for obstacles — speaks of this turnaround.

Apart from being an aggressive trader, Nithin Kamath is also a poker buff. But Kamath, the entrepreneur, “ain’t no punter”. He is building his financial services empire with what is called a "tight-aggressive" approach in poker jargon. In this game style, ‘tight’ means being selective about what hands to play and what hands to fold, and bet ‘aggressive’ only when holding strong hands.

For Zerodha, the zero-brokerage model was one of the strong hands that gave the initial fillip, bringing the company into the limelight. While that may have worked initially, can this strategy hold in the crowded discount brokerage space now?

The self-made entrepreneur

Zerodha was attempting to enter the market at a time when other players were making an exit, after the 2008 crash. The company remains bootstrapped to this day. Kamath admits that not taking external investment was the only choice left after Zerodha was rejected by almost all big Venture Capitals (VCs).

“The year 2010 was probably the worst year to start a broking firm. After the 2008 collapse, the activity in the market had dropped, and there were no trading volumes. It was a risky bet then and no investor was keen to back us,” Kamath says.

The tipping point for Zerodha was introducing the “zero brokerage model” in December 2015. This meant that equity investments on the platform now had no upfront fees, no minimum volume, or any hidden clauses. Though they were still charging a discount fee-based brokerage for F&O and intraday trades, this was less than what peers charged.

Zerodha had the option to grow at a faster pace by acquiring smaller players, and consolidating. Yet, the company chose to grow organically without diluting equity or accumulating debt on its books. Now that the company has scaled, the business is generating cash for itself, and there is no need for external funds.

In an episode of the Maharajas of Scale podcast series, Kamath spoke about how a famous VC who had rejected him in 2010, was forcing him to raise funds in 2014. “He asked me: ‘How does Zerodha feel like; what kind of a hand (Poker hand) is it?’ And I told him: ‘It is Ace-Queen (suited).’ To this, he replied: ‘Ace-Queen (suited) is a decent hand in Poker, but it's one of those hands on which you're supposed to bet money when you get it, and make sure weaker hands now fold.’ So, he was giving me logic on why I should be raising money at that point of time,” he said.

Kamath explained, “I argued saying that after being in this industry for so many years, maybe I knew the kind of hands my competitors had now. So I did not need to bet harder to make them fold.”

Kamath believes that Zerodha’s edge comes from its agility. There are no investors who demand answers, and the decision-making is fast. “We have been making money since 2014-15. Last year (FY19), we made approximately Rs 400 crore in profits. Even if someone now offers me a large cheque, what will I do with that money? The company is funding its own growth and expansion,” Kamath adds.

The company will roll out its NBFC business soon, a cash-guzzler that may break Zerodha’s bootstrapping run. But Kamath is averse to equity dilution. “We have credibility and would prefer raising funds through options like commercial papers, etc.”

No VC money = No cash to burn

Zerodha runs its consolidated operations as a partnership firm, and, going by its statements, the company posted a net profit of Rs 400 crore on a total revenue of over Rs 850 crore last year. With no easy money at its disposal, Zerodha never had the chance to burn capital for customer acquisition.

Kamath explains: “We have not spent a single rupee on advertisement, which is the biggest cost in running a business these days.”

According to a report on Indian brokerage industry released in 2019 by ICICI Securities, Zerodha’s total operational expenses as a percentage of its total revenue was 36 per cent, lower than all its peers. HDFC Securities is the only player close to Zerodha, at 37 per cent. For others, this metric falls in the range of 60-80 per cent. The report estimates total expenses for Zerodha during 2018-19 at around Rs 320 crore.

Let us assume 50 per cent of this to be employee expenses or other fixed expenses, and the rest as customer acquisition cost (CAC) as sales and marketing expenses, which turns out to be Rs 160 crore. Kamath claims that Zerodha executes 4-5 million trades a day. With an active client base of 1.1 million – that translates into 4-5 trades per day per client.

Let us now assume that only half of these trades earn the company a brokerage at Rs 20 per trade. During 2018-19, Zerodha added roughly 350,000 active clients on its platform. Hence, the CAC comes out to be Rs 4,752 per client added during the year. If an average of 2 trades a day is getting it brokerage, it comes to Rs 60 as revenue per client. That implies the company can recover its CAC in just around four months.

Leveraging technology

Zerodha’s thrifty approach extended towards its technology backbone as well. In the initial stages, the company rode on a note of ‘freebies’ to form its technological ecosystem. Kamath became a member of the National Stock Exchange (NSE), and gained access to the newly launched in-house trading platform, NSE Active, for free. He also received a back-office management software from a Chennai-based company, free of cost, for initial testing.

The company’s technology expenditure was almost zero till 2013, when it realised it would have to up its ante. “That is when we shifted our focus to building a tech-based platform because we realised we needed a differentiated product,” explains Kamath.

In 2015, the company launched the first version of its trading platform, Kite. “We have an in-house deep technology-enabled developers’ team. Very few Indian brokers have proper tech teams,” says Kailash Nadh, who heads technology at Zerodha.

“From day one, we knew we did not want those black screens with numbers flashing everywhere. In 2013, people were getting used to the modern interfaces, but the capital markets were not changing,” he adds.

Based out of Bangalore, Zerodha was able to create a national-level financial services company, by tapping into the city’s brimming pool of technology developers, and build its product with a 30-member team. On-boarding a customer used to be a lengthy process, with 30-40 pages of documentation. But since demonetisation, and with the growing use of Aadhar-based e-KYC, it has become digital since 2017. Zerodha added 75,000 customers in 2017, and 80,000 in January 2018 alone.

Product, not pricing

According to Kamath, “The game was never about pricing. It was about product proposition.” He believes that whoever offers a better product experience to the customer wins the race. “Between Google and Yahoo, users prefer using Google because they like the experience.”

Even for Zerodha, the pricing was just a kicker. “There is not a big difference between Rs 20 and zero, but the idea was to throw a sweetener for clients, and to change the brand image. While the cost of executing a trade does not go up with the size of the trade, all brokerage firms were charging brokerage as a percentage of trade value. We moved to a flat fee of Rs 20 per trade,” he adds.

Zerodha was initially catering to the trader community (F&O and intraday traders), with very few doing equity delivery trades. But this community in India is small, hardly 300,000 to 500,000. “There is no point building a product for a shallow market. So, we began attracting equity delivery investors by making brokerage free for them,” he says.

Zerodha has now positioned itself as a platform for first-time investors and traders. Around 70 per cent of net client additions last year were those of first-time investors. Most of Zerodha’s customers are in the age bracket of 25-40 year, with 75 per cent of its clients under the age of 35.

Even with this limited customer profile, Zerodha’s active client ratio is high when compared with other players, for whom the number is in the range of 24-32 per cent. In 2018-19, almost 69 per cent of its client base of 1.5 million comprised active traders.

The broking industry had an active client base of 9.8 million as of January 2020, growing at a compound annual rate of 15 per cent from FY14-19. This provides adequate headroom for growth in terms of client base additions, with brokers having technology and distribution edge best placed to capture them.

Other discount brokers in the market

While Zerodha has seen a 20x increase in market share in the past five years, other discount brokers are catching up. Upstox and 5Paisa have also made their way to the top-10 list of brokers in terms of active clientele, gaining more than 3x in market share in FY20 alone.

Ravi Kumar, co-founder of Upstox explains: “Upstox has also been awarded by Central Depository Services Limited (CDSL) for opening 100,000 demat accounts in December 2019, a record for the highest addition ever in a single month by any broker. India has a huge potential and is massive in terms of its demographics. If you can build a product that can disrupt and has potential to scale, you can even get 100 million users for your product.”

Despite the rise of discount brokers, bank-backed brokers have been able to retain a 27-29 per cent share of active clients (as of January 2020). The loss has been mostly for smaller brokers, while large brokers are maintaining their turf.

“It is not only the shift of the customer base to discount brokers but an influx of new-to-market clients. This is good for the overall industry as the market is expanding, while our loyal client base is still intact. In the past three years, customers of over five year have contributed around 60 per cent to the broking revenue,” says Vijay Chandok, managing director, ICICI Securities.

While the ‘new-to-investing’ are driving growth for discount brokers, changing regulations after Karvy debacle is strengthening the position of large (mostly bank-owned) brokers.

“Bank-based brokers have gained credibility of late and we are seeing a consolidation from weaker independent brokers. Trust factor has become an important proposition for customers,” says Ashish Rathi, whole-time director, HDFC Securities.

The 40+ age segment

“One of the segments where we have not been very successful is the 40-45 age bracket. This segment does not care about the product experience, they cannot move away from the old ways. That is why we are not looking to expand in that customer profile,” says Kamath. This segment is currently dominated by bank-owned brokers.

In the 40+ age segment, which Zerodha has neglected so far, traditional brokers have a clear edge. “The 40+ age segment requires different client servicing. The age group is not tech-savvy and requires services like relationship managers. Research services also play a crucial role here. That is where discount broking firms lag,” says Rathi.

Ajay Menon, managing director and chief executive of Motilal Oswal Financial Services, agrees. “The kind of physical presence we have in these cities helps gain trust of customers there. They may still prefer trading online, but offline presence gives them more confidence in the brand. We have a large physical presence, with over 2,000 franchise networks across the country.”

The traditional brokers are also coming up with discounted plans to compete with discount brokers. For instance, ICICI Securities launched two new plans — Prime and Option 20.

Prime is a subscription-based plan, already subscribed by 230,000 clients, with 90 per cent of them opting for a Rs 900 subscription plan. This reduces the brokerage to 0.25 per cent. In Option 20, customers pay flat Rs 20 per order and only Rs 5 per lot. According to the company’s website, ICICI Direct, on a four-lot Nifty futures contract – 300 quantity – they have to pay only Rs 40 as brokerage for the entire order, against Rs 380 earlier.

Traders from Tier-II cities

Another profile which does not interest Zerodha is that of traders from Tier-II cities and beyond. “Someone like Paytm Money can do a better job of going to Tier-II and -III cities and expanding the markets there. The parent company already has a deep penetration in that segment of the market,” Kamath explains.

However, the traditional brokers and others are aggressively trying to get a share of that pie. For 5 Paisa, a large number of its customers are from Tier-II and -III cities. Upstox, too, is trying to keep up. “Though Metro cities continue to contribute to Upstox's robust growth, we are witnessing massive demand from Tier-II and -III cities. Close to 80 per cent of the participation in 2019 came from these cities,” says Kumar.

Tier-II and -III cities are also very lucrative in terms of mutual fund distribution. According to a recent report by Elara Capital, MF penetration beyond top 35 cities has almost doubled in FY19 to around 25 per cent from a sub-10 per cent share in FY17. Also, around 43 per cent of new retail registrations in MF on the NSE were from beyond top-100 cities as of March 2019.

Testing waters: widening the financial services net

After disrupting the stockbroking business, Zerodha diversified its operations. In April 2017, it launched ‘Zerodha Coin’, an MF distribution platform which offers direct MF plans to investors. It was a natural extension to a stockbroking service as it targeted the same customer pool. Those who are interested in trading and investments in stock might also want to invest in MFs and vice versa. There is a strong cross-selling synergy.

In March 2018, Zerodha received an NBFC licence from the RBI to enter the lending business. This raised a few eyebrows, as the industry was going through a turmoil, but Zerodha was playing it safe by giving loan against securities (LAS). Zerodha lends to its existing clients (both stockbroking and MF distribution), whose shares or MFs are kept in the demat account with Zerodha.

These are small-value loans catering to the short-term capital needs of the clients. This is in stark contrast to unsecured small-value loans by lending companies like Early Salary, MoneyTap, and Paysense. Also, LASes through Zerodha have 12-15 per cent rate of interest, compared with 20-35 per cent rate interest charged by players providing unsecured lending.

“It's a calculated move by Zerodha. There are two things which work in its favour. First, it is extending this service to the existing customer base. Second, it will be doing small-value, short-term loans against a collateral, and the company itself is holding the collateral (in form of shares or MF units) in the demat accounts. This gives Zerodha a lot of control and safety,” says a former senior executive in a Mumbai-based broking house.

More than just a stock broker

Zerodha’s most recent move is to seek an AMC licence from Sebi. With this, Zerodha plans to complete its transition to a full-stack financial services company rather than being just a discount stock broker.

The company plans to enter the MF industry as a passive-only fund manager. Passive mutual funds, or index funds, try to track or replicate representative benchmark indices by investing in the same stocks in the same proportion, with no active management of funds. On the contrary, active funds try to beat their benchmarks, through careful selection of stocks.

“Active management requires time and patience. You need almost 10 years to build a track record and have a capital threshold scale to become viable. The mutual fund market is already a crowded one and it is mostly active funds. There are big players, and everyone who has played by their strength has their own legacy. So, a passive-only MF house is a safe bet,” explains Dhirendra Kumar, founder and CEO, Value Research, a mutual fund advisory firm.

“If at some point, active funds are unable to perform and fail to beat the market benchmark, index funds will gain popularity and it (Zerodha) will be at the forefront,” he adds.

New entrants smelling the opportunity

The market dynamics are yet to feel the pinch that comes with the entry of a deep-pocketed player. Paytm Money is upping its game and is currently testing its stockbroking platform. Its mutual fund distribution business, launched in September 2018, already has 5 million users. It has seen a wide participation in Tier-II cities and beyond.

“Over 70 per cent of our MF customers are first-time investors and roughly the same proportion of investors come to us from Tier-II cities and beyond,” says Pravin Jadhav, who heads Paytm Money.

Paytm Money received Sebi’s approval to start stockbroking in December 2019 and has an approved membership of both the BSE and NSE. It does not have an AMC licence yet, but it does not deny the possibility of entering that space in future. It is also planning to launch National Pension System (NPS) services as soon as it gains an approval from the Pension Fund Regulatory and Development Authority (PFRDA). On March 3, 2020, it received an insurance broking licence from the Insurance Regulatory and Development Authority of India (Irdai).

Paytm Money has operational synergies with parent Paytm, and the group’s payments bank. “Payments bank customers account for the biggest chunk of investments taking place on Paytm Money. There is also a large base of merchants (about 15 million today) using Paytm’s digital payments across the country. We are now considering launching an investment product for this merchant network,” explains Jadhav.

Parent Paytm had raised $1 billion in November 2019, taking the total funds raised by it to about $3.5 billion. “Our focus is distribution right now, but we may look at manufacturing financial products, too. We will focus on growing our current user base first. We have not said no to acquiring an AMC licence, either; there is no reason for us not to do it. We will look at it at an opportune time,” he says.

Being risk-averse has worked as a model for Zerodha but the real test will be competing with Paytm Money. So far, Zerodha’s tight-aggressive business model has paid off. However, with both traditional and new entrants smelling the opportunity, and the competition getting intense, there is a fascinating game ahead. With the kind of approach Kamath has followed, he certainly has enough chips to play.