From the Social Media to the Social Trading: A Financial Perspective
Marcello Forcellini, Andrea Vivoli
Italy
*Corresponding Author E-mail: marcello.forcellini@gmail.com, info@andreavivoli.com
The paper starts analyzing the evolution of social media in the financial field according to a new phenomenon, called social trading. Precisely, there is an increasing number of trading platforms which enable all segments of investors - such as the retail ones - to operate in financial markets with risky financial contracts called contracts for difference (CFD). The paper describes how the on-line trading platforms of CFDs work and how the new international regulations are changing the CFD market. It also provides an overview of the main tools and services that trading platforms are offering that are driving the social trading to become a reference social media in the financial field. Finally, the paper examines some possible challenges that the social trading could face following the new regulations and market trends in order to protect investors from eventually adopting insane asset allocation strategies.
The general overview
Social media influences the way of life of human beings with regard to a broad range of different aspects of people’s interactions in their personal and professional scope. Several aspects of the human behavior - such as ways of thinking, preferences, habits, choices, etc. - are biased by the other’s information which is daily spread through on-line platforms on virtual communities and social networks. In such a way, the different types of social media have been able to change the traditional way to communicate across the world by transforming passive users into active ones: the information flow is not managed as it was a monologue, but it turns to be as a dialogue among active users on the web. In addition, the World Wide Web offers an easy tool to everyone to set up platforms to create lists “of individuals that you want to connect with, and then managing interactions thought that list” (J. Obar and S. Wildman, 2015). The impact of social media on the society has “introduced substantial and pervasive changes to communication between organizations, communities, and individuals” (J. Kietzmann and K. Hermkens, 2011) across several sectors, including significant transformations in the financial industry.
In fact, the new ways of communication have positively impacted on the flow of financial information across investors who could not have access to technical data platforms in the past. In theory, financial intermediaries cluster investors in categories according to their amount of money in order to enable them to have access to different financial products: i) people with less than 100’000 Euros (the so called retail segment) can generally opt for low risk-return financial contracts such as bonds, certificate of deposits, etc., ii) people with savings amounting between 100’000 and 500’000 Euros (so called affluent) can generally decide to invest in pooled funds managed by a specialist, iii) people with more than 500’000 Euros (so called high net worth individuals - HNWIs) can generally appoint a wealth manager. The approach of client segmentation is not only anchored in the economical sustainability of the wealth management, but also in the level of information that every investor can receive and manage in function of the financial knowledge. Even though, in the past, only some segments of savers had the information and knowledge to invest in a wide range of financial products using leverage, nowadays, new technologies as well as social media have changed the idea underlying the traditional money management industry. In practice, the recent evolution of social media has narrowed the barriers to entry, “transforming the traditional money management industry, in order to open the financial markets to everyone, everywhere” (eToro-website, 2018). At this point, some questions arise regarding the manners of investors can both trade in “open” financial markets and take properly decisions without possessing a specific professional and/or academic background in the economic field.
The issue related to the ability to enter the financial markets in order to exchange listed assets have been solved through the implementation of controversial derivative contracts called contracts for difference (CFD), while social networks such as social trading systems have provided the investors with some possible ways to bridge information and knowledge gaps.
Contracts for difference are financial contracts, introduced around 20 years ago, whose price derives from the value of other types of financial instruments. Instead of negotiating or physically exchanging the financial asset, the CFD allows two parties to exchange money based on the change in value of the underlying asset between the time at which the transaction is opened and it is closed. CFDs can be used to replicate movements in the price of listed assets, without necessarily possessing the underlying instrument (Borsa Italiana, 2008). CFDs have allowed people to have access to financial markets through specialized brokers that can also grant high leverage rates. For instance, “the underlying security is common shares listed on a stock exchange, but may also be foreign currencies, bonds and indices where there is market transparency of price and traded volumes” (Investment Dealers Association of Canada, 2007). Thus, CFDs - offered by specialized brokers - have considerably reduced barriers to entry for all segments of investors, even if the risk is quite high being marketed as high leverage products.
It has also to be considered that retail investors do not usually look for balanced long-term investments through on-line platforms since they typically show risk adverse utility functions, instead, they tend to implement risky short-term trading strategies that are in compliance with the CFDs’ essence. In this regard, such investors - in an “open” market - consider the trading as a type of gambling far from the money management standards. The adoption of CFDs has clearly reduced the barriers to entry for small investors like the retail ones, even though some relevant limitations still exist whereas issuers tend to offer CFDs to only underlying securities where they have straight market access.
The ongoing theoretical analysis shows new business opportunities for professionals in derived financial markets regardless of the user’s awareness; in this regard, the Executive Director of Supervision Investment of the UK FCA writes in 2018 that CFDs put “individuals at risk of losing significantly more than their original investment. Because of this, firms should define their target market precisely”. Beside the users’ expectations to be free to invest in financial markets, they need to build the minimum level of knowledge in order to “understand and evaluate how suitable and appropriate the product is and also assess whether it is meeting their clients’ needs on an ongoing basis” (M. Butler, 2018).
The CFDs are not only appealing for their implicit flexibility under regulations and profit opportunities, but also for the structure of CFDs which is not particularly complex: there are three parties involved in the contract which are the issuer, the on-line broker and the client. The issuer and the client assume the principal risk of the contract that replicates the financial performance of the underlying asset. The on-line broker is a market intermediary even though it could also operate “as principal such as in a CFD on foreign currencies in which it hedges its principal FX exposure with another counterparty. The broker/dealer is registered and licensed by the issuer to distribute its CFD product offerings on an unsolicited on-line trading platform. The trading platform is generally a proprietary system owned by the issuer” (Investment Dealers Association of Canada, 2007). The broker - acting also as agent - is in charge of issuing the financial contracts and it performs the administrative procedures such as account openings and credit monitoring or eventual equity deficiency, in fact, the broker issues and collects margin calls on behalf of the issuer.
These investments implicate operational and transaction costs, which are directly or indirectly paid by the market’s users. Considering direct costs, investors have to consider CFD execution costs, broker commissions, and financing costs for the leveraged CFD positions, while the indirect costs regard the minimum margin deposits required by both the issuer and the broker.
Even if the contract structure appears technically simple and economically competitive, the way that CFDs are offered from brokers to inexperienced traders creates some concerns. In particular, the perception of investors could not properly reflect the real risk-return profile of this typology of investments, especially regarding the gain advertised; some central banks across the world have started strengthening their regulations and policies since the market experienced a wise increase in the number of deals at the beginning of 2010 (L. Battersby, 2009).
CFDs are currently available in several markets across the world such as: United Kingdom, Germany, Switzerland, Italy, Singapore, South Africa, Australia, New Zealand, etc. even if “contracts for difference are not currently permitted to by USA residents” (Contracts for Difference.com). Thus, there is evidence that CFDs have lately experienced a considerable success starting from their introduction in financial markets, which has required the strengthening of new regulations and policies both for brokers and clients by national competent authorities. A research conducted by the Director of ILQ Australia Pty shows that “CFDs and specifically Margin FX comprise one of the largest segments of the world’s financial markets; foreign exchange markets transact 5.4 trillion US dollars every day. Due to the high degree of leverage within the specifications of these products, it is not uncommon for small to medium size firms offering CFDs to trade USD 1 billion (known as a “yard”) per day, with bigger operations trading multiples of this figure” (James O’Neill, 2017). In addition to the considerable size of the CFD market, the relative risks cannot be neglected considering that the UK-FCA has noted “that the majority (76%) of retail customers who bought CFD products on either an advisory or discretionary basis lost money over the 12 month period under review (July 2015 to June 2016)” (M. Butler, 2018).
In this context, some mature markets such as Australia, United Kingdom, Cyprus, and USA have already issued relevant regulations in order to address two main issues regarding the protection of: i) the money client from the event of the CFD issuer’s insolvency, and ii) the investors from experiencing losses due to unreasonable behaviors for taking extreme leveraged positions. Concerning the first concern, the above-mentioned markets have already defined, mutatis mutandis, that “client money must be deposited into a designated client money account which is operated as a trust account. This account must be segregated from company funds” (James O’Neill, 2017). This is oriented to enhance the saving protections of investors even though there are still some residual doubts about risks of losing money if “enough clients in the same pool make the wrong bets and cannot meet margin calls” (L. Battersby, 2009). Regarding the second issue, competent authorities have adopted policies that require brokers to inform ex-ante users about trading risks as well as the introduction of restrictions for brokers of leveraged positions and balance protections. In this regard, the European Securities and Markets Authority (ESMA) has recently issued a measure (Decision 2018/796) - that will be applied starting on August 1, 2018 - in order to limit the riskiness of investments in CFDs for retail investors. Briefly, the ESMA decision states that: “1. Leverage limits on the opening of a position by a retail client from 30:1 to 2:1, which vary according to the volatility of the underlying: 30:1 for major currency pairs; 20:1 for non-major currency pairs, gold and major indices; 10:1 for commodities other than gold and non-major equity indices; 5:1 for individual equities and other reference values; 2:1 for cryptocurrencies; 2. A margin close out rule on a per account basis. This will standardize the percentage of margin (at 50% of minimum required margin) at which providers are required to close out one or more retail client’s open CFDs; 3. Negative balance protection on a per account basis. This will provide an overall guaranteed limit on retail client losses; 4. A restriction on the incentives offered to trade CFDs; and 5. A standardized risk warning, including the percentage of losses on a CFD provider’s retail investor accounts” (ESMA Press Release, 2018).
National competent authorities are enhancing local regulations to address risks related to the trading in CFDs, however further analysis should be conducted in order to face eventual threats related to the on-line trading platforms.
In Over-the-Counter (OTC) markets, CFDs can be traded through trading software systems which enable clients to operate with the broker and the issuer of the contracts. “The system must enable the issuer to effectively monitor its exposure to open contract positions that it has issued instantaneously with price feeds from listed markets where the underlying equities and indices trade or OTC market places where underlying bonds or currencies trade. This includes having systems linked to global exchanges to hedge their open contract positions on a net basis. The intermediary must have sophisticated software systems to provide the investor with necessary investment tools such as news, position monitoring, price quotation and charts. This includes an order entry system, open contract position monitoring, and price feeds for valuations to instantaneously track customer equity profit and loss. Given the interdependence of software systems between the intermediary and the issuer, the systems developed by such organizations are generally integrated and proprietary” (Investment Dealers Association of Canada, 2007).
The market competition spurs the intermediaries to differentiate their services in order to control wider market’s shares according to: i) cost reduction, ii) research for appealing software interface, and iii) the increasing range of CFD products. Basically, users look for the cheapest CFD providers which drive intermediaries to set up their headquarters in countries with low tax rates in order to reduce commissions and fees. The suite of software tools, the grade of interface simplicity, and the flexibility of the interface are the main aspects that are advertised to clients which generate monthly fees for trading volumes. To avoid marketing abuses, the new ESMA decision obliges brokers and dealers to post risk warnings on their Webpages including “an up-to-date provider-specific loss percentage based on a calculation of the percentage of CFD trading accounts provided to retail clients by the CFD provider that lost money” (ESMA Decision 2018/796).
Considering the riskiness of the product, brokers have to offer to clients some basic risk management tools such as the order entry system which allows users to limit risk. For instance, the clients can set up: stop-loss (positions are closed if the loss is greater than x%), limits (orders are executed at specific prices), contingent orders (allowing the simultaneous execution of two or more transactions), etc. Thus, the above-mentioned risk management tools concern the field of risk analysis which should be performed as for any kind of investment. The market risk is the most important one that is related to the nature of CFD positions because it implies, not only concerns to lose money following negative market movements, but also losses that are magnified by high leverage rates. In such a way, investors have also to pay attention to the closing risk because severe adverse movements in financial markets could force the broker to close instantaneously the clients’ positions following an unsatisfied margin call. Both the monitoring of the available margin and the time control of broker requests are the two most impotent variables that should be constantly analyzed jointly with the right type of order. As previously mentioned, the OTC nature of CFDs implies that the default of an investor “could adversely affect all the other clients that have positions with that derivative provider” based on the fact that “two counterparties are compelled to take on each other's risks”: the real existence of the counterparty risk has encouraged national competent authorities to issue regulations about the segregation of users’ funds in order to reduce the likelihood of the insolvency risk (Contracts for Difference.com).
On-line trading platforms show different tools to enable everyone to manage risk and to define strategies for asset allocation. Since several users are not expert traders, an increasing number of on-line trading platforms is offering the opportunity to copy trading strategies of “expert users”, creating a new social phenomenon called social-trading.
In addition to the users’ needs to find profitable ways to invest consciously money on web platforms according to specific skills in the money management industry, some specific causes - such as the loss of trust in traditional portfolio managers after the financial turmoil of 2008, the lack of transparency in the hedge funds asset allocation, and the presence of information asymmetries between retail investors and asset managers - have also paved the way to the boom in the use of the online trading platforms. In that regard, social trading platforms could be considered - at a certain extent - the natural evolution of traditional information sharing systems used by professional traders, willing to send “signals” to their followers, to suggest the trades to be replicated. In fact, social trading, which enables inexperienced investors to “mimic the strategies of more experienced or successful traders”, works as social media where traders “share their live account trades in real time” and “follow each other and receive feedback on their actions” (ForexDictionary.com).
In truth, the social trading is not properly a new phenomenon, considering that it has experienced an historical evolution starting from the so-called newsletter, as shown in Figure 1. In such a way, “people have been following successful traders through newsletters long before the Internet. With web-based technologies, however, the ease of real-time sharing and collaboration has made social trading much easier. Social trading is largely made up of self-taught forex traders learning from each other’s experience, with some thought leaders emerging as gurus and community experts. A social trader could theoretically throw out all other indicators in favor of community input or social indicators, making financial decisions based purely on the opinions of others” (ForexDictionary.com).
In practice, from a financial point of view, before the arrival of the social trading platforms, people have taken their decisions about asset allocation by relying on fundamental and technical analysis; however, social trading has allowed people to integrate their own “traditional” investment techniques with social indicators which derive by the others’ decisions (Neil Glassman, 2010).
From Newsletter to Social Trading: different methods for sharing investment decisions
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NEWSLETTER
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Traders recommend specific trades, sending e-mails to all members of their mailing list. No automated execution system in place. Any member can place (or not) the suggested (buy / sell) order using his own brokerage account. Out of the scope of investment services regulation and supervision. |
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VIRTUAL ROOM
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Traders recommended specific trades posting the signals in a virtual room. No automated execution system in place. Any member can place (or not) the suggested buy or sell order using his own brokerage account. Possibility to interact live with traders via chat room. The followers need to be constantly in front of the PC to detect new “signals”. Out of the scope of investment services regulation and supervision.
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COPY TRADING
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Signal providers publish their trades on online platforms where signals followers (investors who subscribe to one or more signals providers) mimic the trades through contracts for difference (CFD) using automated execution systems. These platforms integrate information sharing with online CFD trading. The platform provider falls within the scope of the investment services regulation and supervision for any transaction involving financial instruments. Out of the scope of investment services regulation and supervision.
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SOCIAL TRADING
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Same features of copy trading with plus social interaction between traders and followers All signals published are automatically executed into the follower’s brokerage account proportionally and in real-time. Signal providers receive a platform-specific fee for publishing trading signals. Existing subscriptions can be cancelled at any time. Although followers do not transfer capital to the signal provider’s accounts, the latter de facto act as portfolio managers.
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Figure 1
But which are the main benefits deriving from online social trading platforms from a social media point of view? At its core, sharing ideas and past experiences help increase everyone’s learning curve in order to become a savvier investor, and “democratizing” the asset management industry at the same time. According to Yoni Assia, chief executive officer of eToro (i.e. one of the most well-known social trading platform) the purpose of social trading is to “give our users a better position to succeed by transforming the lonely art of investing into an exciting collaborative activity”. In this regard, following the advice of peers on social networks can be considered as an important step of the decision-making process to create reasonable investment portfolios for many investors. It has to be also considered that, nowadays, such investors make a daily use of social media platforms - such as Facebook, Twitter, or LinkedIn - to learn more about investment opportunities so that people are already substantially aware of how social trading platforms work in the money management industry (Schade, 2017).
In summary, there are a lot of advantages related to such platforms because they would therefore enable: i) full and easy access to reliable trading information by providing extensive information from professional traders who disclose their holdings and strategies, ii) quick grasping of the trading market by replicating the trades of skilled traders who constantly monitor the financial trends, iii) earning while still learning by trying to understand the underlying factors that drive signal providers to reallocate their portfolios thanking to social interaction and immediate feedback on the traders’ investment decisions; and iv) build a trading community of investors where they can interact with professionals and share information each other.
From a regulatory perspective, in 2008, ESMA announced that financial operators active in the social trading network, could exercise “investment discretion by automatically executing the trade signals of third parties” which implied that brokers and market-makers active in that field were assimilated into the other financial intermediaries which needed an ad-hoc authorization according to portfolio management as per Markets in Financial Instruments Directive (MiFID). Subsequently, the same authorization requirements were also confirmed in 2012 by ESMA (ESMA, 2012). In fact, whenever a service provider makes an investment through an automated algorithm in view of trade signals coming from third parties - in relation to MifiD financial instruments - this implies that the provider has to perform some consequent duties according to suitability assessment, conduct of business obligations, and information standards for both clients and authorities.
In addition, the Financial Conduct Authority in Europe has also supported this view, specifying that: “This service falls within Article 4(1)(9) of MiFID. This article defines ‘portfolio management’ as ‘managing portfolios in accordance with mandates given by clients on a discretionary client-by-client basis where such portfolios include one or more financial instruments’. In copy trading and mirror trading, investment decisions are implemented with no intervention by the client other than an agreement (‘mandate’) between the service provider and the client on the discretionary service provided” (FCA, 2015). According to ESMA, where no automatic order execution occurs because client action is required prior to each transaction being executed, the activity performed will not amount to portfolio management and, depending on the interaction with the client, other investment services may still be relevant (e.g. investment advice in the case of personal recommendations, and reception and transmission of orders).
In the end, even though some improvements have been made in this field, two main issues would still need to be addressed:
1. The regulatory focus is on the operator running the platform, not on the traders publishing the trade “signals”. All posts are not subject to MiFID regulation despite their influence on followers’ investment decisions. It has been investigated how unsophisticated retail investors tend to rely on social interaction when making investment decisions, reacting to comments posted by traders, independently from the real informational value of posting. In other terms, followers’ investment decisions are mainly driven by sentiment rather than rationality (Ammann and Schaub, 2016). The tone of traders’ comments and their wording are quite free (being not regulatory constrained) if compared with the communications of fund managers who must instead comply with stringent rules on fair and true information: in fact, they have to publish periodically compliant information about past performances and trading strategies.
2. The MifiD regulation applies exclusively to trades that involve financial instruments. Therefore, trades on cryptocurrencies - which are decentralized digital currencies or assets which are not issued by any central bank or issuer in which encryption techniques are used to facilitate the generation of units of the currency or asset and verify the transfer of units - are out of the scope of the investment services regulation. This is clearly stated, for instance, in the eToro “Addendum to terms and conditions” for using its platform: “Since Cryptocurrencies markets are decentralized and non-regulated our Cryptocurrencies Trading Services are unregulated services which are not governed by any specific European regulatory framework (including MIFID). Therefore, when using our Cryptocurrencies Trading Service, you will not benefit from the protections available to clients receiving regulated investment services such as the access to the Investor Compensation Fund for Customers of Cypriot Investment Firms and the Financial Ombudsman Service for dispute resolution.” (eToro, 2018).
Online social trading platforms are likely to become major players of the asset management industry considering that there is still ground for improving the regulation and supervision on them.
The evolution of social media has caused several changes in different business industries such as the financial industry which has recently required for further regulatory interventions according to saving protections. In fact, social trading, like each social media, allows a free flow of information through the market that can create abuses and distortions without possessing specialized skills and experiences within a clear regulatory framework. However, social trading platforms have enabled financial markets to reach higher levels of transparency that were unthinkable in the past: traders would not have even thought to share statistics and strategies about their investment portfolios beside the fact that they were not even encouraged to do it. As described, social media – merging its essence with that one of money management – has broken this pattern, paving the way for new financial perspectives in transparency. In fact, “publicly-traded companies have even started to use their investors’ relations department to spread the information. Some companies have even started to use social media to launch their products” (Mucklai, 2017).
Probably, social trading will change the money management industry more and more, creating new challenges and opportunities as it usually happens when different areas interfere each other over time. In this regard, while people have to judge a new service, which is currently considered to be trendy and cheap, financial intermediaries - like banks - have to face another typology of competitor which exploits the advantages of the web and reduces costs compared with the “traditional financial services”. In the end, the market will have to show if social trading platforms are a new concrete and stable business line in the financial sector that will have to change again both the investors’ preferences and the banks’ market strategies in the long-run.
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Accepted on 22.06.2019 ©A&V Publications all right reserved International J. Advances in Social Sciences.2019;7(1-2):15-22. DOI: 10.5958/2454-2679.2019.00004.5 |
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