Social trading grows amid calls for regulatory oversight

By:
Solomon Teague
Published on:

The full-scale disruptive potential of social trading is beginning to become clear, according to proponents. But there are fears that it is encouraging inexperienced traders to load up with risk in the pursuit of large returns and there have been calls for tougher regulation.

Rune Bech
We are entering what we call the 'eBay-moment of finance' 

Rune Bech, Saxo Bank

Social trading platforms, which incorporate social media and relatively transparent data, across a variety of asset classes, have come of age over the past five years.

"We are entering what we call the 'eBay-moment of finance',” says Rune Bech, global head of digital media and communications at Saxo Bank in Copenhagen. He sees TradingFloor.com, Saxo's social trading platform for FX, equities and even commodities, as “democratizing and opening up the trading world by releasing peer-to-peer power through a fully transparent community of investors sharing their performance data and trades in real time”.

But even those inside the business recognize the potential danger associated with the rise of social media and retail investment. “I don't like some of the other social trading models out there that encourage copying and the FCA [UK Financial Conduct Authority] is rightly looking at that,” says Francois Nembrini, co-founder of TopTradr, another social trading platform, which is focused solely on FX. “Copying” refers to the increasingly popular practice whereby users can "follow" users on a given social-media platform and replicate the trades on their proprietary accounts, effectively mimicking the trading strategies of those who have developed a track record, exacerbating herd-behaviour risks.

“Social trading shouldn't be about copying what others are doing but encouraging discussion to learn how best to manage risk and losses,” says Nembrini. “It’s about creating a community where we can easily challenge our own ideas rather than blindly copying others."

Saxo chart

Nembrini calls for tighter regulation of the industry. “Social trading needs to be regulated, though it isn't easy and there are a lot of issues to be considered. I hope we see more regulations in this arena because well-regulated social trading platforms would be great tools to help educate a new generation of traders.”

In March, the FCA gave its first pronouncement on the regulatory status of social trading in the UK, suggesting that it viewed the activity of copy trading as constituting managing investments, meaning institutions involved in this practice would require licences for such activity and the provision of reports and an audit trail for trades. But it is less clear whether or not the information available on such sites constitutes investment advice, and therefore if social trading platforms fall under the scope of regulation governing that. In 2012 the European Securities and Markets Authority published its own thoughts on the matter, suggesting social trading should be included under MiFID guidelines requiring that this service be licensed.

Of concern is the way social trading might lead gullible clients to copy the trading activity of strategies they do not understand, taking more risk than they intended, leading to outsized losses.

Nembrini is not the only one with concerns. Social trading platforms are clearly fertile hunting grounds for scammers to prey on people for whom a large investment is only a couple of clicks away. “I am not against social trading but I am against how some people currently use it,” says Nembrini. Digital media has made the distribution of information much easier but now there is so much information the problem isn't getting the information but filtering it.

Social trading is potentially problematic if it encourages traders to focus on poor or misleading information, but if the quality of information associated with social trading is of high quality, that can only be a good thing, Nembrini says.

“Some social trading sites seem to be selling a fake dream,” he says. “Traders are only ranked by performance and others blindly follow them but may not be aware of how much risk they are taking.”

Top Tradr gives traders a score that is based on their performance, Sharpe ratio against the equity in the account and the risk/reward ratio for individual trades, with each factor contributing equally. Nembrini emphasizes risk-adjusted returns, noting that a 5% performance can be better than a 20% performance if it is delivered taking less risk.

But he is concerned that social trading might attract clients who haven’t been trained to think this way about risk and will have their heads turned by the outsized returns generated by traders loading up on risk.

“Coming up with a unique score summarizing multiple factors was not easy and we have had input from a quantitative analyst,” says Nembrini. “We have been making improvements to the system, for example extending the period the algorithms are based on from one month out to three months. We have certainly picked some losers but also a group of five to 10 traders who have proved themselves very solid performers over an extended period now.”

It isn't the only site that gives prominence to information about the risk-adjusted returns of traders. TradingFloor also enables traders to be analysed in a number of ways, measuring performance outright or on a risk-adjusted basis, and there are filters to screen out traders who take too much risk or deliver inconsistent returns.

Its advocates see massive disruptive potential for social trading. In its sights are not only traditional retail FX brokers but even potentially the asset management industry. Investors could save themselves substantial fee bills by picking talented traders and replicating their trading activity.

Given its meteoric rise in popularity and the stunning success of social media outside the world of trading, anything seems possible. TradingFloor, Saxo Bank's social trading platform, already sees 300,000 traders a month coming onto the site, where they can follow other traders, much as they would on Twitter. With the trading ticket embedded into the site, copying other traders couldn't be simpler.

Social trading could also do much to democratize trading and dramatically expand the talent pool from which financial institutions can draw talent, and from which aspiring traders can showcase their skills.

“It allows someone who lives somewhere that would otherwise have no access to financial markets, like Edmonton in Canada for one of our winners, to get discovered without having to move to New York or London,” says Nembrini. “That is invaluable for institutions in those financial centres where there is very stiff competition for local talent.”

Both platforms report instances of successful traders being approached by hedge funds and other trading operations and this is the most obvious explanation for the popularity of social trading. But even for those not looking for a career in trading, the business taps into a human instinct to share information that also underpins the rise of Twitter and Facebook.

“There have always been financial communities; in the past these were found in bars where people discussed their trading strategies,” says Bech. “The unique new thing is that the discussion is linked to real and verified numbers so people can see for themselves transparently, which makes it easier for people to trust each other.”

The architects of TradingFloor confess to being initially surprised by the enthusiasm its clients had for sharing their trading information. There is little obviously to be gained by an individual from sharing such information other than kudos. Although hedge funds are renowned for being secretive, it is interesting to observe the increasing trend of traders promoting their positions and being very open about their strategies.

“Secrecy doesn't matter so much in the retail space, where you don't encounter issues around liquidity or market depth,” says Nembrini. “Hedge funds encounter problems with execution because of the size of their trades but retail traders are usually operating with around £10,000 or so, which is not an issue. It can be a problem in some rare cases for the banks managing the flow when trade copying gets many retail clients to do the same trades. This can generate very large spurts of individual tickets that are hard to process.”

Bech insists there is no systemic risk posed by a business that exacerbates an existing issue about the herd mentality of traders. “The size of our trading community is tiny compared with algorithmic trading, for example. Therefore I cannot see copy trading having any impact on the broader markets.”

Other social trading sites already offer trading across asset classes and although FX might have the broadest appeal to the novice trader, the trend extends well beyond this asset class.

“With the lowest volatility of all instruments on a cash basis, currencies are the most conservative asset class available, you can't lose as much by betting on the wrong currency as you can betting on the wrong stock,” says Nembrini. “The reason currencies can have a bad reputation is the access to leverage, with retail shops allowing trades to be levered up by 100x or more. This makes it far more speculative. But the markets themselves are relatively easy to read as currency trends last for months if not years."