The death of social trading: Conflict of interest results in exit rally; due diligence finds 80% of lead traders to be fake

The lid has been closing on social trading platform providers for quite some time, and its legacy of faddishness has been coined. However, many brokerages have dropped their own social trading platforms this year – Could the conflict of interest be too much of a risk?

During the past few months, FinanceFeeds provided an insight into the increasing lack of viability that took place during the period at which a number of retail FX brokerages were sold the ideology of social trading, when the word ‘social’ prefixed every passing fad in the same way that ‘crypto’ does now, and the letter ‘i’ did in the early part of this Millennium.

Social trading may well have been written off as a fad, a triumph of marketing over substance which generated volume-based commissions for its developers, and which led many retail FX brokers to consider it a tool to increase the confidence of novice traders, whilst paying the social trading provider a pip per transaction in order to generate greater return on investment by extending client lifetime value.

To no surprise whatsoever, social trading is largely a thing of the past.

Three tenets that describe today’s retail traders are self-empowerment, enlightenment and understanding, and the basis of the demands placed upon retail FX brokerages in themajor and well respected jurisdictions of North America, Britain, the Far East and Australia these days revolve around requirements from direct retail traders, not, as was once the case, the dictation of services by the broker to the client.

Retail FX trading is a rare beast in that it embodies not only fluid and instantaneous access to extremely liquid financial markets but it combines this with technological infrastructure which means that it is not just a financial service but a technological and mathematical science.

Today, it is a science which a large proportion of retail traders understand clearly, and, as has been noticed by FinanceFeeds for quite some time, this has led to the passing of the social trading era, which was once a no more an engagement tool to bolster the confidence of novices.

A placebo, in which unaccredited ‘lead traders’ were producing volume for a broker whilst it was not their profession, and in an electronic case of the blind leading the blind, novice traders would feel some degree of comfort as their accounts automatically executed trades following the actions of an equally inexperienced retail customer of an often b-book brokerage.

Examples of the haplessness that began the fate of social trading include OANDA Corporation’s failed attempt at taking its fxUnity product to a wide audience over five years ago. The company is a technological tour de force, yet it brought ruinous R&D costs into the boardroom when it canned the fxUnity proprietary social trading platform a very short time after launch, before then becoming embroiled in the catastrophic purchase of the Currensee social trading network which was wound down and discontinued very soon after its acquisition.

Compare that to the self-directed traders that favor proprietary platforms and are experienced in navigating the markets electronically, and OANDA’s migration of 2,200 Tradestation users onto OANDA’s fxTrade platform last year when IBFX exited the US market demonstrates that the same company could not engage traders on social platforms, but was absolutely able to benefit from the onboarding of astute, self-empowered traders who favor a high quality brokerage environment and proprietary platform.

Since then, pretty much every single social trading platform has shuffled off the cyber coil.

ZuluTrade, one of the original entrants into the social trading arena, was fined by the National Futures Association (NFA) in the United States, just at the time that the future was looking bleak for such services, leading to a very important matter which other regulators that preside over good quality jurisdictions took note of – that this constitutes financial advice, and indeed financial advice provided by private individuals with no license and no responsibility to ensure the customer’s best interests.

In fact, quite the opposite was the case in most social trading business models, in that many b-book brokers incentivized lead traders, experienced or not, to connect as many ‘followers’ as possible to their accounts and reward them for it on a P&L basis.

Britain’s Financial Conduct Authority (FCA), despite its glaringly outstanding shortcomings, is recognized globally as the most prestigious non-bank financial markets regulatory authority.

Indeed, it may well be, as is FinanceFeeds opinion, that its reputation was not earned via its own regulatory and jurisdictional merit, but by the high quality of the companies that operate in Britain, and by Britain’s first class, world dominating business environment.

Either way, whether a byproduct or not, the FCA is the flag that flies over much of the respected element of the retail FX industry, its benchmark status resonating across the globe, including in the all important mainland China, where MAM accounts and portfolio management are the mainstay, and self-directed trader are very much a rarity. In essence, the FCA does it the right way by making the trade leader apply for an asset management license, thus viewing actual trade leaders as financial advisers.

In today’s post-social trading era, those who developed their systems themselves and garnered a loyal client base that appreciate highly advanced proprietary trading platforms and completely integral trading environments as provided by the vast majority of British FX and CFD firms, many of which have been in establishment for three decades, will be the driving force.

This is because said companies made their investment into developing solutions that would engage and retail retail traders which are largely based in their own domestic markets.

A diverging factor is about to drive a massive wedge between firms whose traders are self-directed, and those which do not appeal to large professional overseas portfolio managers, as small scale Western market orientated social trading, already a dying effort, has become a focus of the new MiFID II rulings.

The Financial Conduct Authority already stipulated two years ago that social trading and copy trading is an activity that should require ‘lead traders’ – those whose trades and signals retail traders on copy trading platforms and social trading networks follow – to qualify and be regulated as investment managers.

This ruling, which was made part of the FCA’s regulatory remit in May 2015, has been a very silent ruling, with no companies having been taken to task over allowing unqualified or amateur retail traders to execute trades which are then ‘mirrored’ by an automated system to execute trades on behalf of other traders.

Largely, the focus has moved away from copy trading by regulators, just as it has by large, established companies, as social trading was a fad that rode the ‘social everything’ trend that prevailed in many electronic and online business sectors at the beginning of this decade.

So, if the regulators have diverted their eyes, why did so many firms exit the market recently? Indeed, many stand-alone, third party social trading platforms are now history, but some companies that offer their own have been deleting the product from their range of services.

FxPro is a recent example, its SuperTrader service having been put out to pasture, along with a handful of others which took the same quiet path.

Trasdesocio, an innovative investment platform which operates very much on a social network basis, has waved goodbye to its CEO and founder, and some key staff, and whilst the implementation of MiFID II looms, the conflict of interest has been firmly denoted by the new infrastructure directive.

A question that has very rarely been asked, and is often overlooked centers on how likely amateur traders that gain commission from retail brokerages and social trading providers by becoming ‘lead traders’ are to be able to pass such exams and be in a position to act as an investment manager, and report their activities in such a capacity.

Bearing in mind that the vast majority of such individuals are based in developing market jurisdictions, are not professional traders or wealth managers, and are using social trading platforms in order to gain commission for generating extra deposit revenue for B-book brokers which then use a profit/loss model and split the inevitable losses between introducer, lead trader and brokerage, the exact conflict of interest that the regulators are attempting to remove from the retail market.

When MiFID II is implemented, Article 19(1) will be invoked, which establishes that the overriding obligation for investment firms when providing investment services is to act “honestly, fairly and professionally in accordance with the best interests of its clients”.

Therefore, the European Securities and Markets Authority considers that when a firm offers the possibility to deal in financial instruments which have other products (commodities, financial indices, currencies, etc) as underlying, then, depending on the exact circumstances, it is likely to be artificial, and contrary to the overarching obligation of the firm to act honestly, fairly, and professionally, to make a distinction between advice regarding the underlying products of a financial instrument and that financial instrument.

In this situation, the underlying product of a financial instrument and that financial instrument should be regarded as a whole and any personal recommendation, for example, about the underlying product should be regarded as investment advice within the meaning of MiFID.

The developing market presence of so many ‘lead traders’ has led to not only a conflict of interest between client, lead trader and brokerage, and between brokerage and social trading provider, but also to a conflict of interest between regulators which oversee the activities of brokerages in their jurisdictions, and the services deemed to be financial advice by such regulators, that are being carried out by unregulated lead traders in developing markets outside any regulatory jurisdiction, whose intention is to rake in the commissions for either massive leveraged volume, or from customer losses.

Regulatory discussions on this matter  by law firms and auditors in Europe have concluded that approximately 80% of ‘lead traders’ are not really traders, but retail customers who have been converted from cold leads by brokerages and then told that they can earn more by others following their trades.

Indeed, MiFID II has no provision for this, and will stipulate that third country service providers would need to be licensed, but licensed by who? There is no such financial advisory license for social trading in any developing market nation, thus it falls through the regulatory net.

The United States was able to take a social trading fraudster to justice, as reported by FinanceFeeds in May, when a company named 2waytrading, which offers stock trading tips and investment advice, with the focus of operations being on options trading, had its assets frozen by the SEC.

The self-proclaimed “lead trader” and operator of the fraudulent entity is Mohamud Abdi Ahmed, who had already been in jail for investment fraud but hid that fact from the clients of his new company.

2waytrading was set up shortly after Ahmed left jail in 2014 – he lured investors with promises of artificially high returns and claims he had an investing experience of 15 years.

Its perpetrator also had a very interesting command of the English language, addressing those who questioned the rationale behind the high upfront fees with: “U will make it in ur first month.”

Jail sentences and semi-literate attempts to encourage high volume trading are not attributes associated with genuine wealth managers, and the only reason that this scheme was brought to a standstill was because it took place on US soil.

FinanceFeeds research has deduced that the vast majority of small to medium sized retail b-book brokerages derive most of their social trading ‘lead traders’ from India and South East Asian countries such as Malaysia, Vietnam, Thailand and Indonesia.

A notable recent case of fraud involved a ponzi scheme in India run by Anubhav Mittal, along with his company’s CEO Sridhar and technical head Mahesh that operated between 2015 and 2017. They duped Rs 3700 Crore (just over $570,000) from nearly 700,000 people through an online portal

The investors were given web links to click. They were told that the company earned 6 rupees for each click and passed on 5 rupees to them. The more they invested, the more links they got to click.

People were also told that they would get a bonus if they got others to invest. The size of the bonus would depend on the investments they brought in. But the police found the company did not earn anything from the web links – they were just a prop to reassure the investors.

Whilst the operators of this scheme were arrested by police in India’s Uttar Pradesh region, there was no recourse, and there would be even less recourse if the investors had been in a different region, trading with a broker that they trusted as regulated, yet the lead traders were operating this type of methodology.

Whilst this is just one example, it does point to the pitfalls and why the onus is really on the broker rather than a regulator should client interests not be aligned with those of the lead trader and provider.

The abandoning of social trading services by many retail firms this year, and the focus on development of platforms to engage self-directed traders by the larger firms is a dynamic that should serve to future proof any compliance matters of this nature in future.

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