Social Trading - Implications for Investors and Platform Operators

Josef Bergt
2023

Introduction

In an era characterized by the democratization of financial markets and the proliferation of digital platforms, social trading has emerged as a compelling alternative to traditional investment strategies. Social trading platforms serve as digital arenas where investors, colloquially known as "followers," can observe, discuss, and replicate the trading strategies of more experienced traders, known as "signal providers." While the allure of social trading is undeniable, given its potential for cost-efficiency and lower barriers to entry, it is imperative to scrutinize the complexities and risks that accompany this innovative form of investment. 

Operational Mechanics of Social Trading Platforms

Social trading platforms function as intermediaries that facilitate the interaction between followers and signal providers. Upon registration, followers are granted access to a plethora of publicly disclosed portfolios and trading strategies. Subsequently, they can opt to replicate these strategies, but only after explicitly consenting to automated order execution. Once consent is obtained, the platform forwards the trading decisions of the signal provider to a cooperating financial institution, typically a financial services company or a bank, where the follower's social trading account is maintained. This institution is then responsible for executing the orders and updating the follower's portfolio accordingly. It is worth noting that some platforms may receive a commission for facilitating these transactions, and signal providers may also receive a share of this commission which needs to be transparently disclosed to avoid agency problems.

Variability in Financial Instruments

A salient feature that distinguishes various social trading platforms is the diversity of financial instruments they offer. While some platforms restrict trading to specific financial instruments like Contracts for Difference (CFDs), others offer a broader array of options, including stocks, fund shares, certificates, and leveraged products. In certain instances, the trading strategies of signal providers are securitized into certificates, which are then issued in collaboration with a bank and traded on stock exchanges. This model allows followers to invest in a certificate that tracks the performance of a particular trading strategy, thereby eliminating transaction costs associated with individual investments but introducing issuer risk.

Legal and Economic Implications

For Investors

Social trading is often touted as a cost-effective alternative to professional wealth management. Indeed, the model allows for lower investment sums and potentially reduced fees. However, these ostensible benefits are counterbalanced by elevated risks. Leveraged products, frequently traded on social trading platforms, can rapidly accrue losses and may even result in a margin call for the investor. Additionally, the delegation of trading decisions to a signal provider entails a loss of control over one's own assets. Therefore, meticulous due diligence is essential when selecting a signal provider, including an assessment of their objectives, performance metrics, and alignment with the follower's investment goals.

For Platform Operators

Platform operators must navigate a labyrinthine regulatory landscape. Some platforms function solely as intermediaries, offering no custodial services, which are provided by a regulated custodian respectively depository (typically a bank) while others provide a more comprehensive suite of services, including account management, requiring corresponding licensing. Regardless of the business model, transparency in operations is paramount, and platforms must secure authorization from relevant regulatory bodies within the European Union or European Economic Area.

Regulatory Considerations

Given the complex nature of social trading, regulatory oversight is crucial, depending on the exact services provided. Platforms should ideally offer a range of adjustable risk parameters, such as stop-loss or take-profit orders, and explicitly state any additional costs, like overnight fees for holding CFDs or performance-based fees. Moreover, platforms should be transparent about their criteria for admitting and monitoring signal providers, ensuring that they invest real money and adhere to ethical trading practices.

Key Findings

Social trading platforms have the potential of democratizing access to financial markets but have also introduced a new set of complexities and risks. The operational mechanics of these platforms vary, as does the range of financial instruments they offer. Both investors and platform operators must be cognizant of the legal and economic implications of participating in social trading.

Source: BaFin on Social Trading - Signaling and Automated Order Execution Platforms

Executive Summary:

• Social trading platforms serve as intermediaries between followers and signal providers, each with its own set of financial instruments and operational mechanics.
• While social trading offers cost-efficiency and lower barriers to entry, it also entails elevated risks, particularly with leveraged products.
• Due diligence is crucial for investors, who must assess the alignment between their investment goals and the strategies of the signal providers they choose to follow.