Op-ed: The social trading conundrum

At the dawn of retail FX trading, when the general investing public began to gain its first insight into what had previously been a method of conducting business which was reserved for the long-established institutional trading desks of Chicago and New York, or the centuries-old banks which proliferate London’s vast financial markets economy, the modus operandi was considerably different to that of today.

Despite the vast majority of retail FX firms being less than a decade ago, the entire retail business is no longer recognizable when compared to its original format, which has posed as many advantages as it has obstacles for many companies, and it is a combination of  advantage and obstacle, in the form of how social trading services can help or hinder companies that has perplexed many companies over recent times.

Something of a “me too” approach by many companies in the retail FX sector was adopted at the end of the last decade, when retail brokers whose business model involved operating a dealing desk, not transferring any trades to liquidity providers, and operating a fixed and often high spread on MetaTrader 4 platforms. Under these circumstances, social trading platform providers partnered with such market makers, who in turn added a pip to the spread, serving as a form of introducing broker by default.

This paved the way for brokers to retain customers by providing them with the dubious assertion that by following lead traders, they would be led to profit, therefore increasing lifetime value for brokers, lowering acquisition costs, and ensuring the opportunity for some of the market makers of the time with less than pure intentions to engineer the entire loss of client funds before splitting the artificial spread between social trading provider and brokerage.

This, of course, is a largely defunct practice and in the transition from this model to complete emulation of the institutional sector by the widespread adoption of the agency model and subsequent reduction in margin to that provided by a combination of increasingly astute trader and being unable to fix spreads has resulted in some adaptions by brokers and social trading providers.

By the time the agency model became de rigeur in retail FX, and brokers were having to consider that their profits would rely on the relatively small sum remaining after having paid affiliates, sales staff, media advertising which continued to increase in cost due to competition, and partners such as IBs and social trading firms. With spread down to 0.3 pips on EUR/USD in most circumstances, or even more critical brokers adopting a fee-based model with FXCM’s Japanese operations spearheading this methodology as reported by LeapRate today, and all links in the aforementioned chain driving an ever hard bargain, the question was raised as to how to sustain the entire model.

The answer was clearly that this was not sustainable in its existing format, but brokerages had become overtly reliant on social and copy trading solutions as a means of keeping a trader in action for longer, and as an antidote to rising advertising and client retention costs. Surely it is better to invest in technology to retain existing clients than to have to risk the less than 10% effectiveness of expensive advertising campaigns?

Or is it?

A catch twenty-two situation has arisen among brokers, social trading providers and lead traders in that many regulatory authorities around the world have now realized that financial advisers are no longer a suited gentleman with a brief case who comes to the door of clients with printed material about investments, but instead appear on trading platforms in the form of an icon whose transactions can be followed or automatically copied by retail traders. In the post-social network world, regulatory authorities such as the Financial Conduct Authority and the Japanese Financial Services Agency have begun to realize that this is how financial advice is being provided in the modern world.

The upshot is that it is entirely possible that lead traders may have to become registered as financial advisers, in the same vein as their forebears were in the days of FIMBRA in the 1980s and overseen by the authorities, including be subject to compliance inspection.

Will this put social trading platform providers off providing services to brokers in such jurisdictions? A moot point most certainly surrounds this matter, as these are both regions in which social trading has become an integral part of retail FX, yet with yet more bureaucracy and state interference, it may render the cost model obsolete.

A means of avoiding this could be for social trading platform providers to attempt to tap the Chinese market, where many traders rely solely on either portfolio managers or automated trading systems where a lead trader executes the trades. The downside of this is that China is a nation which is host to numerous very keen traders who operate via IBs and referral agents, all of whom drive a very hard bargain, resulting in very small profit margins for brokers insofar as that compared to in some other markets, a vast amount of volume would have to be conducted in order to render it viable due to lack of loyalty and very high IB commissions.

Some companies have responded to this by performing a total metamorphosis from social trading provision via partnership in exchange for spread percentage, into providers of all-encompassing end to end solutions which integrate the social trading aspect into the actual trading platform, back office solution, CRM and  marketing components, which likely came about in order that these companies can capitalize the entire brokerage technology solution by charging brokers for all of these components rather than relying on narrow spreads and forthcoming regulations on social trading.

In this case, social trading is integral and therefore serves to increase client activity and reduce retention costs, but is not the absolute bread and butter of its provider, who can capitalize a trading platform and full brokerage solution based on volume which is driven by social trading.

Such displays of total revolution as this may go some way toward explaining the increase in venture capital funding which is being provided to financial technology firms, as indeed the entire financial services industry worldwide may be in facing a situation in which it is gaining the vast majority of its innovation and adaptation in the case of changing market conditions from technology providers rather than traditional financial experts.

How times have changed….

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