“[Critics] argued that derivatives trades caused unnatural price fluctuations not related to fundamentals, were merely a form of unproductive gambling that did nothing for the economy, and were a means for [market makers] to manipulate share prices.”
What does this sound like to you? Perhaps it describes the response to Robinhood and the Gamestop short squeeze which took place in early 2021? Or maybe it’s a broad overview of the regulatory ire unceasingly directed at the CFD sector over the past decade?
To spare you further suspense, it’s a short summary of some pamphlets issued against derivatives trading in the UK during the early 1700s.
From pretty much the moment a cohesive stock trading industry took shape in the City of London in the late 1600s, market makers – known as ‘jobbers’ – sprung up that engaged in the buying and selling of shares.
In many instances, ‘investors’ wanted to speculate on the price of a share without actually owning it. Market makers realised they could facilitate this process by creating cash-settled contracts, often traded on margin, which involved paying the difference between the price at the opening of the contract and its close. Sound familiar?
In 1734, the ‘Stock-Jobbing Act’ was introduced in parliament that proscribed derivatives trading. It didn’t work and further legislation was introduced in 1746 and 1756 to “more effectually prevent the infamous practice of stock-jobbing.” These new pieces of legislation also didn’t work and derivatives trading continued to be a mainstay of life in the City of London.
Today’s CFD workers may take solace in all of this. Not only is regulatory and societal disdain for their work hundreds of years old, but the industry has managed, in some shape or form, to continue existing for most of that period. But the reason I bring this up isn’t to make you all feel better about yourselves.
At the end of last week, ESMA released a new report on investor protection policies. A big part of the document, another fun piece of bureaucratic finger wagging, is concerned with ‘gamification’ techniques. These are apparently being used by brokers to get people to trade more.
What is gamification? According to ESMA:
“Gamification techniques add games or game-like competitive elements to non-game contexts such as financial services.”
Looking at CFDs, it seems err…really obvious that these would be ‘gamey’ products? This is an industry that has its roots in spread betting and was regulated for over three decades under gambling legislation, not financial services laws. Worrying that high leverage CFDs are ‘gamifying’ investing thus seems a bit like wandering into an arms dealer expo and expressing concern that the AK-47s being sold may be used to kill people – that’s kind of the whole point.
ESMA’s beef appears to be, however, less about the nature of the products on offer and more to do with the technology used to facilitate retail trading, whether in derivatives or cash equities.
Since the start of the pandemic there has been a surge in the number of individuals trading the markets. This has not gone unnoticed by the press, who lost their minds about ‘GAMIFICATION’ after the GameStop/AMC fiasco of early 2021, and began pumping out articles attacking the sector in its wake.
The logic seems to be that:
- Technology is making it easier than ever before for regular people to invest.
- The companies offering these services are ‘gamifying’ that technology to make people invest or trade in a risky way.
There is some credence to these claims but to read the mix of regulatory press releases and gawping, church lady news articles, you’d think that it was an entirely new phenomenon.
In reality retail investors have been sucked into manic trading frenzies in…
- The mid-90s through to the early 2000s, during the Dot Com boom
- The 1960s, during the so-called ‘go-go years’, when franchises were the next big ‘thing’
- The 1920s prior to the 1929 Wall Street Crash
- The 1840s in the UK during Railway Mania
Other instances of retail trading frenzies include the recent Iranian stock market bubble, the tulip mania of the early 1600s, the Beanie Baby bubble of the late 1990s, and Japan’s asset bubble in the late 1980s and early 1990s.
In short, people have been pumping their money into dumb stuff for a long time, without the help of mobile trading apps. And as the quote at the start of this post shows, people have been fretting about this behaviour for as long as it has been happening. Incidentally, probably my earliest memory of the spread betting sector was one of my parents’ friends, a senior executive at one provider (its name rhymes with ‘tai chi’), complaining about new companies making their offering like a gambling product. This was close to 20 years ago.
Nonetheless, there is still a debate to be had about the streamlining of the trading process. Someone making a speculative bet hundreds of years ago would have to physically go somewhere, speak with a real person, and engage in a tangible transaction.
Today you just have to open up your phone and tap ‘buy’. Just to test this, I stopped writing, opened up my phone and went through the process of buying some shares in my ISA. It took about 30 seconds.
That is not by definition a bad thing. Speeding up and simplifying the trading or investment process is what makes your product easier to use. And making your product easier to use is the goal of most companies, financial or not.
That’s why it may be hard to stop ‘gamification’. What critics call ‘gamifying’, may just be an improved user experience. To give a different example, you could say new payment technologies, like Apple Pay or PayPal, make it so simple to buy stuff that they are wasting people’s money and need to be regulated to prevent that from happening. There is some logic to that argument but it’s hard to say what the solution is – for most people it’s just making the payments process faster and easier.
The other reason I find the ‘gamification’ argument a bit dubious is that MetaTrader remains the most popular trading platform for CFD providers. MetaTrader (no matter if it’s 4 or 5, probably also 1, 2, and 3, if those exist) looks like a modded Excel file from Windows 98. This is not a glitzy, glamorous, roulette wheel trading platform that lures newbies into taking a punt on the market.
If the goal is to confuse customers and trick them into doing something moronic, MetaTrader seems like a good option, and it’s one that many CFD providers proudly take advantage of. If your goal is to create a casino-like product that encourages customers to blow all their money on leveraged Dogecoin CFDs, then it doesn’t seem like the optimal platform to use.
Payment for order flow
Another part of the ESMA paper put out last week dealt with payment for order flow (PFOF). Interestingly the regulator said “the Gamestop case” (this is the actual phrase they use) was what put the practice on its radar.
PFOF is something that a small group of loud, very often demented, retail traders obsess over. Along with spreads, trading commissions, FX rates, platform fees, or any other method a broker uses to make money, they see it as part of an evil Wolf of Wall Street, credit default swap conspiracy to try and screw them over. Merely mentioning the first syllable of the phrase is likely to result in your corporate Twitter account being bombarded with hate mail by these strange basement dwelling creatures.
In simple terms, PFOF involves a broker receiving orders and routing them to a market maker. The market maker makes money on the spread and gives the broker a rebate for the order flow it sends.
This does create a couple of potential conflicts of interest. One is that the broker is incentivised to route orders to the market maker which gives them the best commission, rather than the best price for their client.
Proponents counter that:
- The price they get is better than the one available on exchange because of cost efficiencies.
- They have to give a price better than or equal to the one on exchange anyway, in order to adhere to best execution regulations.
Both of these points are fair. The only problem with ‘best execution’ is that it could mean executing within a certain price range, rather than at a specific price. In that case you could meet ‘best execution’ requirements by giving your customer the worst price permitted under regulatory requirements, which doesn’t seem great.
On the other hand, the amount of money involved is often so small that it makes you wonder why everyone is getting so worked up about it, particularly as the alternative is paying a platform fee, widening spreads, or having trading commissions – something the nutcases will also lose their minds over.
For me, the question seems to be fairly straightforward: does PFOF leave you better off than you would be by paying some other kind of fee?
I don’t know what the answer is but my impression is that for someone investing a regular amount of money every month in some boring ETFs, over 20 or 30 years, the difference paid between PFOF or a fixed platform fee probably wouldn’t be that much, and would likely be lower than if you were paying high trading commissions on individual trades. I could be wrong, so feel free to send me hate mail if that’s the case.
What’s more concerning about PFOF, as opposed to nitpicking on the fractions of a penny typically involved, is what it incentivises brokers to do.
PFOF is flow-based. You make more money from customers the more they trade. This isn’t true of a fixed-fee (or percentage-based with a fee cap) model.
As a result, brokers that make their money from PFOF are incentivised to get their customers trading as much as possible, which usually means making dumb decisions and losing money.
Compounding this is the fact you earn more money the more risk your customers take on. Riskier investments, like derivatives or small caps, tend to have wider spreads and so the rebates market makers funnel back to brokers are larger.
This is the reason Robinhood, the PFOF pioneer extraordinaire, makes most of its money in options and crypto trading. It’s also why German broker Trade Republic encourages its users to ‘leverage the market’ or ‘hedge the market’ (translation: ‘YOLO the market’) using a range of high risk derivatives products.
This seems worse than profiting from rebates. An incentive structure which means you’re encouraging people to day trade an AIM-listed Transnistrian oil exploration company with a £1 market cap or gear up to buy call options on Squid Game Crypto Coin seems much worse to me than making pennies, or less, on a given trade.
PFOF is already banned in the UK and some EU jurisdictions. It also seems likely to be banned by ESMA, although the German regulator, you know, the well-respected one which regulated Wirecard, may prevent it from happening. Who knows?
In the meantime, CFD providers looking to ride the PFOF gravy train would be better off going to the US. IG, Plus500, and eToro have all done this and the first two are making a big effort to get into the options trading business there. This seems smart. Options trading is much more widely-adopted there than in Europe, plus PFOF looks unlikely to get banned. It is the Land of the Free, after all.
Have a good week everybody.
Stuff happened:
Plus500 had one of its best quarters ever
