One of the key factors behind the recent stock market surge, which has propelled the S&P500 up 72% from its March 2020 lows, has been the growth of online trading platforms which have allowed millions of new retail investors to have unrestrained access to financial markets. Lax regulation has been a major contributor to their meteoric rise, begging the question of whether these platforms should face greater regulatory scrutiny.
Many of the online trading platforms which have experienced rapid growth in retail investor volumes charge zero commission. Attracting more investors, no-commission trading increases liquidity in capital markets so the risk that investors are unable to quickly convert assets to cash without reducing prices (liquidity risk) falls. If liquidity risk falls, the overall market risk level reduces. Because expected return, equivalent to the cost of capital to firms, and risk are positively related, a decrease in risk reduces the cost of capital for firms. Therefore, firms will be able to raise more capital at a lower cost, which aids their growth prospects. Given the significant benefits that online trading platforms bring, there seems little need for regulation
However, there are significant concerns over retail investor exploitation. This is particularly prominent for online platforms selling derivatives such as contracts for difference. These trades are zero-sum, meaning that one party can only gain at the expense of another, so there is zero net benefit. Derivatives platforms know that most retail investors usually enter the losing side of a trade, so they take the other side, a position from which they are likely to profit. The firm’s profits are inversely proportional to retail investor losses, so there is a strong incentive to maximise their loss rate by encouraging them to enter into trades that the firm knows that they will lose. This is further assisted by significant information asymmetries. Many retail investors are not knowledgeable about the specifications and risks of the derivatives they are trading, whilst the platform employs experienced traders who fully comprehend both. The duty of the regulator is to protect consumers, and these exploitative practices seem to justify intervention.
The authorities have made some progress regulating these platforms. The UK’s Financial Conduct Authority has recently banned UK platforms from allowing retail investors to trade cryptocurrency derivatives, due to the extreme complexity and volatility of the underlying assets. This change is expected to prevent retail investors nationwide from losing 53 million GBP in 2021. Additionally, the advertisements must now explicitly disclose the probability of consumer losses, which tends to be around 80%. Regulators also actively warn investors about certain assets, for example the FCA stated that bitcoin investors ‘should be prepared to lose all their money,’ although such warnings are arguably far less effective at persuading investors to modify their behaviour compared to outright bans. Thus, while regulation is being implemented, no-commission trading is still a relatively new phenomenon and it will naturally take time for regulators to adapt. As such, further regulation can be expected and these activities may be curtailed further.
The rise of online trading platforms has the potential to bring significant benefits to financial markets, but as most users of these platforms tend to be inadequately educated on investment, there is a significant chance they can be irrational and fuel bubbles. Regulation to improve information provision for retail investors could improve their rationality and decrease this likelihood, particularly for derivatives trading platforms. Overall, whilst some progress has already been made, consumers are still not fully shielded from excessive risks and exploitative practices, so further regulation is required.
By Jon Garner
Sector Head: Jackson Philips