Copy Trading: Assessing the regulatory landscape and licensing requirements
An examination of the regulatory issues associated with copy trading and the licensing requirements that firms may need to comply with in order to offer these trading services.
By Stathis Kyriakides and Alexandros Constantinou
What is Copy Trading?
|Copy Trading is a product of the social trading movement which in its broadest sense is defined by investors’ willingness to share intelligence, expertise as well as actual trading decisions and reasoning. It encompasses sharing of trading strategies and real time flow of trades, carried out on the basis of individual trader choices or effected through robots, algorithms or other purpose build software developed or configured by third parties. Given sharing of trading information, Copy Trading emerged as the logical next step and refers to the practice which allows one trader to replicate the transactions carried out by another. Copy trading may take many forms, e.g. it may be done manually whereby traders actively select the individual trades they wish to copy; however, the term has habitually come to refer to the automated service offered by some social trading platform operators and which allows every position taken by a selected trader to be copied into the trading account of another. Typically, copying traders will allocate a portion of their funds (in their trading account) which will simulate the trade activity of the copied trader. How long this will continue rests at the discretion of the copying trader.|
Beyond the heavily regulated US (and up until now closed Japanese markets) Europe has represented an important destination for operators of platforms offering copy trading. That said, European supranational regulatory authorities are exhibiting increasing ambition in front-running financial market regulation. The EU’s Markets in Financial Instruments Directive (MiFID), which seeks to regulate investment services offered within the Union, represents the legal framework likely to impact the evolution of copy trading. The directive does not specifically address the issue of Copy Trading but it lays down principles which would constitute the basis for formulating any explicit rules.
Regulators are increasingly inclined to interpret Copy Trading as incorporating aspects of Portfolio Management which is a regulated investment service under MiFID (transposed into national law in all EEA countries). We anticipate a similar approach to be adopted by the Japanese regulator who, according to recent unconfirmed publications, is about to issue its first licence to a platform operator offering copy trading services in its jurisdiction. In the US rules governing copy trading have been codified by the NFA for some time; we expect that both European Law and NFA’s rules will continue to affect regulatory interpretation and implementation beyond their respective national borders.
ESMA’s response to a question dated 22 June 2012 (ESMA/2012/382) revealed the likely direction that explicit regulation on Copy Trading will take in Europe. In that response ESMA explains that in a situation where: (i) a service provider gives its clients the opportunity to choose one or more third parties that provide trade signals; and (ii) subsequently to choosing such a signal provider(s) the client authorises the service provider to issue orders on his/her behalf and transform each signal received into a buy or sell order (executed by the service provider or transmitted for execution), without further intervention from the client, the activity qualifies as Portfolio Management.
This is derived by the definition of Portfolio Management under MiFID which requires that a mandate be given by a client to a third party to manage the client’s portfolio/funds, that this is done on a discretionary basis and that decisions are implemented without any further intervention being necessary by the client.
ESMA also notes that where no automatic order execution occurs, because client action is required prior to each transaction being executed, the activity performed will not amount to Portfolio Management; however depending on the interaction with the client, other investment services may still be relevant (e.g. Investment Advice in the case of personal recommendations, and reception and transmission of orders).
According to media publications earlier in the year, it emerged that in a letter to companies operating social trading sites (sent in March 2014) the UK’s FCA communicated positions resembling those articulated by ESMA. It was reported that the FCA asserted that operators of social trading websites offering automatic trade copying may be required to obtain a Portfolio Management licence while those providing trading signals (allowing customers to replicate individual trades) may be required to secure a licence to provide Investment Advice. The FCA is understood to have announced its intention to offer more guidance on the matter soon.
Other European Regulators
Several platform operators facilitating Copy Trading are already licenced, in a number of European Countries, to offer investment services regulated under MiFID. Some have obtained a Portfolio Management licence while some have reception and transmission only. However, some licences obtained by platform operators are not overtly linked to their Copy Trading services, as the matter is not explicitly addresses in European Law (or regulations).
Would all operators be subject to the same licencing requirements? What are the determining parameters?
The licencing requirements of platform operators offering Copy Trading facilities would depend on the nature of the service provided, the method by which the service is delivered, the agreements signed between the interacting parties and the level and nature of interaction among the parties.
For example, although the process of automatically copying one trader’s transactions into the account of another would necessitate issuance of a Portfolio Management licence (see above for rational applied by ESMA), the question of who needs to obtain the licence would depend on how the service is delivered.
Similarly, there are cases where brokers provide for customer-use platforms offering copy trading facilities which are developed and operated by third parties. In such cases, determining whom customers/traders mandate to carry out copy trading would determine who is required to hold a Portfolio Management licence. To assess this one needs to consider:
|1. the nature and form of agreements signed between interacting parties (i.e. the platform developers/operators, brokers and customers (traders));
2. the level and nature of the interaction between the parties including the means by which customers pay fees for the service (who could the customer reasonably assume is providing the service); and
3. the process by which trades are actually copied. It is thus conceivable that regulators could require either the operator of the platform or the customer’s broker to secure a Portfolio Management licence.
It is also possible that under certain circumstances operators of platforms that allow manual copying of trades would be required to obtain a licence for providing Investment Advice. However, licencing obligations would not be trigged if platform operators; (i) don’t make specific recommendations; (ii) don’t actively promote and/or solicit copying of particular trades; (iii) are not seen to actively rank trades on the basis of criteria interpreted as the operator’s recommendation of one over another. It is unlikely that facilitating manual copying of trades would on its own trigger a requirement to obtain a licence for providing Investment Advice.
The aforementioned notwithstanding in nearly all cases operators of platforms offering Copy Trade would likely need to have a licence for brokerage services. In providing Copy Trading, platform operators bring together parties (the trader and ultimately the execution venue which receives the order to execute) for the purpose of carrying out a transaction. New orders are generated into the customer’s account (matching trading signals generated by the copied trader) and these are subsequently transmitted/placed for executio