Imitative trading strategies are becoming more common and are used by retail investors to tap the experience and knowledge of more experienced traders in the hope of generating good returns.
The IOSCO report very helpfully delineates three separate types of imitative trading strategies, while nothing that many regulators do not differentiate between these mainly because they are “not widely offered by market intermediaries in their jurisdictions.”
| Copy trading | Allows a trader (copy trader) to copy trades executed by one or more other trader (lead trader). Trade execution is frequently automated with trades opened and closed without manual intervention and without the copy trader necessarily being aware of each trade placed. Some manual intervention may be possible in this model however and the copy trader tends to retain some agency over the trading. |
| Mirror trading | Unlike copy trading this is a fully automated trading strategy based for the most part on programmed algorithms. A mirror trading account automatically copies all trades of the selected lead trader with no involvement from the copy trader after selecting the lead trader(s). |
| Social trading | Less formalized copying of the trades, usually involving social media or online communities. Generally not automated, with the copy trader making a decision whether to execute any trades or recommendations. |
IOSCO’s research points to the fact that there are definite benefits to traders stemming from these strategies. They include much higher retail trade participation and financial inclusion. They can also act as an educational tool, allowing inexperienced retail investors to observe and learn from more experienced traders and also gain a better understanding of the trading behaviors of “other market participants with similar risk profiles.”
As governments around the world attempt to replicate the vigorous strength of the US capital markets with their extensive retail investor participation, there may well be reasons why, as a matter of policy, trading strategies such as this could be seen as those that should be encouraged as a matter of policy.
The additional potential benefits are not inconsequential and include:
- improved returns;
- access to more sophisticated investment strategies;
- investment and asset diversification;
- less expensive alternatives to advisors and portfolio managers.
However, the IOSCO report also draws attention to the potential risk of significant investor harm associated with these strategies:
| Risk | Description |
| Misleading disclosure / lack of transparency | If a formal link exists between copy and lead trader there is a potential for the lack of adequate information being passed on about risks, costs, potential conflicts of interest as well as remuneration structures and use of the personal data of copy traders. |
| Poor investor outcomes / excessive risk taking | Copy-trading generally creates an environment where more risk is taken and risk-taking is normalized as entirely positive. |
| Mis-selling | Copy trading is usually promoted as simple and profitable, but it may be anything but if the lead trader is engaging in complex trading. In some instances lead traders can promote themselves by using falsified returns. |
| Misleading presentation of lead trader qualifications and experience | This is a particular problem if the lead trader has been added to a market intermediary’s platform, which is consequently read as an endorsement of their knowledge and experience by the copy traders. |
| No or inadequate assessment of suitability | Copy traders may choose to follow trades that are completely unsuitable for their investment objectives or risk tolerance and, in particular, their capacity to bear losses. |
| Conflicts of interest | Lead traders put their interests ahead of those of copy traders – particularly in connection with selling complex or volatile products such as CFDs, crypto or illiquid securities. |
| Unannounced and unexpected changes to trading strategies | Lead traders can change their strategies with no or at short notice and copy traders who follow these automatically can find themselves exposed as a result. |
| Frequent trading / high turnover ratios | If the lead trader engages in frequent trading this may quickly erode the funds invested by the copy trader. |
| Timing and pricing risks | In cases of lead traders having a large enough following to move the asset price the copy trader may be exposed to much higher or lower prices than the lead trader whose strategy is being replicated. This is a particular issue with illiquid securities where the number of followers required to move the price may not be very high. The lead trader can then take advantage of the price momentum, while the copy traders lose out. |
| Operational risk | Technical problems, security vulnerabilities and potential inherent bias are all issues that can affect online trading platforms and algorithms. |
| Enforcement challenges | Identifying the perpetrators of market abuse becomes more challenging and lead traders who are located in offshore jurisdictions may be difficult to pursue by regulators and law agencies. This means that recourse for copy traders may be very limited. |
There is support from IOSCO members for, at the least, the introduction of some definitions to enhance regulatory clarity as well as some targeted rules associated with some types of financial products (CFDs) that are frequently marketed in copy trading practice and draw in investors who would normally not consider highly complex or leveraged products.
In terms of regulating market intermediaries who are involved in copy trading practice the current regulatory landscape is a patchwork with some jurisdictions far ahead of others in terms of implementing a formal supervisory regime. However, rules and regulations, where they exist, are, not unexpectedly more mature. The biggest issue for regulators is the frequent cross-border nature of this activity with lead traders located or positioned in jurisdictions where they are not registered and where their activities remain completely unsupervised by local authorities.
This is an interesting report because it seems to be demonstrating that a parallel trading eco-system, one that does not necessarily involve advice from firms and is facilitated by the now ubiquitous online trading platforms is beginning to coalesce.
This is important because it has implications not only for policy, but also for commercial and compliance strategies at financial services institutions. Financial markets are constantly evolving and the availability of automated tools underpinning these trading strategies is a potentially important development and could signal an area that might experience rapid growth that could replicate the trajectory followed by ETFs and passive investment strategies following their launch more than 30 years ago now.
