Black Swan Partners & Reed Smith Social Trading & Marketing Seminar

Mirror Trading and Social Media Marketing – Regulatory and Business Risks

Reed Smith and Black Swan Partners

February 2013

Robert Falkner

Reed Smith

[email protected]

Dominic Crosthwaite

Black Swan Partners

[email protected]

r e e d s m i t h . c o m February 2013 i

Table of Contents Page

Social Media Marketing and Social Trading ..................................................................... 1

Mirror Trading: Social Media Marketing Regulatory Issues ............................................. 7

Consequences of Contravention. ................................................................................. 7

UK Regulation. ............................................................................................................. 7

Regulatory Risks. ......................................................................................................... 9

Mirror Trading: Regulatory Issues .................................................................................. 15

Consequences of Contravention. ............................................................................... 15

The UK Regulations. .................................................................................................. 15

FSA Jurisdiction. ........................................................................................................ 16

Regulatory Risks. ....................................................................................................... 17

Appendices .................................................................................................................... 18

Reed Smith..................................................................................................................... 18

Black Swan Partners ...................................................................................................... 19

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r e e d s m i t h . c o m February 2013

Social Media Marketing and Social Trading

Is social trading the next big thing or just another marketing channel for the retail

derivatives industry and how is social media marketing going to develop in this sector?

We believe that the impact of social trading could be significant however the role of

regulation may be decisive. The business model of less sophisticated investors

following leaders on social media networks has inherent risks. The current regulatory

regimes in the UK and elsewhere do not clearly address this model but if it enjoys

success it is certain that the regulators will catch-up. The industry should be sensitive to

balancing the risk of rigorous compliance halting business growth against the longer

term risk of a light touch compliance attitude leading to adverse regulatory intervention

with the same outcome. This paper gives a summary of the business model concept

and the social media challenges and identifies some of the regulatory issues which

need to be considered.

Rob Falkner Dominic Crosthwaite

Reed Smith Black Swan Partners

February 2013


SEE MARKETS DIFFERENTLY

JANUARY 2013

SOCIAL MEDIA MARKETING: OVERVIEW

SOCIAL MEDIA CATEGORIES

• Micro blogging

• Crowd sourced content

• Social networks

• Picture sharing

• Video sharing

• Business networks

• Reviews & Rating

• Social bookmarks

The Conversation Prism: By Brian Solis & JESS3


BASIC FACTS: MAIN PLAYERS

Founded Registered Users Registered UK Users Total Active Users

LinkedIn 2003 200,000,000 10,000,000 160,000,000

Facebook 2004 1,000,000,000 33,000,000 1,000,000,000

Twitter 2006 500,000,000 10,000,000 200,000,000

Tumblr 2007 168,000,000 8,400,000 120,000,000

Pinterest 2010 25,000,000 500,000 10,000,000

eToro 2007 2,000,000

Note: Where not published, UK figures based on BSP Estimates

Facebook ‘Likes’ (Endorsements by users - Jan 2013)

BASIC FACTS: EXAMPLE METRIC

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000


Be the conversation AND comply with financial regulations

Take advantage of recommendations made by friends that are not classified as financial promotions

CHALLENGES FOR CFD/FX COMPANIES


‘Compete’ or ‘partner’ with the companies designed to disrupt



Respond to the changing world of search

• 2009: 25% of shoppers started research for an online purchase on a search engine like Google and 18% started on Amazon*

• 2012: 13% of shoppers started research or an online purchase on a search engine like Google and 30% started on Amazon*

Your company needs to be in the search owners environment

* Forrester Research


Find the categories that work for you, the tools within it and be part of the conversation

Your

Business

Multiple

Conversations

The Tools


REGULATION AND SOCIAL MEDIA

Each category has a conversation

Each conversation has its own tool

Each tool has its own regulatory approach

The Conversation Prism: By Brian Solis & JESS3


Mirror Trading: Social Media Marketing Regulatory Issues

The rapid growth of marketing through social media sites generates significant

opportunities for the retail derivatives market.

But do we understand what this means in terms of legal ramifications. Features of

social media with broadcast and followings, interactive collaboration and search

through social media site links in the highly regulated financial services sector raise

immediate regulatory compliance issues.

Consequences of Contravention. Contravention of the UK FSMA financial

promotion restriction is a criminal offence. From a commercial perspective, an

investment transaction is unenforceable against a person who enters into it as a

consequence of an unlawful communication. There is provision for firms to appeal to

the courts’ just and equitable discretion to enforce contracts but this is not something

that could be relied upon in the normal course.

UK Regulation. Marketing communications which constitute “financial promotions” in

the UK are unlawful unless they are made or approved by an FSA authorised/regulated

firm or an exemption applies.

A marketing communication is a financial promotion where the communication is made

in the course of business.

This means that the communicator must have a commercial interest in the matter, as

opposed, for example, to recommendations made by friends in a social group to each


other for no financial gain. Someone who sends trading signals in return for fees or a

commission will have a commercial interest.

To be a financial promotion a marketing communication must also be an invitation or

inducement to engage in investment activity.

Information or image only communications do not constitute invitations or inducements;

there must be an added element that seeks to persuade the recipient to enter into an

investment transaction.

Search links, banners and logos on their own will not constitute invitations or

inducements. There is only a financial promotion where there is accompanying content

which seeks to persuade investors to take steps to execute investment transactions.

Simple statements such as 'these are links to brokers' or 'click here to find out about

markets” or “we provide links to all the big exchanges' will not amount to inducements

to invest.

Where a data supplier or trader merely presents transaction execution prices of

investments, whether historic or real time, this purely factual information will not be an

inducement. Nor will adding contact details to such prices make them invitations or

inducements to engage in investment activity. However, any additional wording seeking

to persuade persons to connect to brokers so that they may buy or sell such

investments at or following the real time prices displayed will amount to an invitation or

inducement and therefore will be a financial promotion.

Performance tables showing the past performance of investment managers or traders

on social media networks determined by the application of pre-set criteria will not, in

themselves, be inducements. But if the tables are accompanied by, or presented or

provided in a way that they are, an actual or implied recommendation that a particular

manager or trader’s performance should be followed by entering into like transactions,

they will become inducements and therefore financial promotions.

There are only very limited exemptions for electronic communications in this context.

Generic promotions which neither identify a particular investment (only a general

class of investment products – e.g. FX as an asset class) nor identify a person that

conducts investment business. The exemption will not apply if it refers to any person

who may arrange, recommend or execute transactions.

Mere conduits, typically news sites, that communicate the financial promotions of other

persons are exempt. The exemption does not apply to the person who causes the mere


conduit to make the communication. It only applies to the mere conduit if (a) it exercises

no control over the content of the communication: and (b) the principal purpose of the

mere conduit is to receive and transmit other person’s communications.

Regulatory Risks. The principal regulatory risks than can be identified in relation to

social media marketing are first unregulated social network platforms carrying

marketing communications which are not approved by an FSA authorised firm or

exempt. The marketing communications of any social network platform wherever

located in the world will be subject to FSA regulation to the extent those

communications have an effect in the UK – that is- if they are acted on by UK clients. If

there is a contravention of the financial promotion restriction resultant investment

transactions may be unenforceable.

Second, where social media sites promote social interaction there is a risk that

broadcasts or chat messages from top trader or leaders (who receive fees or

commission for trades made by followers) are sent to encourage followers and so may

be characterised as financial promotions but which are not approved by an FSA firm

and therefore unlawful.

Third, there is a risk that marketing communications from or approved by regulated

firms (social network platforms or execution brokers) are considered not to be COBS

compliant, or not - “fair clear and not misleading”. For example information about top

trader performance may be misleading because performance on open positions is not

included. Adequate risk warnings are another area where there may not be COBS

compliance. Are risks about a leader taking larger risks after enjoying initial success

and then making significant losses which wipe out followers adequately disclosed? Is

there enough information about the make-up of past performance sufficient for followers

to understand the risks and that there are no guarantees that past behavior and

performance will be indicative of future results?



JANUARY 2013

SOCIAL TRADING: OVERVIEW

WHAT IS SOCIAL TRADING?

Constituent Parts:

• Clients (social)

• Technology (network)

• Trades (signals)

• Broker (execution)

The final element is:

• ‘humanisation’


THE PROVIDERS

Algo

Signals

Networks

Network & Broker

HISTORY OF THE MARKET

‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13

2005 Metaquotes launches including EAs

Tradency launches

2007 ZuluTrade launches

2008 Currensee and eToro launch

2009 Ayondo launches

2010 eToro launches Open Book

2011 eToro release Copy Trader

2012 FX Junction and ZuluTrade launch copy trader

Oanda launch FX Unity, Tradeo goes live

Metaquotes launches signal copy trader

2013 Alpari goes live with FX Junction

Markets.com launches social trading with Sirix


SIZE OF THE MARKET

• The global CFD and FX

market is estimated to be

close to USD$8 billion

revenue per year

• Social trading, excluding

MT4 EAs estimated at $40m

per year

• Accounts for close to 0.5%

of annual revenue

Note: Excludes revenue generated within existing brokerages

AN INTERNATIONAL MARKET

A different regional distribution of clients

Social Trading

CFD Provider

FX Provider


MARKET TRENDS

• Existing CFD/FX providers launching social trading white label

partnerships

• Regulatory solutions to social trading / investment networks

• Continued humanisation of trading solutions

• Increased price transparency and sensitivity from followers

• The empowerment of the network

WHY DOES IT FEEL DIFFERENT?

vs.


A CUSTOMER EXPERIENCE

1. Open an eToro account. (You can login using a Facebook a/c)

2. Deposit with debit card

3. Never see a trading screen

4. Pick up to 5 people

5. A maximum of 20 clicks

6. Check it every few weeks/months

Up 20% and down 9% and still paying 3pips on EUR/USD

20 clicks = 1,500 trades



Mirror Trading: Regulatory Issues

The model of unsophisticated investors following leaders has inherent risks. The

current financial services regulations in the UK do not clearly address this business

model or risk but as it grows it is certain the regulators will pay more attention.

Consequences of Contravention. Compliance with the regulations matters

because if it is determined that a firm is undertaking a regulated activity and is not

authorized and regulated by the FSA it is a criminal offence. From the commercial

perspective, the matter of most significant importance for execution brokers is that an

agreement made by a person undertaking a regulated activity without FSA

authorisation is unenforceable against the investor (subject to the just and equitable

jurisdiction of the court) and the investor is entitled to be put back into their original

position. Further an investment transaction is unenforceable against a person who

enters into the transaction as a consequence of something said or done by any person

in the chain leading up to the transaction undertaking regulated activity without FSA

authorisation.

On the other hand where a firm is FSA authorised but does not have the correct FSA

permissions, for example the person is authorised for the activity of arranging but is

found to also be undertaking the activity of managing or advising, then that of itself

does not render the investment transaction unenforceable – although there may

however be an associated breach of FSA COBS rules which provides the investor with

a basis for a claim and could lead to FSA (from 1 April 2013 FCA) disciplinary action.

The UK Regulations. The most relevant regulated activities in connection with

mirror trading are (a) arranging (bringing about) deals in investments or making

arrangements with a view to transactions in investments; (b) advising on investments;

and (c) managing investments.

With respect to “arranging (bringing about) (or arrangements with a view to) deals in

investments” arrangements must be such that they bring about, or would bring about

the relevant transaction. A person arranges if his involvement in the chain of events

leading to the transaction is of sufficient importance that, without such involvement, the

transaction would not take place.

Social network platforms that make technical analysis available, facilitate the selection

of trading strategy applications or top traders and facilitate connection to transaction

execution services are carrying on the regulated activity of arranging.


With respect to “advising on investments” this activity is the activity of giving “advice on

the merits of…buying [or] selling…an investment,” . Giving a person generic advice

about investments (for example, invest in FX rather than gold) is not a regulated activity

nor is giving information as opposed to advice

Recommendations or guidance about trading strategy applications or trading algorithms

does not actually constitute advice on an investment’s merits but whether trading

signals constitute trade recommendations and therefore advice has to be considered.

On one view the publication of trade execution information (a trading signal) which an

investor may elect to follow or not is simply the publication of information and not a

recommendation on merits. But this view may not prevail where there is chat between

investors and top traders on social network sites about the trader’s strategy etc. Social

network platforms will have to consider whether they may be held responsible for this

activity or the individual top trader will be or both?

With respect to “managing investments” a person must exercise discretion. Further the

discretion must also be exercised in relation to the composition of the investments

under management and not in relation to some other function. Trading signals of a top

trader is just the communication of real time transaction execution data but could

automatic following without a last look function constitute managing investments?

On one view, a social network platform only acts as a conduit hosting software

applications and processing real time execution data that is received. But where the

investor relies on a top trader acting as an agent for a social network platform to select

transactions which will in practice be automatically executed in the investor’s account it

may be that this activity will constitute managing investments by either or both of the

social network platform or the top trader.

FSA Jurisdiction. The online mirror trading market is international such that which

country’s regulations may apply has to be considered.

Generally the characteristic place of performance determines where a regulated activity

is undertaken. Countries interpret this concept differently. In the UK arranging and

managing investments is usually taken to be carried out where the arranger or manager

is located. Advice is usually treated as being provided where the recipient is located. If

the service provider and its host servers are located outside the UK then it can

reasonably contend that although it may be undertaking the activities of arranging or

managing investments it is not doing so within the jurisdiction of the FSA. In addition

the Overseas Persons exemption may apply where the firm does not maintain a


permanent place of business in the UK. An overseas person does not carry on the

regulated activities of arranging if the relevant investment transaction is entered into by

the client with an FSA authorized firm.

In addition those firms that are regulated in other EEA countries, such as Cyprus, will

probably have obtained MiFID passport rights to carry on regulated activities in the UK.

Regulatory Risks. As with social media marketing the first risk that can be identified

is that of unregulated social network platforms operating in the UK being characterised

as “arranging” transactions with the consequence that resultant transactions are

unenforceable.

In addition top traders making broadcasts or sending chat messages may render their

signaling activity a regulated activity of arranging, managing or advice with the

consequence that resultant transactions entered into by followers or copiers may be

unenforceable.

Secondly, those social network platforms that are regulated may fail to adequately

assess appropriateness in relation to their users who blindly follow others. Do the users

have the necessary experience and knowledge to understand the risks involved in

selection of trading strategy applications and top traders?

There is also an issue of churning. Where either trade signals are characterised as

trade recommendations or where automated trade execution on following top trader

signals are characterised as managing investments – in either case- there is a risk that

the top trader may over trade to generate fees from followers rather than to achieve

trade performance.

Lastly there is the rogue trader risk. What is the exposure of service providers where a

top trader suddenly assumes spectacular risks with the result that all followers monies

are lost or seeks to manipulate the market – what control do firms exercise over top

traders, leaders, gurus etc. with respect to sticking with past strategies or with respect

to broadcasts or interactive chats by top traders with followers? It is also noted that

regulated execution brokers in the EEA are generally expected to monitor client orders,

including those generated by trading algorithms, and ensure compliance with

exchange/trading platform rules and market abuse rules.

February 2013

Appendices

Reed Smith

Reed Smith is a global relationship firm with more than 1,700 lawyers located in 25 offices throughout the United

States, Europe, Asia and the Middle East. Founded in 1877, we represent leading international businesses, from

Fortune 100 corporations to mid-market and emerging enterprises, and have been ranked 2nd as “International Law

Firm of the Year” two years in a row at The Lawyer Awards.

Reed Smith has more than 300 practitioners based in London. We pride ourselves on big firm expertise coupled with

a long-standing commitment to quality, teamwork and professionalism. We represent large listed companies as well

as mid-market and emerging companies and successfully represent our clients in a broad spectrum of legal concerns.

Two-thirds of our work has a cross-border dimension and firmwide clients include financial institutions, media, energy

and pharmaceutical companies, manufacturers, technology companies and innovators, healthcare providers and

insurers, communications companies, universities, real estate developers, and government bodies. We have a very

strong reputation for client service, a notable string to our bow for which we regularly receive public endorsements,

including our recent ranking in Legal Week’s Client Satisfaction Report as one of the best legal advisers for the third

year running.

Robert Falkner

Partner

[email protected]

London

T: +44 (0)20 3116 2980 F: +44 (0)20 3116 3999

Education

University of Cambridge, Sidney Sussex College, 1985, LL.M.

University of Cambridge, Sidney Sussex College, 1984, Evan Lewis Thomas Scholarship

Victoria University, New Zealand, 1984, LL.M.

Victoria University, New Zealand, 1981, LLB, Hons

Overview

Robert's practice covers domestic and international financial services. He

specialises in litigation, regulatory enforcement defence work, general

regulatory and compliance advice in the securities, derivatives, commodity and

foreign exchange markets.

Robert joined the London office of Reed Smith as a partner in 2009. Prior to

that he was a partner in the London office of a US firm for five years and

before that he was General Counsel for, and a director of, Cantor Fitzgerald

February 2013

Black Swan Partners

Black Swan Partners www.blackswanpartners.co.uk is a specialist retail derivatives and FX consultancy. Founded in

2008, we offer consultancy and data analysis services to exchanges, banks, brokers and gaming clients. The directors

of Black Swan Partners have more than 40 years of collective sector experience and a unique range of expertise in

business planning and development, product strategy, research, data analysis, regulation and technology.

Our consulting offering is centered on three core service offerings:

Business - establish new CFD/FX projects or divisions within existing businesses and address market trends.

Technology - specify technology requirements, determine implications and implement new projects.

Regulation - understand the business implications of regulation and implement compliant solutions.

Black Swan Partners is results driven and has produced clear deliverables and innovative solutions for a broad range

of clients, including some of the leading financial services companies in the market.

Victoria University of Wellington, New Zealand, 1978, Sweet & Maxwell Prize in the law of Contract

Professional Admissions / Qualifications

New Zealand

England and Wales

International (broker-dealer) and eSpeed International (electronic markets) and

their European and Asian affiliates for nine years. He was responsible for

legal, compliance, tax, company secretarial and risk matters arising in Europe

and Asia. Before joining the Cantor Fitzgerald group, Robert was a partner in

both the Litigation Department and the Antitrust Department of a leading UK

law firm where he acted in numerous securities, banking, insurance and

antitrust litigation matters, including the Bank of England Board of Banking

Supervision Barings Inquiry and for the SIB (the FSA predecessor) in various

regulatory enforcement proceedings. Robert dealt with antitrust actions before

the High Court and European Commission.

Employment History

2009 - Reed Smith

2004 - Morgan Lewis & Bockius - Partner

1995 - Cantor Fitzgerald International - General Counsel EMEA

1990 - Norton Rose - Partner

1985 - Norton Rose

http://www.blackswanpartners.co.uk/

February 2013

Dominic Crosthwaite

Founder/Consultant

[email protected]

London

T: +44 (0)20 3176 0090 W: www.blackswanpartners.co.uk

Overview

Since 2008, as a founder of Black Swan Partners a consultancy and data

analysis company Dominic has worked in the derivatives, FX, CFD and

exchange sector working on projects for clients that include LMAX, NYSE

Euronext, Eurex and Paddy Power Trader. His experience includes setting up

and running regulated and non-regulated start-up businesses.

Dominic was previously a Partner and Managing Director of Cantor Index,

owned by Cantor Fitzgerald LLP, running the spread betting, fixed odds and

sports exchange business.

He joined Cantor Index as a Business Analyst and was instrumental in the

development of Cantor FFO, the white label financial fixed odds platform

used by Ladbrokes, launched Cantor Spreadfair the first retail derivative

exchange and developed Cantor’s Spot FX product.

Before Cantor he worked at US based consultancy The Hackett Group

(answerthink). He is also an investor in Goddard Global, an issue advocacy

company, specialising in social media and coalition building. Dominic has

over 30 assigned patent applications and 12 granted patents in his name,

including the first real-time regulated online account opening system.

Employment History

2008 – Black Swan Partners - Founder

2006 – Cantor Index - Managing Director

2001 – Cantor Index - Business Development

1997 – The Hackett Group (answerthink)

1996 – BSMG Worldwide, UK

Black Swan Partners & Reed Smith Social Trading & Marketing Seminar

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