IOSCO’s report is entitled “Neo-brokers” and defines this subset of brokers as “characterised by providing online-only execution services and by the absence of physical operating branches.” These firms use technology to facilitate services and provide access to financial markets and tend to be “limited to providing only execution services, with very limited or no human interaction” available to retail investors using their services.
The report notes that treatment of such firms varies and that this definition is not one that is recognized in the United States where the SEC and FINRA “generally do not distinguish neo-brokers from other broker dealers.”
The operating model as described is one that will, nevertheless, be easily recognizable irrespective of firm domicile and operating geography. As such the conclusion of the report and particularly the risks highlighted remain useful reference points, particularly for compliance officers who are tasked with ensuring regulatory compliance at such entities.
Young retail investors
The focus of such brokers on younger retail investors as well as their use of social media, finfluencers, and the deployment of various incentives and tactics to attract new retail investors and “stimulate trading activity” among existing retail investors requires some caution by specialist compliance teams in order to ensure that potential risks are adequately managed.
Regulators have taken actions against this type of firm in instances of:
- inaccurate or unbalanced claims about the absence of charges;
- misuse of a regulator’s name or logo to promote products and services;
- finfluencer activity leading to inappropriate investor trading behavior;
- the creation of misleading impressions of risk-free trading through the use of terms such as ‘safe’ and ‘secure’;
- inadequate compliance or governance arrangements; and
- non-compliant regulatory reporting of transactions.
Key potential risks identified by the report are those connected with:
- conflicts of interest; and
- lack of transparency about costs, charges and fee.
The low or zero commission cost structures of online brokers can generate conflicts of interest between firm and investor by encouraging trading activity or the take-up of other services offered by the firm.
| Investor activity | Potential conflict of interest between firm and customer |
| Trade more frequently | Bid-ask spread costs shouldered by the investor and higher trading frequency resulting in potentially lower returns while generating revenue for the firm |
| Utilize ancillary services offered by the firm and related to the trading or holding of assets | No disclosure of the true costs and risks assumed by the investor as a result of taking up the bundled offering with profit and advantage accruing to the firm |
| Use of other firm services to execute the trade | Reduction in transparency, potential additional costs as well as reduced price improvement opportunities on some venues, with revenues flowing to the firm |
| Engage in trading activities that generate other sources of revenue for the broker | Receipt of indirect trading revenue that benefits the firm bottom line of the firm prioritized over trade best execution for investors |
In connection with other sources of revenue the payment for order flow (PFOF) can be a particular problem because it may “potentially affect the broker’s compliance with rules relating to best execution and disclosure of information on costs and charges.” This issue appears to have been dealt with successfully in the US by way of SEC and FINRA rules that require disclosure and centralized publication of fees, rebates and routing reports (see tags below).
The report notes that regulatory views on both the prevalence as well as the impact of PFOF on investors in other jurisdictions appear to be quite varied.
According to the report, the practices itemized above have the potential “to contribute to a lack of transparency on the costs charged to retail investors”. Even in instances where information is disclosed, it “may not always be sufficiently clear to investors.” It appears that FX charges as well as inducements for instant settlement accruing higher fees are particular issues identified in at least some of the jurisdictions submitting detail to IOSCO.
