ICQ Log - Talking Points:

What does Investor Protection Look Like in
the Era of the Activist Retail Investor?


Last Updated:  9 December 2021

AUTHOR: Ciara O'Grady, Inoma FinTech Risk and Compliance Professional

Investor protection has been, and always will be, the cornerstone of the proper functioning and integrity of our markets. In this era of growing participation by retail investors in equities markets, many do so in the confidence that the firms they use are subject to the highest forms
of regulation and regulatory scrutiny to ensure that those at the bottom scale of sophistication and experience use our markets with the highest
levels of protection and confidence.
The source of these rules, the European and Irish investor protection rulebook, did not emerge overnight. Instead they have slowly evolved from the original Investment Services Directive 1 through to MiFID in the mid-noughties and the more sophisticated MiFID II in the late twenty-teens. The rules have adapted and changed in accordance with market dynamics, selling practices, scandals, financial crashes and increasing sophistication in market infrastructure aimed at promoting trust, investor confidence, operationally resilient markets for the free and democratised use of all individuals.
With this in mind, looking at the changing face of the retail investor in today’s markets, their purchasing habits, their investment motivations, their investment experience, their younger, more digitally native profile, it’s time to question - Are we entering into a new age of investor protection and more importantly, what should that look like?

Changing Landscape 

The last eighteen months have seen a welcome surge in retail stock investing and investing in alternative assets like crypto-assets, facilitated by easier, democratized access to stock markets through exchanges with lower barriers to participation. The AMF in France published 2  results of a study in April 2020 which reported that purchases in French equities by retail investors increased four fold in March 2020, 150,000 new
investors bought shares in SBF120 for the first time in March 2020 and new investors are between 10 and 15 years younger than “regular” investors in French equities. 3 These insights were generated from MiFID II transaction reports.

Similar trends have been seen across many markets globally and the drivers for the retail investor increase include:

• Surplus cash: The Central Bank of Ireland reported 4 a surge in household deposits while COVID -19 measures were being adhered to, to restrict movements during the onset of COVID-19. It reported a jump of deposits of €3 billion in April and €1.5 billion in May 2021, reaching €135 billions in September 20215. It also reported that retail sales fell by 45% in March and April (cumulatively) 2020. While this
increase was exceptional to the context, it was reported that pre-COVID-19 deposits were already growing at an accelerated rate through 2019. In the current low interest rate environment, investors sought alternative outlets and looked to the markets for a more interactive way of getting a return on their surplus cash, during the period.
• Investment platforms providing economies of scale and scope: with increased time on their hands and more time being spent online and on social media over COVID -19 lockdown periods, investors have taken an interest in the easy and convenient way in which platform providers facilitate access to trading in the stock market. Such platforms have disrupted the market by presenting opportunities to investors to trade at low cost, with low custody fees, in a far more personalised and engaging manner through the user's mobile phone. These platforms have benefited from economies of scale and passport their services across EU borders and are facilitating a surge
in retail investment participation in the EU, US and UK stock markets.
• Fractional share ownership: blue chip listed stock can be expensive and beyond the affordability of many retail investors to purchase whole shares. Investment platforms are now increasingly offering the possibility of fractional share ownership, so an investor can buy a dollar/ euro amount of a share in fractions, including the purchase of less than 1 whole share - enabling far more democratised access
to successful listed stock to the public.
• FOMO: The concept of the “Fear of Missing Out” is centred around a feeling of wanting to be part of a group, event, movement that is being hyped (usually now, on social media) and not wanting to miss out on the action/ opportunity or excitement.
This phenomenon is growing around online trading, where traders are sharing their trading activity and experiences with their online social community and FOMO is being accelerated by their and their peers' returns.

New Risks, Old Solutions

Traditionally, for a newcomer to investing, a brokerage account would be set up, face to face in the room with the Broker. The Broker would take the time to understand the overall financial health of the individual including source of income, financial assets and liabilities, sources of wealth and the investors capacity to bear losses in the future. The Broker would also seek to understand the aims and objectives of the investor
- i.e. whether they are seeking to grow their capital, retain their principal and/ or diversify their financial holdings. The Broker will, through a series of questions, understand the risk appetite and tolerance of the individual and their experience of investing. They will also seek to understand their overall level of knowledge, experience and capacity to understand the risks involved in investing in different products. All of this information is captured in what is called a Suitability Assessment and enables the Adviser to know their Investor better to provide the most suitable advice. Except where an Investor is seeking to invest in complex instruments e.g. some CFDs, derivatives, options, futures etc., Suitability Assessments are not required where no advice is being provided (Execution Only). Fast forward to 2021 where a lot of the retail investing cohort are using investment platforms. They are new to investing and are a much younger age demographic. Most are investing
on an execution only basis (without formal advice) in non-complex products. There is no regulatory obligation on the platform to determine suitability of stock portfolios, to assess capacity for loss of investors which would ordinarily be done through a Suitability Assessment. Without this rich data, some platforms may struggle to assess the capacity of their investor to understand the risks of investing. While many products might be deemed non-complex, given the changing demographic of this new investor it begs the question - is it time for a Suitability-lite Assessment to be undertaken to further enhance protections afforded to this group of retail investors.

Transparency; Presentation of Information and Gamification
A common feature of recent regulatory discourse, in the context of digitalised financial services, is the most effective way to present information, regulatory disclosures and key facts to customers to ensure effective engagement through a mobile application.

MiFID II has various different client disclosure requirements, one of which requires “all information, including marketing communications addressed by investment firms to clients to be fair, clear and not misleading” 6 .One of the key risks with the presentation of information is the risk that it confuses, complicates, contradicts or is otherwise unhelpful or misleading to the investor. It’s important for their protection that they are easily able to consume the pertinent information relating to product features and risks to make an informed investment decision. However, the amount of regulatory disclosures are intense and there is a very real risk of information overload when presented to a client on a mobile screen.

It’s refreshing to see ESMA introduce the possibility in the future of alternative 7 concepts of presentation of information through video, infographics and gamified reward programmes. Lastly, on the topic of gamification, while it might be useful from a behavioural perspective to incentivise the consumption of important information by the investor, global regulators are concerned with its use to incentivise more trading on investment platforms.
While an effective Conduct Risk Framework should identify these risks, ensure mitigants and controls are in place to manage them - many commentators are questioning whether these practices should be legislated against in the pursuit of enhanced levels of investor protection.

Protecting the Activist Investor in a Stock Frenzy
This article must reference stock frenzy episodes as an emerging risk within the investor protection space and the appropriateness of our current regulatory framework to protect the retail investor during such episodes. While this section will not address the market infrastructure nuances to the Gamestop Frenzy, nor the potential and perceived market abuse risks, it will address the investor protection risks that arose.
In February 2021, an activist investor frenzy rallied around the Gamestop stock (Gamestop is a high street retailer in gaming merchandise which saw a drop in financial health between 2014 and 2020). The Frenzy was spun by social media users through various platforms
and Reddit feeds. Users believed there was understated value behind the stock and began to rally behind it and promote it toward the end of 2020. Wall Street on the other hand began to short the stock. On the back of this, activism grew online amongst the retail investing
community. Social media users and investors coordinated to buy and hold the stock in a short squeeze and promoted others to do the same which saw the stock price rise to it’s peak at a price of $483 (the stock was valued at $3 dollars in 2014 and $50 at the end of 2020). From an investor protection perspective this presents various risks. Firstly, questions are raised as to what exactly is the investor protection role and
responsibility of the investment platform in a scenario where an activist investor whose investment objectives are “to stick it to Wall Street '', is incentivised, on a third party media outlet to invest in the stock. At the very least the platform should be warning the investor of the risks of doing so and of the volatility in the market. Secondly, notwithstanding the investment objectives - the high returns being achieved by some investors are not guaranteed to continue and while FOMO will spur on and incentivise investment during the Frenzy, the week that followed the Gamestop peak saw a significant reduction in the share price, whipping out large value in the stock amounting to losses for those who came
late to the episode. Lastly, democratised access to the stock markets has been amazingly scaled through investment platforms, but Gamestop reminded us that they are not immune to disruption. During the Gamestop episode, given the volatility some DTCC members in the US
were subject to a demand for collateral to be posted with the DTTC to increase their backstop against losses. This caused some platforms to limit buy orders in the stock. This was an unforeseen consequence of the episode but a definite emerging risk to uninterrupted market access to be managed for the protection of investors in the future.

Preparing for a more Financially Inclusive Future
There are of course various other emerging risks including those relating to costs and charges disclosures, transparency, unregulated advice, conflicts of interest associated with payment for Order Flow and many more which the current legislative framework needs to be measured against to ensure the benefits of investing for retail investors continue in a safe, resilient and sustainable environment.

All of these market dynamics are currently being considered at ESMA and SEC level. There is an excellent opportunity for consumer advocacy
groups, the FinTech sector and the Investment Management industry generally to respond to a call for evidence on various aspects of retail
investor protection by January 2022. This is our opportunity to participate in the formation of our legislative framework for the future digitalisation of the industry and one which welcomes all innovative solutions to drive the industry forward in the interest of the retail investor community.
Democratisation and increased participation by retail investors in the stock markets is to the benefit of society as a whole. While the future of our financial markets looks to be more inclusive than ever, we need to ensure that we have set the right foundations for resilient, trustworthy
and sustainable growth in our markets.

Lawyer Photo

Author: Ciara O'Grady 

Director - Risk Advisory | Ex-Revolut | FinTech Lecturer

ICQ Winter Edition 2021

This article was taken from the   ICQ Winter Edition 2021