ESMA communicates supervisory expectations on copy trading services

RegCORE Client Alert | Capital Markets Union

QuickTake

Copy trading has gained considerable popularity in the past decade. The lure of copy trading has increased particularly amongst more inexperienced traders who may lack the requisite knowledge and experience to trade themselves, such that the ability to copy (more) “successful” traders (or those that appear as such) has led to greater retail market participation. While greater retail investor participation in wealth creation through capital markets is welcome, copy trading needs to comply with relevant requirements.

On 30 March 2023, the European Securities and Markets Authority (ESMA) published a 25-page Supervisory BriefingAvailable here.] “on supervisory expectations in relation to firms offering copy trading services” covering (a) information requirements; (b) product governance; (c) suitability and appropriateness assessments; (d) remuneration and inducements; and (e) qualifications of copied traders, as discussed below.

Copy trading refers to the service of trading a client’s assets in a way which copies (or is based on) the trades of another trader.See ESMA, available here.Show Footnote Copy trading services are typically aimed at “retail clients” – to whom investment services are provided – and is usually automated but may also (partially) involve manual based trading of client’s assets. Copy trading service offerings have grown across a number of asset classes both for “traditional financial instruments” as well as crypto-assets. Correspondingly, those persons who copy the trades of the copied traders become the “copy traders” and the copied trader acts as the signal provider to a regulated firm which may execute the trades on behalf of its clients i.e., the copy traders.

ESMA’s Supervisory Briefing updates but goes beyond ESMA’s June 2012 Q&A document relating to the legal definition and categorisation of the automatic execution of trade signals. Accordingly, the Supervisory Briefing sets out ESMA’s and the national competent authorities’ (NCAs) supervisory expectations on the topic and thus serves to ensure effective and consistent application of relevant regulatory requirements applicable to copy trading services. It also serves to foster convergence in supervisory outcomes expected of investment firms, including credit institutions, UCITS management companies and alternative investment funds managers (AIFMs). Interestingly and perhaps quite welcomingly, the Supervisory Briefing includes “indicative questions that supervisors could ask themselves, or firms, when assessing firms’ approaches to the application of relevant MiFID II rules.”Certainly useful, but beyond the scope of analysis in this Client Alert. It is conceivable that these questions may change over time.Show Footnote

While risk and potential investment losses are an intrinsic part of investing in markets, ESMA has long been evaluating how to regulate copy trading. This is largely due to a need to provide recourse for copy traders placing their faith in the copied trader to execute trades with the best possible outcome in mind plus the risk that the copied trader may not be successful. Another and certainly no less important motivation behind the Supervisory Briefing is ESMA’s continued push of contributing towards the development of a convergent supervisory culture across the EU. Further developments to this end are covered and available on our website.

This Client Alert from PwC Legal’s EU RegCORE looks at some of the key legal and regulatory points regulated firms should consider when providing copy trading services. It is very conceivable that ESMA and NCAs will continue monitoring this development and may undertake further steps to ensure that copy trading is provided in a manner that is consistent and applicable with MiFID II’s requirements and that investment services continue to be provided in the best interests of the client.

Differing copy trading models merit case-by-case supervisory scrutiny

The legislative framework relevant to copy trading may be complex and dependent on who is providing what service to whom, where and when. Nevertheless, copy trading services include elements of all of the following legal issues that ideally should be taken into account by those conducting regulated activity:

•    Regulation and licensing of platforms and brokers – specifically the EU’s MiFIR/MiFID II regime but equally the bulk of other “traditional” financial services legislation part of the EU’s Single Rulebook;

•    Laws protecting the privacy and personal data of investors – notably the EU’s General Data Protection Regulation (GDPR) which protects investors’ personal data and how companies may process and store this data. Copy trading service providers, whether platforms and brokers must ensure that they obtain investors’ consent before processing or sharing their data with third parties and to protect it from unauthorised access;

•    Consumer protection laws and policies – including also requirements to ensure copied traders abide by their obligations to not provide false information, commit market abuse and/or not offer investment advice themselves; and

•    Liability issues relating to trading losses – this is important given that when investors suffer losses as a result of copy trading services provided to them, notably when copying trading strategies of others, the question may arise as to who is responsible for the losses. In principle, investors are responsible for their own trading decisions, even if they copy the strategies of others. In some cases, however, the copy trading platform provider or broker can be held liable if such persons violate legal regulations or neglect their duties of care. It should be noted that while the amount of court cases on this point may be limited, those judgments that do exist focus on whether a platform and/or broker had sufficiently complied with its information disclosure obligations or whether appropriate consents for copying had been obtained.

Just in how these issues will apply, to whom and when, will depend on the relevant business model employed by a relevant firm and its set-up. Consequently (perhaps unsurprisingly), the Supervisory Briefing clarifies that firms’ copy trading business models are capable of being organised and offered in different ways. Accordingly, these should, in the view of ESMA, be assessed on a case-by-case basis, notably as to the linkages and interplay between firms, copied traders and/or copy traders.

In terms of “typical” business models, ESMA highlights a first example where investment firms offer the possibility to their existing clients to share their trades with other clients. In such instances, both the copy traders and copied traders are clients of the same firm. A further variable exists in whether the copied trader has a commercial arrangement in place with the firm executing the orders to receive benefits from the firm.See ESMA, available here.Show Footnote Alternatively, ESMA highlights that an employment contract may be in place with the firm executing orders to pay the copied trader pays (fixed) remuneration. As a further structural solution, ESMA highlights a number of other business models with various degrees of intermediaries involved, each acting with different roles, that are relevant in determining as to (i) where the signals are published and by whom as well as (ii) where copied trader and copy trader come together. Any further number of permutations can arise where outsourcing arrangements are involved as these may change the chain of copy traders following one or more copied traders.

Assessing the right regulated activity license

As discussed above, a case-by-case analysis is required to assess the type of business model contemplated, what is regulated and in respect of whom. Consequently, this also applies in assessing, on a case-by-case basis, what type of investment service is triggered and thus which type of license is required by the respective (regulated) firm. Most of this will depend on the firm-client relationship and who does what with respect to and for whom.

ESMA notes that one firm may provide signals but not execute them, other firms may provide both the signals and execute them, as described in the example above. While this is arguably all a bit baseline and somewhat frustrating that the Supervisory Briefing does not offer more certainty, it does provide some guidance of whether, when and how the copy trading service qualifies as one of the following regulated activities:

a.    portfolio management; or
b.    investment advice.

Depending on the facts, as assessed in a case-by-case analysis, and the guidance in the Supervisory Briefing, a person providing copy trading services may provide any one or both of the regulated activities above as well as possibly the further regulated activities of “reception and transmission of orders” and/or provisions of signals.

For sake of completeness, it should be noted that copy trading and “mirror trading” are two different approaches to (retail client focused) automated trading. As discussed above, whereas copy trading copies trading strategies and decisions of the copied traders, mirror trading an investor follows a specific trading strategy created by an algorithm or trading software. As per above, the legal differences are mainly in the areas of copyright and liability. With copy trading, copyright issues can arise if the trading strategies of others are copied and used without their consent. In mirror trading, such issues are less relevant because investors follow a strategy created by an algorithm. However, in both cases, investors are responsible for their own trading decisions and liability for losses depends on the circumstances.

Whatever the regulated activity that a license is required to be held, the Supervisory Briefing’s aims and supervisory expectations on copy trading focus on investor protection, increasing transparency and addressing potential conflicts of interest. Some of the key principles include:

1. Ensuring brokers and copy trading platforms provide sufficient information on the risks involved;
2. Requiring that the traders being copied are experienced and qualified;
3. Mandating detailed disclosure of trader information, trading strategies, and past performance;
4. Regulating remuneration schemes for traders and brokers; and
5. Requiring proper management of any potential conflicts of interest.

These are explored in further detail in the sections below.

Supervisory Briefing: Information requirements: marketing, costs and charges

According to ESMA’s Supervisory Briefing, all regulated firms must be open and clear in their advertising, including on the full cost of their copy trade services as well as risks involved. This follows on from the relevant articles in the MiFIR/MiFID II regime that requires “All information, including marketing communications, addressed by the investment firm to clients or potential clients shall be fair, clear and not misleading”. This specifically includes providing information on past and project performance and a clear and understandable information on the method used to calculate and present information on performance. This is a long-standing and general conduct of business requirement applicable to all regulated firms operating in or from the EU. Importantly, ESMA together with the NCAs launched a common supervisory action in January 2023 reviewing the quality of and compliance with standards relating to financial promotions and other marketing communications. It is conceivable that outcomes from that supervisory review will translate into new and/or revised supervisory guidance from ESMA and possibly, over the longer-term, new rules to reflect new forms of communication channels.See our Client Alert EU reiterates rules to regulating “Finfluencers”.Show Footnote

In addition to the above, products offered must put the needs of investors and their interests first. Moreover, firms should verify the knowledge and credentials of the traders whose positions are copied. By ensuring that only experienced and qualified traders can be copied, the guidelines set out in ESMA’s Supervisory Briefing aim to reduce the likelihood of inexperienced investors following unsuitable trading strategies. Moreover, the regulation of remuneration schemes helps prevent the misalignment of interests between traders, brokers, and investors. Ultimately, ESMA reiterates that providing clear information about risks, trader qualifications, and performance, besides being a legal compliance obligation, can help foster trust with investors.

Supervisory Briefing: Product governance requirements

Firms providing copy trading services are required to define a target market for the service, taking into account the peculiar features of copy trading. Even if the firm provides investment advice or portfolio management services, they still need to define a target market prior to providing such service. The intended distribution strategy and defined target market must align with the needs, characteristics, and objectives of the target clients.

Moreover, copy trading services and the risks involved require a certain level of knowledge and awareness from clients. Relevant firms must provide clear information to clients about the service’s content and underlying risks to ensure they understand what they are getting into. Firms offering copy trading services must regularly review investment products and services. This evaluation should consider events that could materially affect the potential risk to the identified target market. The goal is therefore to ensure that the distribution strategy remains appropriate and responsive to changing circumstances and that any product governance arrangements are addressed and amended appropriately in a timely manner.

Supervisory Briefing: Suitability and appropriateness assessments

The extent of the suitability and appropriateness assessment required will depend on the nature of the investment service the firm is providing. Breaking this down, the Supervisory Briefing communicates the following principles:

1.    Regulated activities of (i) Investment advice and/or (ii) portfolio management as part of copy trading services mean that:

•    If the copy trading service qualifies as investment advice or portfolio management, the firm must comply with the MiFIR/MiFID II suitability assessment requirements.
•    Accordingly, the firm must ensure that the specific financial instruments recommended or invested in are suitable for the client and within their mandate.
•    Challenges may arise depending on the relationship between the firm and the copied trader and policies and procedures must be in place to perform the suitability assessment.

2.    Regulated activity of reception and transmission of orders or execution of orders as part of copy trading services mean that:

•    If the service qualifies as reception and transmission of orders or execution of orders, the MiFIR/MiFID II appropriateness requirements apply.
•    Accordingly, the firm must verify if the specific investment product is appropriate for the client, and prior warning may be necessary if the product is deemed unsuitable.

3.    Suitability assessments:

•    Firms providing copy trading services must select copied traders carefully and have policies in place to evaluate their trading activity.
•    As per above, firms must ensure that transactions fall within clients’ mandates and suitability assessments.

4.    Monitoring and Reporting: Firms “should” (i.e. must) monitor copied transactions to ensure they remain within clients’ stated risk limits. They should also comply with reporting requirements under MiFIR/MiFID II.

5.    Client Information: As per the above, the firm must collect necessary information from clients on their investment objectives, financial situation, knowledge, and experience to ensure suitability and appropriateness assessments are accurate.

6.    Switching and Compatibility: The firm should ensure copied traders do not switch to unsuitable instruments, and that copied trades are in line with the client’s profile.

7.    Reporting: The firm must provide a suitability report to the client prior to every transaction when providing investment advice.

ESMA’s Supervisory Briefing presents a further number of issues for firms to consider when providing copy trading services. These contain further supervisory expectations that follow on conceptually from the above:

•    Gathering necessary information from clients on investment objectives but specifically their financial situation and compared to their knowledge and experience.
•    Ensuring that risk profiles for clients and copied traders are not defined too broadly.
•    Monitoring copied transactions to remain within the client’s risk limits.
•    Conducting suitability assessments for copied trades to match the client’s knowledge and experience.
•    Ensuring the client’s mandate to copy trades is precise and clear.
•    Implementing IT and other arrangements to avoid automatically copying unsuitable transactions.
•    Reviewing and assessing the outcome of automated tools used for copying trades.

Overall, ESMA’s Supervisory Briefing clearly emphasises a greater need for investment firms to be diligent in defining their target market, complying with suitability and appropriateness requirements and ensuring that copied transactions align with the clients’ risk profiles and investment objectives. The Supervisory Briefing’s text includes a number of indicative questions that relevant firms but also competent authorities should consider when assessing compliance with the supervisory principles and outcomes set out in this thematic area.

Supervisory Briefing: Remuneration and inducements

The Supervisory Briefing provides specific rules on conflicts of interest and remuneration for firms providing copy trading services. The Supervisory Briefing communicates the following principles:

1.    Conflicts of interest and remuneration:

•    Relevant firms are required to take reasonable steps to avoid conflicts of interest between themselves and their clients or between clients of the firm. The expectations are more granular than those that apply already as per the MiFIR/MiFID II rules on this principle.
•    Conflicts of interest may arise from the structure of payments made to the traders whose trades are being copied and from the fact that the copied traders may also be clients of the investment firm.
•    The remuneration of copied traders may need to comply with MiFID II remuneration requirements if they fall under certain categories defined therein.

2.    Remuneration policy:

•    Investment firms offering copy trading services should have a remuneration policy for copied traders if MiFID II remuneration requirements apply.
•    The policy should consider criteria for determining variable remuneration, such as the number and value of trades copied, number of followers, and performance of average assets under management (AUM).
•    Remuneration policies should not create incentives that favor the interest of copied traders over the best interests of clients.
•    Qualitative criteria should encourage copied traders to act in the best interests of clients.

3.    Non-applicability of remuneration requirements:

•    In cases where MiFID II remuneration requirements do not apply, investment firms should still have arrangements to ensure compliance with inducements requirements.
•    Such firms should still inform the copy trader client about inducements paid to the copied trader and justify any additional or higher-level service provided in proportion to the inducement paid.

In keeping with the above, the Supervisory Briefing’s text poses several questions for relevant firms to consider regarding their contracts with copied traders, remuneration policies, compliance with remuneration and inducement requirements, and the management of conflicts of interest arising from copy trading services.

Overall, the Supervisory Briefing underlines the importance of firms actively ensuring compliance with remuneration and inducement regulations so as to safeguard clients’ interests when offering copy trading services in the EU.

Supervisory Briefing: Qualifications of copied traders

The Supervisory Briefing provides specific rules as to the expected qualifications of copied traders. Looking at this in further detail, the Supervisory Briefing communicates the following principles:

1.    Qualifications of copied traders:

•    Relevant firms are required to ensure that natural persons providing investment advice or information possess the necessary knowledge and competence to fulfill their obligations under the rules and standards set out in the EU’s MiFIR/MiFID II regime.
•    As per the above, copy trading services that are likely to fall under portfolio management or investment advice, require copied traders to have the requisite knowledge and competence.
•    Accordingly, firms must have relevant procedures in place to ensure that copied traders comply with qualification requirements and act honestly, fairly and professionally. Copy trading service providers will therefore want to periodically review how copied traders measure up to those standards.

2.    Outsourcing arrangements:

•    When copy trading services involve outsourcing arrangements, the firm performing outsourced functions must have the ability, capacity, and resources to perform the service reliably and professionally. Again, while these principles are already enshrined across the EU’s MiFIR/MiFID II regime, the Supervisory Briefing is unequivocally clear in the level of supervisory scrutiny that will be applied.
•    The investment firm and the service provider must ensure that copied traders who share their trades meet all necessary obligations as they may be considered “relevant persons” under the MiFID II Delegated Regulation.

3.    EU’s Market Abuse Regulation (MAR):

•    Copied traders who present themselves as having financial expertise or experience and provide investment recommendations may be considered “experts” under MAR. They would then be subject to additional requirements, such as disclosure of interests or conflicts of interest compliance requirements. Again, the onus falls on the copy trading service provider to periodically review how such standards are being met in practice.

As with the above, ESMA’s Supervisory Briefing poses several questions for investment firms to consider regarding their procedures and processes related to copied traders’ qualifications and compliance with regulatory requirements. It also addresses the responsibilities of firms and service providers when copy trading services are outsourced.

Overall, the Supervisory Briefing highlights the importance of ensuring that copied traders possess the necessary qualifications and act in accordance with the relevant firm’s procedures to safeguard the interests of clients and comply with relevant regulatory requirements in the EU.

Outlook and next steps

ESMA’s Supervisory Briefing is certainly timely and should be viewed as helpful first step in the right direction so as to help by financial services firms navigate supervisory expectations in respect of existing and new copy trading services. That being said, rulemaking in this area is not likely to stop at this Supervisory Briefing. It is likely that further changes, including as a result of the EU’s Retail Investment Strategy package of reforms (see our coverage thereto on our website), will be forthcoming. Whether these will be advanced in legislative rulemaking instruments or further supervisory guidance with rulemaking character remains to be seen.

That being said, there are a number of legal, regulatory along with other challenges that those complying with the Supervisory Briefing may be faced with in the immediate short-term. In particular this includes impacts on:

1.    Compliance costs: Adhering to the new guidelines in the Supervisory Briefing may require significant investment in technology, personnel, and processes as well as changes to client-facing documentation as well as relevant agreements;

2.    Reputational risk: Failure to comply with the Supervisory Briefing can result in reputational damage, fines, or even license revocation; and

3.    Individual business models and changes across the copy trading market as a whole: Some brokers may need to or otherwise might choose to move away from offering copy trading services or make changes to their business models to align with the new regulatory framework and stricter supervisory tone. Smaller brokers may find it challenging to keep up with the costs and complexities of compliance, leading them to exit the market or merge with larger firms. This consolidation could result in a more stable and reliable industry but may also limit investor choice and stifle innovation.

In conclusion, to ensure that copy trading abides by the relevant criteria and that investment services continually prioritise clients’ best interests, ESMA and NCAs will continue to monitor the industry’s progress and may take more targeted (as well as invasive) measures in the future if necessary, including potentially for specific asset classes such as crypto-asset focused copy trading. All of this also, in the eyes of ESMA, aims to drive a broader overall push for a more convergent supervisory culture across the EU and the Single Market for financial services.

About us

PwC Legal is assisting a number of financial services firms and market participants in forward planning for changes stemming from relevant related developments. We have assembled a multi-disciplinary and multijurisdictional team of sector experts to support clients navigate challenges and seize opportunities as well as to proactively engage with their market stakeholders and regulators.  

Moreover, we have developed a number of RegTech and SupTech tools for supervised firms, including PwC Legal’s Rule Scanner tool, backed by a trusted set of managed solutions from PwC Legal Business Solutions, allowing for horizon scanning and risk mapping of all legislative and regulatory developments as well as sanctions and fines from more than 750 legislative and regulatory policymakers and other industry voices in over 170 jurisdictions impacting financial services firms and their business.  

Moreover, in leveraging our Rule Scanner technology, we offer a further solution for clients to digitise financial services firms’ relevant internal policies and procedures, create a comprehensive documentation inventory with an established documentation hierarchy and embedded glossary that has version control over a defined backward plus forward looking timeline to be able to ensure changes in one policy are carried through over to other policy and procedure documents, critical path dependencies are mapped and legislative and regulatory developments are flagged where these may require actions to be taken in such policies and procedures.

If you would like to discuss any of the developments mentioned above, or how they may affect your business more generally, please contact any of our key contacts or PwC Legal’s RegCORE Team via de_regcore@pwc.com or our website.