ESMA expresses its views on the developments, benefits and risks of neobrokers’ activities in the EU

RegCORE – Client Alert | Capital Markets Union

QuickTake

As discussed in extensive Thought Leadership coverage from our EU RegCORE as well as wider coverage across the PwC Network, both national competent authorities (NCAs) and the European Securities and Markets Authority (ESMA) have been monitoring the developments, benefits and risks of neobrokers and their activities in the EU. On 9 July 2024, ESMA used its periodic “Trends, Risks and Vulnerabilities (TRV) Risk Analysis” series to publish an in-depth look at neobrokers and communicate certain observations (the Neobroker TRV Analysis).Available here.Show Footnote

While the term “neobroker” is not defined in EU law, nor in Member States’ national laws, the term is conceptually understood by ESMA and other members of the European System of Financial Supervision to mean those “investment firms that operate digital-only offerings that have disrupted traditional brokerage models through user-friendly, online investment services primarily to retail clients and specifically consumers.”

Neobrokers have also been in the supervisory spotlight through some firms’ approach to order execution, hidden costs and/or the use of payment for order flow (PFOF), a practice that is now being phased out in the EU.See Client Alert here and here.Show Footnote The growth of neobrokers has been particularly pronounced during the COVID-19 pandemic, which acted as a catalyst for increased retail trading activity. As these entities continue to gain market share, they bring both opportunities and challenges to the EU financial markets. ESMA launched a data collection exercise which surveyed entities operating in the EU that ESMA identified as neobrokers based on their online platforms and their business models. This covers around 10 million client accounts with 90% of such accounts from the sampled firms relating to retail investors.

This Client Alert assesses ESMA’s key messages in the Neobroker TRV Analysis and the legal and regulatory outlook for such firms. While ESMA and NCAs in their publications welcome neobrokers where they can bring a value-add to the EU’s Single Market for financial services, it should be cautioned that ESMA may well look to use other instruments to communicate its supervisory expectations in ways that go well beyond this most recent update.

Key takeaways from ESMA’s Neobroker TRV Analysis

In the EU, all investment firms (including those that operate a neobroker business model), must operate within the EU’s legislative and regulatory framework applicable to investment services. This includes (but is not limited to) compliance with the EU’s Markets in Financial Instruments Regulation (MiFIR) and the accompanying Directive (MiFID II) (each as amended and also as supplemented by the Investment Firms Regulation (IFR) and accompanying Directive (IFD) as well as the Market Abuse Regulation (MAR). Importantly, and rather welcomingly, a number of more commercially successful neobrokers are also in the process of upgrading their regulatory permissions to apply for authorisation as credit institutions i.e. banks.In such instances their business model and operations become subject to further scrutiny by NCAs and ultimately by the European Central Bank (ECB) acting in its role at the head of the Banking Union’s Single Supervisory Mechanism (SSM). Such authorisation applications then generally also have to follow the ECB-SSM’s specific expectations for license applications by what it terms (again not at law) as “fintech credit institutions”. Coverage on this specifically is available here. Further coverage on the ECB-SSM’s supervisory expectations on fintechs more broadly are set out across Thought Leadership contributions from our EU RegCORE.Show Footnote No simplified supervisory requirements or exemptions apply from standards to protect consumers under EU and equally under national investor and/or consumer protection laws.

ESMA’s Neobroker TRV Analysis highlights significant growth in the neobroker segment, with a substantial increase in client assets and trading volumes. This growth trajectory indicates a shift in investor behaviour towards digital platforms for investment services. NCAs have also noted that trend albeit also in a rise in complaints about neobrokers.Specifically in the case of Germany, please see Client Alert here and earlier BaFin article here.Show Footnote ESMA notes that larger neobrokers offer a wide range of securities, including those issued in the EU and the US, while smaller firms tend to specialise in national markets. Building on these general observations, ESMA’s analysis focuses on the following themes – some of these apply to neobrokers, some to the market as a whole and others to NCAs when they supervise:

1. Benefits of neobrokers: ESMA notes and welcomes neobrokers having democratised access to financial markets, promoting capital market participation among households. They potentially offer lower transaction prices and have introduced innovative features that make investment services more accessible to consumers. This aligns with the objectives of the EU's Capital Markets Union (CMU) initiative, which aims to encourage retail participation and channel capital towards economic growth. 
2. Risks associated with neobrokers: Despite their benefits, ESMA concludes that neobrokers can pose certain risks. They may facilitate trading in complex products that may not be suitable for individual retail clients. The integration of social media functions into trading platforms can encourage uninformed trading decisions often amplified by use of financial instrument and/or credit-based leverage. This is in addition to supervisory concerns on the use of finfluencers.See extensive coverage from our EU RegCORE on supervisory expectations applicable to firms that use finfluencers as well as to finfluencers themselves.Show Footnote Moreover, the digital provision of services across borders can complicate the oversight of retail investor activities by NCAs and other domestic authorities responsible for investor and/or consumer protection.See also recent publications by the European Commission on consumer protection reforms available here.Show Footnote
3. Operational models of neobrokers: ESMA’s review also assessed and concluded that neobrokers employ various operational models depending on the financial instrument traded albeit with a (welcome) focus on offering clients easy access to investing as well as “To facilitate access to trading services and curb costs, neo-brokers typically invest in process automation and offer applications designed to be user-friendly. These applications typically enable clients to open an account quickly and easily (often using AI-based identity checks) and to buy and sell a range of products”. For shares and exchange traded funds (ETFs), neobrokers generally act as intermediaries, executing client orders on trading venues. In contrast, for products like contracts for differences (CFDs) they often act as counterparty to clients, executing trades over-the-counter (OTC). ESMA’s analysis also specifically assesses neobrokers’ activity in respect of fractional shares and fractional ETFs. This is an area that ESMA has previously shown heightened supervisory interest in.See Client Alert available here.Show Footnote ESMA also notes that neobrokers offering instruments issued in foreign currency typically apply currency conversion fees – this is equally an area that ESMA and NCAs may take a supervisory interest in. 
4. Revenue streams and business models: In addition to the above, ESMA notes that neobrokers derive revenue from multiple sources, including transaction-based commission fees and bid-ask spreads on OTC trades. Some neobrokers have also relied on PFOF (payment for order flow), although recent regulatory changes have introduced a ban on PFOF with a phasing out of such practice within the EU. 
5. Execution strategies and market impact: The report indicates that neobrokers execute most client orders in shares and ETFs on a limited number of trading venues, which are often not the main national markets. This could potentially fragment order flow and affect market liquidity. However, the overall impact on trade execution for the market as a whole appears to be limited given the small proportion of trades executed by neobrokers relative to total trading activity in the EU.
6. Investor/consumer protection concerns: ESMA expresses its views on the rise of neobrokers having amplified investor/consumer protection concerns. The report underscores the need for trading platforms to promote sensible investment decision-making rather than excessive trading. It also highlights the importance of compliance with MAR when users post investment recommendations on social media of otherwise use finfluencers. 
7. Financial literacy and investor education: ESMA has across a number of publications and equally in its review in this report stated that enhancing financial literacy is crucial for ensuring that retail investors are informed about the risk-return profile of different financial products. ESMA expects that neobrokers play a role in educating their clients, particularly those who are investing for the first time. ESMA does note that certain neobrokers “may feature ‘educational’ tools intended to enable clients to trade even with no or limited prior knowledge of financial instruments and markets. Some firms provide additional services such as portfolio and wealth management, investment advice, custody and safekeeping of financial instruments.”
8. Supervisory implications for neobrokers: From a supervisory perspective, ESMA’s continual monitoring of neobrokers reconfirmed to readers as being essential to identify emerging risks and ensure market stability. This role includes assessing the impact of market developments on financial market participants and informing relevant authorities about micro-prudential trends. Moreover, ESMA sets expectations that NCAs should follow, namely that as neobrokers continue to innovate using technologies like AI and machine learning, regulators must ensure that these advancements do not compromise investor protection or market integrity.
9. Regulatory response to market developments especially where potential for market volatility exists: ESMA’s observations in the Neobroker TRV Analysis are also used to remind regulators to respond proactively to market developments involving neobrokers. This includes ensuring that neobrokers comply with existing regulations such as MiFID II and MAR, as well as adapting regulatory frameworks to address new challenges posed by digitalisation and cross-border activities. The report specifically references events such as the GameStop short squeeze, illustrating how digital trading platforms can contribute to market volatility. Regulators are reminded to be vigilant in monitoring such market developments and take appropriate measures to mitigate systemic risks.
10. Cross-border challenges: ESMA concludes in warning that the cross-border nature of neobroker services presents challenges for regulatory oversight. Accordingly, authorities must (further) collaborate at an EU level to monitor trends and risks associated with these platforms effectively. ESMA also offers its views on the future outlook for the neobroker market segment, specifically that further consolidation within the industry, partnerships with established financial institutions (or upgrades to bank licensing) or acquisitions will mean NCAs need to monitor these developments closely. 

ESMA’s Neobroker TRV Analysis concludes by signalling a growing supervisory interest to ensure neobrokers operate in the same way as all other investment firms, full cognisant by the attributes i.e., the risks and benefits that are specific to neobrokers. This is specially evidenced by the following statement: 

“Neo-brokers have grown in recent years, though still only account for a small share of trading activity in the EU. Characterised by innovative, online-only business models, their use increased rapidly during the pandemic. As the GameStop episode demonstrated, the interaction of convenient, real-time retail trading with social media has the potential to drive volatility in certain market segments (e.g., ‘meme stocks’). ESMA has since issued public warnings on related risks.”

With this statement ESMA leaves the door open for further supervisory guidance that may follow as a result of the findings flowing from its analysis. 

Outlook

ESMA’s Neobroker TRV Analysis sets a strong signal that while neobrokers are a welcome part of the market that also helps build CMU, there is a growing supervisory interest to ensure they operate on a level playing field with traditional investment firms. ESMA’s focus is likely to result in heightened regulatory guidance, emphasising the importance of investor protection and market integrity. Neobrokers will need to prioritise compliance with existing regulations such as MiFIR/MiFID II and MAR while being prepared for potential new regulatory frameworks that address the challenges of digitalisation and cross-border activities.

In addition to better compliance with existing rules, the rapid adoption of technologies such as AI and machine learning by neobrokers presents further opportunities and challenges. Regulators will be keen to ensure that these technological advancements do not compromise investor protection or market integrity. As a result, neobrokers must revisit existing or further develop new robust compliance strategies that incorporate these technologies while adhering to regulatory expectations. Finally, across the EU over the next couple of years, the emphasis on investor protection is expected to intensify, with regulators closely monitoring neobrokers’ practices to prevent excessive risk-taking by retail investors and to ensure that financial literacy and investor education are at the forefront of neobrokers’ service offerings.

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