The practice of trading with other people’s money has been happening since antiquity, when rulers would commission advisors to implement strategies for many spheres, including financial.
With time and increasing wealth amongst the different social strata, money management has become increasingly more common and sophisticated. To protect the needs of the consumer, fiduciary standards were created. These are a set of standards whose primary goal is to ensure that the main priority of money management is to make money for you, rather than from you.
Despite what you might believe, not all financial service providers, including money managers for the most part, are required to follow a fiduciary standard. This means that they can undertake services on your behalf, where their activity is more for their own profit than yours.
There are many ways in which a money manager can undertake this, but for those disbelieving souls, let’s describe a very common and simple Forex example. A money manager who refers a client to a brokerage will often receive a commission for their activities. This is favorable for both the broker, who does not have to pay costly sales commissions, and the money manager, who can monetize this aspect of their activity. For a money manager who also trades on behalf of other clients, if a broker makes their money on volume (most of the broker’s business model depends on volume), it will likely incentivize a money manager to trade to a certain volume. The referral to a specific broker can be in conflict with the interests and needs of the clients, who may benefit from better conditions at another brokerage. By incentivizing volume, a money manager may compromise his trading for further commission profits, again potentially at the detriment of the client.
For social trading, the waters are even more muddied. For example what is the responsibility of a master in social trading? What is the responsibility of the broker in protecting the copier? Is anyone responsible for protection of the interests of the client?
The master has limited fiduciary responsibility in this structure, which is understandable considering the master is fundamentally trading for themselves. This leaves the only other party which could take responsibility as the broker. In the past, a broker was not required to undertake fiduciary responsibility, being considered a financial intermediary by the SEC and other regulatory bodies. Thankfully, regulations are being put in place to ensure that this situation is remedied.
While practically regulations necessitate that a broker have a dedicated on site portfolio manager, this is an area that would be best served by a software system. A software system would have the means to implement criteria that ensures that the master is maintaining adequate risk behavior and that the copier is being adequately protected by diversification, etc. Additionally a software option could add other beneficial functions like risk matching or allow the client to review the master’s activities in relation to the risk and margin.
By addressing fiduciary responsibility, regulatory agencies are working towards closing the loopholes to ensure that money management avoids conflicts in trading for clients. Whilst still in its early days, it is certainly a step in the right direction toward making social trading and money management free of rogue behavior.