Why private investors should stick to regulated markets

By: Tim Bennett

In a low yield world, investors may be tempted away from regulated products and markets. Tim Bennett explains why this is usually a bad idea.

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Why private investors should stick to regulated markets

In the quest to earn a bigger than average yield, or find the next ten-bagger investment, investors may be tempted to stray away from regulated, established markets. This is usually a mistake. That’s because even in the markets that are regulated, things can go wrong. So imagine how much worse things can get in parts of the market where there is little, or no, regulation at all. Here is a summary of seven ways you can be ripped off in any market and seven reasons to be grateful that regulated ones are at least policed, albeit at a cost.

Why have regulations?

Irritating and expensive though compliance with market rules can seem at times, there are good reasons why we need them as highlighted in the July 2018 FICC Market Standards Board report.
So what can go wrong in a competitive market for stocks, bonds or any other asset? Here are seven common traps.

Price manipulation

This comes in many forms. A common one is when a group of market participants try to bid up the price for an asset artificially in the hope of duping someone outside of their circle to overpay. They may do this by submitting fake orders, which are quickly reversed (“spoofing”), submitting multiple orders in collusion with a friendly third party to make it look like an asset is subject to a bidding war (“layering”). The aim is to “ramp” the price and fool the unwary.

Circular trading

This may occur where two parties act together to generate an impression of activity in an essentially quiet market. They may do this by entering zero profit trades, which are later reversed (a “wash” trade). The idea is to artificially boost the reported activity in their area.

Collusion and information sharing

In a regulated market, all private clients have the right to be treated the same way. However, a broker who is trying to impress a preferred client in a market that is unregulated, may direct trades on favourable terms to them, perhaps as part of a broader arrangement that also helps the broker. Or, the same broker may accept trades at uncompetitive prices from a favourite supplier. This is something regulators try to stamp out.

Insider trading

I cover this in more detail in a separate video on Insider Trading. In summary, this is where people with access to price sensitive, non-public information that is capable of moving prices once it is in the public domain, use it to make a profit or avoid a loss. The fact that it happens sometimes in regulated markets is evidence of how difficult it is to stamp out – in an unregulated market, all bets are off!

Influencing reference prices

Portfolio managers are often under pressure to hit quarterly targets when it comes to assets under management (AUM). One way they can do this is to try to influence closing prices (prior to marking their asset prices to them). In sophisticated, regulated markets such as the London Stock Exchange, there are mechanisms designed to stop this, such as auctions. Away from these markets, investors need to be more wary.

Improper order handling

An example is “front running”, where a firm may tip off a preferred client that a sizeable order from a big player is about to be placed in a particular security and aim to position that client ahead of it. This doesn’t guarantee a profit but it increases the chances, arguably unfairly. In unregulated markets, this practice is commonplace (e.g. cryptocurrencies) whilst in regulated markets it is harder to do as trades are monitored and investigated more systematically.

Misleading customers

In an unregulated market, more or less anything may be sold to anyone. It is very much “buyer beware”. Regulated markets on the other hand set rules around the way firms communicate with their customers. In the UK, for example, there is an obligation to be “clear, fair and not misleading” when describing a product or service. This helps to protect the unwary from the sharks that operate in any competitive market.

Closing thoughts

What the FICC report makes clear is that even where regulators are active, things can still go wrong. However, just imagine how much worse things can get where regulation is light, or non-existent. If in doubt, private investors should therefore always stick to safer markets, even at the cost of sacrificing tempting “above-market” returns.