What do Trade Republic, Revolut, DEGIRO, BitPanda, and eToro have in common? They are neobroker platforms making investing more accessible and affordable for retail investors across the EU.
However, there can be significant differences in the way they operate and offer financial products to clients. Not only do some feature riskier products, but their business models can also impact retail investors and influence their offering or execution price.
Let’s explore what are neobrokers and the challenges they pose to retail investors.
What are Neobrokers?
Neobrokers are digital financial platforms that provide self-directed investment and trading opportunities to individual investors. These neobroker platforms also offer a plethora of investment products, including stocks, ETFs, cryptocurrencies, and derivatives.
They are known for their low to zero explicit costs for brokerage and trade execution services via web or app-based platforms. As such, as a technology innovation in retail investing, neobrokers provide accessible and cost-effective entry points into financial markets.
Challenges of Neobrokers
Despite their benefits, neobrokers present certain challenges for retail investors and the broader market. For example, while neobrokers advertise a zero-commission model, this can be misleading due to both implicit and explicit costs.
Implicit costs are the indirect expenses often related to the bid-ask spreads of trade. They may go unnoticed or be undisclosed, potentially affecting investor awareness and the overall impact on their investment.
On the other hand, explicit cost are the tangible expenses that are disclosed to investors, such as subscription fees or transaction charges.
Inducement and conflict of interest
Another key challenge with neobroker platforms is that payment for order flow (PFOF) and rebates are amongst their key financial incentives. PFOF means that neobrokers receive compensation for directing retail orders to specific market makers or trading values. Whereas rebates constitute the premiums ETF providers and asset managers pay for product listings.
While PFOF and rebates help in keeping ETF costs low, such practices can raise concerns about investor choice and market transparency.
Security lending risks
Another practice neobrokers employ to generate additional revenue is that of security lending (lending clients' securities and reinvesting the collateral).
While this practice can increase their income, it also introduces risks for retail clients, including counterparty risk and collateral shortfall risk.
Challenging the regulatory framework
The innovative nature of neobrokers challenges existing regulatory frameworks. This calls for continuous adaptations to ensure investor protection and market integrity.
Thus, it is imperative to implement regulatory frameworks that ensure sound integration of technology-oriented financial services. Such practices include:
- Regulation of Marketing: Address marketing practices, gamification tactics, and behavioural prompts that may mislead investors.
- Transparent Marketing: Implement strategies that clearly disclose the risks involved.
- Enhanced Investor Awareness: Improve understanding of high-risk options and closely examine the ecosystem of digital platforms.
- Retail Investment Strategy: Consider partial bans on inducements.
- PFOF Ban: The MiFID/R regulations aim to address and potentially prohibit Payment for Order Flow (PFOF) practices.
Service diversification
Neobrokers are merging brokerage services with banking and payment options (also known as platformisation), which introduces challenges such as:
- Increased Complexity: Integrated platforms can make it difficult for clients to grasp the full scope of services
- Gamification Risks: Digital engagement tactics, like gamification and nudges, may lead to excessive trading or risky behaviour.
- Regulatory Hurdles: Careful regulatory oversight is needed to ensure compliance, protect investors, and maintain market integrity.
- Risk Management: Users should understand the compounded risks of integrated services.
- Transparent Communication: Neobrokers must clearly explain the risks, costs, and benefits of combined services, so users can make informed choices.
So, the question lies: is an integrated financial platform the solution?
The Bottom Line
While neobrokers offer significant benefits, they also pose challenges that need careful consideration. Retail investors should be aware of these aspects to make informed decisions and navigate the evolving digital finance landscape effectively.
*This article is created as part of BETTER FINANCE’s social media educational campaign to make finance more accessible to Europeans. Check the original post on our LinkedIn page.
To download the original post as PDF, click here.