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Online trading scams: Tips and red flags

I manage Cable Car Capital LLC, an investment adviser that has investigated several companies active in the online brokerage industry. In full disclosure, my firm published a short-biased research report on Plus500 last year and continues to hold a short position. This article aims to highlight warning signs that may help identify brokerages that harm their customers, without singling out any particular bad actor.

Considering a new broker? 5 tips to avoid a potential scam

1. Read the broker’s terms and conditions thoroughly. Watch out for vague definitions and the right to cancel trades

2. Visit the website of your national financial regulator to verify whether the broker is licensed

3. Not sure if a review was unbiased? Search a few key phrases to see if they appear elsewhere online

4. Avoid any broker or salesperson who promises returns or the ability to get rich quickly

5. Search for customer complaints about the broker online. Be especially wary if customers report difficulty accessing funds

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As the online brokerage industry faces increased regulatory scrutiny in Israel and around the world, it is essential for regulators and prospective customers to understand what separates a legitimate brokerage firm from the “wolves of Tel Aviv.” At root, what illicit online brokerages have in common is the promotion of trading activity as a form of gambling rather than investment. It is no coincidence that many brokerage developers got their start in the online gambling business, and gambling firms have recently diversified into online trading.

Although the bulk of industry criticism has focused on trade in binary options, many binary brokers at least have the virtue of explicitly describing client positions as wagers. Spread betting, a form of contract for difference (CFD) trading popular in the UK, is similarly upfront about what customers are really doing (allowing the results to be taxed as gambling losses rather than capital gains).

Far more insidious, in my view, is the way in which other brokers offering complicated financial products blur the lines between trading for investment purposes and trading for entertainment. Gambling may have its place, but it should not involve financial products. It harms the integrity of capital markets when companies encourage financially unsophisticated individuals to take risks they may not fully understand or have adequate resources to bear.

Complex derivatives like binary options, CFDs, futures, and other leveraged financial instruments were originally developed for professional investors to manage risk and lower tax and transaction costs. They were never intended as gambler’s chits. The risks of binary options, CFDs purchased on margin, and highly leveraged forex trading are wholly unsuitable for all but the most sophisticated individual investors.

Existing laws governing customer suitability, registration requirements, false advertising, and contract fairness already prohibit much of the industry’s conduct, but they have not been adequately enforced across national boundaries. It is not enough for brokerages to simply be registered. There is an urgent need for coordinated international regulatory enforcement to protect the public. Jurisdiction shopping is common, and companies facing sanctions in one country sometimes simply move customer accounts to another.

My research has identified 10 potential warning signs that may indicate that a firm violates the law and/or promotes gambling rather than legitimate investment activity:

1. Unregistered activity: Is the brokerage licensed? Even if registered in one jurisdiction, does the brokerage also operate in parts of the world where it is not properly licensed? Is it listed as an unregistered entity on any of the warning lists maintained by foreign regulators? Many Israeli companies flagrantly contravene registration requirements in other jurisdictions, where regulators are under-resourced or defer to the home country’s authority. In my opinion, this should be a high enforcement priority for the Israeli Securities Authority.

2. Unfair contract terms: Does the customer agreement include unreasonable rights for the brokerage, like the unilateral ability to retroactively cancel profitable trades? Many platforms rely on a non-specific definition of “market abuse” as determined in the sole discretion of the brokerage. Does the brokerage encourage short-term trading while stating that short-term trades of unspecified duration may be considered abusive “scalping”?

3. Excessive leverage: Does the brokerage allow high levels of leverage on volatile financial instruments? Single-name securities with 5-10x leverage or currency and commodity derivatives offering 50x or greater exposures are highly likely to result in margin calls through normal fluctuations in the underlying prices. Is there ever a justifiable reason for an individual retail trader to be more leveraged than Long-Term Capital Management or Lehman Brothers?

4. Low balances: If data are publicly available, does the brokerage report annual revenues that significantly exceed the value of customer deposits and positions held on its books? Casinos do not hold deposits; investment firms do. Common sense dictates that a platform intended for investment should hold far more on deposit than it earns off its customers in a short period of time. Reputable brokerage firms hold many times more customer assets than they take from commissions and trading activity each year, even if they cater primarily to short-term traders.

5. Withdrawal delays: Do customers report significant unexplained delays in receipt of withdrawal requests? This may indicate either a Ponzi scheme trying to fund withdrawals from new deposits, or an attempt by the brokerage to encourage further trading activity that might cause losses out of the requested withdrawal amount.

6. Third-party trading: Is the firm providing an algorithm or someone else to trade on customers’ behalf? Is that entity properly registered as an investment adviser? Have the costs and risks of the trading program, its past performance, and the qualifications of the adviser been properly disclosed?

7. Direct dealing: Is the brokerage a “bucket shop” operating a direct dealing model, meaning that it does not intermediate trades on a recognized exchange or external trading venue? Like bookmakers, bucket shops or direct dealing desks take bets from customers without necessarily transacting on an exchange. Contract pricing may be proprietary and not guaranteed to match the underlying, creating the potential for abuse. Legitimate brokerages by contrast do most of their activity on regulated exchanges, which provide a public record of transparent pricing.

8. Live customer support: Is the brokerage reachable in person or over the phone? Although call centers with aggressive marketing can be problematic, is the brokerage at least accessible in a timely fashion in the event of a trade error or dispute?

9. Misleading marketing: Does the brokerage misrepresent itself in online advertising? Does it make unverifiable or false statements about its business? Does it have fake reviews on social media? Do advertisements fully disclose the risks of its services, and are they compliant with rules regarding financial promotion?

10. Affiliates: Does the brokerage rely on affiliate marketing networks like the online gambling industry does? Is material purporting to be a review of the brokerage repeated word-for-word elsewhere on the Internet? False reviews may be provided by the company to third-party marketers who receive significant referral fees.

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Israel has a technology industry that is the envy of much of the world. Unfortunately, that technical creativity has also led to the development of some of the world’s most efficient gambling software. Today, it is being deployed in the financial industry, to the detriment of many unsuspecting individuals around the world. Will Israeli regulators do anything about it?

Jacob Ma-Weaver manages Cable Car Capital LLC, an investment adviser in San Francisco.

About the Author
Jacob Ma-Weaver manages Cable Car Capital LLC, an investment adviser in San Francisco.
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