April 06, 2023 - The European Securities and Markets Authority (ESMA) recently announced new guidance on the marketing of fractional shares as they raise specific investor protection concerns. Their statement highlights that derivatives on fractions of shares are not corporate shares, and therefore firms should not use the term fractional shares when referring to these instruments.
The new guidance from ESMA aims to clarify the application of certain investor protection requirements established under MiFID II on investment firms. It is intended to ensure that these firms are subject to increased obligations to clarify the nature and risks of this specific type of financial instrument to their investor clients so that they are aware that they are buying a derivative instrument. A concern of ESMA is that the term ‘fractional shares’ can potentially provide an investor with the impression that they are buying a fraction of a corporate share when they are effectively buying a derivative that represents a portion of the underlying share's value.
What are fractional shares?
Fractional shares refer to a portion of a single share of stock or other security which have become increasingly popular over recent years - especially with the rise of commission-free trading and investment apps launched by neo-banks, neo-brokers and micro-investing platforms which have increasingly featured fractional share trading as an easily available feature.
Whilst in the past, investors could only purchase whole shares of stock, which meant that they may have been limited in their ability to invest in high-priced stocks, fractional shares allow an investor to purchase a fraction of a share, which allows them to to diversify their portfolio and potentially earn higher returns with smaller amounts of capital. However, these fractional shares are considered to be derivatives because they are financial instruments which derive their value from an underlying asset, which is the underlying share. They are not actually fractions of actual corporate shares.
The combination of new platform launches and the easy availability of new trading apps has also attracted new, younger investors into investing. These new investors have gained increased exposure to fractional Shares which has led to the need for more detailed guidance on what fractional shares actually are. ESMA wants firms to ensure that future investors are provided with balanced details on the risks associated with fractional shares.
Previous issues with fractional trading
ESMA’s guidance follows a few notable cases of problematic fractional share trading over recent years - particularly Robinhood's decision to restrict trading of GameStop shares and other heavily shorted stocks in January 2021. Many investors who held fractional shares of GameStop and other affected stocks were unable to sell their shares during the subsequent trading restrictions.
The investment app Stash was also sued by investors in 2020 for allegedly misleading them about the risks associated with fractional share trading. The investors claimed that Stash did not adequately disclose the fees, expenses and risks associated with fractional shares trading which led to unexpected losses for some investors.
Specific guidance from ESMA
The main thrust of the ESMA guidance is aimed at clarifying the regulatory requirements for firms offering fractional shares trading to primarily ensure that investors are protected. ESMA requires firms offering fractional share trading to, "provide clients in good time before the provision of investment services with a description of the nature and risks of the relevant financial instruments". A high level summary of the guidance is that investment firms operating in this area should:
ESMA expects that investment firms subject to the new guidance may still offer fractional share derivative products so long as they clearly disclose all direct and indirect costs and charges relating to them and the services provided. This includes structuring and other costs embedded in these derivatives, as well as mark-ups and mark-downs compared, on a pro-rata basis, to the market price of the underlying corporate share. Where derivatives on fractions of shares are packaged by investment firms as retail and insurance-based investment products, the PRIIPs Regulation will apply and firms will need to provide retail clients with a PRIIPs KID.
As a result of this guidance, it is expected that the more detailed requirements underlining the complexity of the products and the risks associated will result in narrowing the target market for the products away from the general retail sector that has fueled the recent growth in this area.
What does the future hold for fractional shares?
It's difficult to predict the exact impact of ESMA's guidance on the future of fractional share trading but given the likely increase in regulatory scrutiny, it is highly likely that the products will not be marketed and sold in the same way.
Fractional share trading remains popular and customer demand is unlikely to diminish significantly as a result of the EMSA announcement. So, whilst firms may need to adapt their products and services to comply with ESMA's guidance and further regulation may follow, customer demand means that it is more likely to have an impact on how they are positioned to customers and not reduce the availability of fractional share trading overall.
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