Tag Archives: finance

Platform providers fake being popular

Crowdfunding platforms, stock exchanges and other providers of two-sided markets want to appear popular, because having more buyers attracts more sellers and vice versa. The platform’s revenue is usually proportional to the number of users, because it charges a commission fee on trades or advertisers pay it to show ads to users. The exchange’s marginal cost of a user is close to zero, giving it an incentive to fake a high volume of trades, a large limit order book and a small bid-ask spread.

The platform’s cost of posting a great volume of outstanding buy and sell orders at a small spread is that many investors try to trade at these favourable bid and ask prices. Either the market maker has to take the other side of these attempted transactions or is found fraudulent. Taking the other side results in a large loss if some investors are better informed than the exchange.

The platform could falsely display a large trading volume, but keep the order book honestly small by adding fake trades at prices between the bid and the ask only, so no investor’s real limit order is ignored. This seems difficult to detect, unless one side of the limit order book is empty (e.g. no buyers) and at least one at-market order on the other side (e.g. a sell) is outstanding. In this case, any trades occurring would have to satisfy the at-market order. However, the platform or real investors can then take the other side of the at-market order at a very favourable price to themselves, which discourages at-market orders. A large trading volume with a thin order book is still slightly suspicious, because it requires that crossing buy and sell orders between the bid and ask prices arrive almost simultaneously, in order to be matched without appearing on the order book for long, and without triggering the real limit orders. Displaying the fake buys and sells on the order book risks attracting actual matching trades, which the platform would have to honour (at a cost).

Without automated quote matching, there are no at-market orders, for example on the Funderbeam crowdfunding platform. Instead, everyone either posts a limit order or picks an order from the other side to trade with, e.g. a buyer chooses a sell. Investors can pick an order with a worse price (higher sell or lower buy) on the other side, which frequently occurs on Funderbeam. Choosing a worse price is irrational, unless the traders in question are colluding, so the asset is effectively not changing ownership. Reasons to carry out such seemingly irrational trades are to manipulate price and volume, e.g. price can be raised or reduced by targeted trades outside the bid-ask interval. Volume can only increase after added trades, rational or not, but such seemingly greater activity is exactly what benefits the stakeholders of the platform. The employees of the market maker have a natural motive to fake-trade between themselves to make their firm look good, even without any inappropriate pressure from their boss.

Another way to attract issuers and investors is to demonstrate successful initial public offerings, meaning that the funds are raised quickly (good for issuers) and the price of the newly listed stock (or other asset) goes up, which benefits investors. Adding fake capital-raisers is difficult, because potential investors will check the background of the supposed issuer. Inserting spoof investors into an actual funding campaign is costly, because real money would have to be invested. One way to manipulate popularity upward is to simultaneously add a fake issuer and fake investors who satisfy its funding need. The idea is to not leave time for real investors to participate in the campaign, by pretending that the capital-raiser achieved its target funding level before most investors could react. This is easier in markets with a small number of real investors and without an auto-invest feature. However, the real investors who were supposedly pre-empted may still research the supposedly very popular issuer.

A costless way to briefly boost the popularity of a real fundraising campaign is to add fake investors after the target funding is achieved, and forbid issuers from increasing the target or accepting funds from those who subscribed after the goal was reached. Any campaign meeting its target can then be made to look heavily oversubscribed. However, if the issuers are informed in advance of the restriction not to increase the target, then they may find an alternative unrestricted platform to raise funds. On the other hand, if the restriction is not mentioned beforehand, then it will likely anger the issuers who will then create negative publicity for the platform. Competition between exchanges thus curtails their manipulation incentives.

The platform can motivate real investors to raise their bids when the campaign reaches its target by rationing demand: bidders in an oversubscribed share issue get only a fraction of what they wanted to buy. Anticipating this, buyers will increase their requested quantities so that the fraction of their new bid equals their actual demand. This makes the campaign look oversubscribed and creates a feedback loop: if other investors increase their quantities, then rationing reduces the fraction of a given investor’s demand that will be satisfied, so this investor raises her or his requested amount, which in turn makes others increase theirs.

If investors know of the bid rationing in advance, then they may select a rival market provider without this restriction, but if rationing takes them by surprise, then they may leave and publicly criticise the platform. Capital-raisers compare exchanges, so if many market providers inflate demand and the issuers pay attention to the level of oversubscription (instead of the fraction of campaigns reaching the target, which is what should matter to the capital-raiser), then the biggest inflator wins. Of course, platforms may not want to reveal unsuccessful campaigns (e.g. Funderbeam does not), so public data on the fraction of issuers who achieved their funding goal is unlikely to exist.

Theoretically, the feedback from bid rationing to increased quantity demanded could lead to infinite amounts requested. A countervailing incentive is that with positive probability, other investors do not honour their commitment to buy, in which case a given investor may be required to buy the amount (s)he demanded, instead of the lower amount (s)he actually wanted. If there is no commitment to buy (for example, on Funderbeam the bids are only non-binding indications of interest), then the danger of overcommitting is absent, so the rational choice seems to be requesting an infinite amount. Investors do not indicate infinite interest, so either they are irrational or some other penalty exists for outbidding one’s capability to pay.

Fund management fee paid explicitly to nudge consumers to choose better funds

Mutual funds with lower management fees have higher future before-fee returns (Gil-Bazo and Ruiz-Verdu 2009). Nonetheless, the high-fee funds have not gone out of business, so there must exist a sizable number of silly customers who accept low returns without switching to competitors. When asked explicitly, all fund investors prefer more money to less. Their hourly wage is not large enough to explain their non-switching with the time and hassle costs of comparing fund returns and choosing a new one. Similarly, many Estonians keep their retirement savings in badly performing high-fee pension funds despite the availability of dominating options (Tuleva and LHV index tracking funds). This is costing the customers over one percent of their retirement wealth per year.

By contrast, people with chronic or expensive diseases in the US often pick the health insurance plan that maximises their wealth (coverage minus premiums). This dynamic optimisation involves switching to a different plan when their illness changes. People without costly medical conditions tend not to switch their insurance even when cheaper plans with higher coverage are available.

Both the pension and the insurance plan decisions are complex, but matter greatly for wealth. Why do people pay attention to the financial consequences of their insurance choice when sick, but ignore better options among pension funds (and when healthy, also among insurance plans)? One possibility is that insurance is more salient to the sick, and the greater attention leads to better decisions. Specifically, the premiums and out of pocket payments for medical procedures frequently remind patients of the financial consequences of their insurance, but the missing returns on one’s retirement assets are not observed without explicit comparison to the stock market or competing funds. Most people do not compare their pension plan to the market, so even in retirement may not know what their (counterfactual) wealth would have been had they chosen a better fund .

If it is lack of attention that causes the bad choice of mutual and pension funds, then one solution (proposed by my friend Hongyu Zhang) is to make the management fees more salient by requiring their explicit payment. For example, every month the customer has to transfer the amount of the management fee from their bank account to the fund. Financially, this is equivalent to the fee being deducted from the retirement assets like now (assuming these assets are eventually taxed the same as income, otherwise the transferred fee can be adjusted to make it financially equivalent to the deduction). The attention required is however greater for an explicit payment than for doing nothing following a lack of capital gains. Similarly, requiring customers to pay the difference between the return of their fund and the market return into the fund every two weeks would nudge them towards greater attention to their retirement account.

In practice, such a nudge is unfortunately politically infeasible. Not only would the fund industry lobby against it, but voters would irrationally perceive the required explicit payments as increased taxes. This would make the transition to transferring fees to funds from customers’ bank accounts very unpopular. If people understood the equivalence between low returns on their assets and explicit payments required of them, then they would be financially literate enough to choose low-fee, high-return index funds in the first place. Thus the problem of low-performing pension funds would be absent. To sum up, the fool and his money are soon separated, and it is difficult to protect people from their own bad decisions.