In the wake of the GameStop saga in January 2021, the practice of payment for order flow (PFOF) came under the spotlight. I argued at the time – and still think – that PFOF should be banned. By rerouting trading orders through major brokerages, companies like Robinhood can offer traders ‘commission-free’ trading, which is no such thing. In reality, the traders have become the product.
In the three and a half years since, something even more sinister than PFOF has engulfed the trading world. This trend again seeks to profit from the retail trading boom at the expense of traders.
Many positive things came out of the ‘meme stock’ period (which is in many ways still ongoing). It brought retail trading into the public sphere and popular culture. For a moment, it made trading cool in a way that it had never been before. A whole new section of society, maybe a whole generation, suddenly wanted to learn how to trade.
More accurately, they wanted to learn how to make a lot of money. This isn’t the sinister part, of course. This is what has always driven professional traders, and the incentives of retail traders shouldn’t be any different.
But as befits the laws of demand and supply, this newfound appetite for trading opportunities was swiftly met by a surplus supply of scams and get-rich-quick schemes that sought to turn aspiring traders into profit rather than profit-makers.
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The more research I did, the more one specific type of program seemed to emerge. They had proliferated overnight and were all over the place. They are called ‘funded trader programs’.
This is how they work. A firm will lure in aspiring traders by offering them capital to trade with, which allows them to trade without risking their own money, thus lowering the entry barrier for new traders.
In the US alone, the number of funded trader programs has grown from about 10 in 2019 to over 120 in 2023, with the number of funded traders growing from 5,000 to over 60,000 in the same period. Accordingly, the total funding allocated to these programs has ballooned, with funding in this space growing from around $50 million in 2019 to $800 million by 2023.
This has all been a direct result of the heightened market activity and volatility following the COVID-19 pandemic, which spurred many individuals to explore alternative sources of income through trading.
These firms call themselves proprietary trading firms, though I would argue that they are not. Why? Because the firms' incentives are completely misaligned with the incentives of the aspiring traders.
For a start, traders will pay substantive fees to participate in training programs before they are allowed to trade. Training is standard practice in professional trading, of course, but the training should not be the business model in itself.
These programs collect fees upfront, which means they gain financial benefit regardless of the trader’s success. For instance, if a program charges $100 for an evaluation and 1,000 traders enroll, the firm collects $100,000 regardless of how many traders succeed.
It gets worse. For traders who get through the training and are allocated capital, many funded trader programs impose artificial conditions on trading activity, ensuring that the whole game is effectively rigged against the aspiring traders. Like a casino, the house always wins. How exactly?
Specifically, the programs tend to skew three key aspects of the trading process to the detriment of their traders. Firstly, they offer wider spreads; secondly, higher commissions; and thirdly, sub-optimal execution speeds. What’s the problem with all of this?
By offering wider spreads, the cost for a transaction increases for the trader. For instance, if the average spread is $1 USD in the open market, a funded program might increase it to $2 USD. This effectively doubles the cost of entering and exiting trades, which can significantly eat into potential profits.
Similarly, higher commission rates increase the cost of trading. For example, if a typical commission rate is $5 per lot traded, a funded trader program may charge $10. This higher cost structure can make it difficult for traders to generate a profit, particularly in strategies that require frequent trading. One of them is scalping, a hyper-short-term trading strategy that requires investors to buy and sell securities quickly.
Execution speed can critically affect trading outcomes, especially in fast-moving markets. Slower execution can lead to ‘slippage,’ where the executed price differs from the expected price at the time of the order. In a fast-paced trading environment, even a delay of milliseconds can result in significant deviations from planned entry and exit points, potentially leading to losses or reduced profits. Many funded trader programs offer slower execution speeds than professional traders have access to, which handicaps the people using these platforms.
Perhaps most egregiously, however, many of these programs may also be structured to benefit from losses incurred by traders. For example, if a trader is participating in a profit-sharing arrangement and ends up losing money, any risk-sharing component of the agreement might mean the trading firm avoids financial loss while retaining the initial fees.
All of these factors conspire to pervert and invert the incentives of those taking part. Simply put, the so-called ‘prop firms’ that provide the capital and the traders they provide the money to are rowing in opposite directions.
Just as payment for order flow serves the interests of brokers while turning traders into products, so do funded trader programs turn traders into products from which profit is extracted for the benefit of the company. The funded traders also have little to no affiliation with or loyalty to the firm providing them with capital but rather treat these platforms like lottery tickets from which they might make a quick buck if they’re lucky.
In real prop trading firms, the traders are the talent producing the profit—both for themselves and for the firm. When our traders do well, our firm does well. All of our traders have the same access to the best available market data, spreads, and execution speeds. When they do well, we give them more capital to trade with, so they have an incentive to stay with us long term.
With funded trader programs, the firm can still win when traders do badly. In many cases, the firm does well because the traders do badly.
The heightened interest in stock trading since the pandemic represents a huge opportunity for both individuals and markets across the world. Many people are eager to learn about trading and to trade markets remotely from their homes. If this energy and interest are channeled in the right direction, it could provide a huge boon to liquidity across global markets.
Unfortunately, an equal number of people are eager to take advantage of this increased demand and turn aspiring traders into products for their own profit rather than profit-makers in their own right. This isn’t real trading; it’s fake trading. When incentives are misaligned, the house always wins.
And the losers? It’s not just the traders; it’s the market as a whole.
