The Financial Conduct Authority (“FCA”) has recently turned its attention to firms who may mis-sell contracts for difference (“CFDs”) to customers. The FCA says that it has a “serious concern” about the market.
On 12 Janaury 2018, following a 12 month review of the CFD market, the FCA issued an ominous warning in the form of a “Dear CEO” letter addressed to to providers and distributors of CFD products consumers which was headed “resolving failings which may cause significant harm“.
What are CFDs?
CFDs are complex financial instruments that allow consumers to gamble on price movements on a range of products including markets, currencies and commodities.
The FCA Handbook “designates contracts for difference, spread bets and certain ‘rolling spot’ FX contracts as types of ‘CFD’, which in turn are a type of derivative”. Spread betting involves betting on the direction of the value change of an investment. Investors can “go long”, predicting that an investment will increase in value or “go short”, predicting that an investment will decrease in value.
There are several perceived advantages to owning CFDs. First, they are more tax efficient than owning shares outright, as stamp duty is not payable on disposals. Secondly, customers can invest in a product without needing to buy the asset in which they wish to invest. Thirdly, customers can leverage (sometimes up to several hundred times) the amount they hold on deposit, increasing the potential return (but also risk) of their investment.
The FCA’s review focussed on 19 firms that offer CFD products to intermediaries, who then distribute the products to retail customers on either an advisory or a discretionary portfolio management basis and 15 firms who distribute to retail investors.
The FCA have highlighted what it perceives the main failings of CFD providers and distributors as follows:
- An overly wide target market (which was poorly defined);
- Ineffective communication, monitoring and challenge practices;
- Inadequate due diligence procedures;
- Weaknesses in the conflict of interest management arrangements of distributors;
- Room for improvement in the remuneration arrangements of CFD distributors; and
- Problems with the criteria for the categorisation of clients as “elective professionals”.
The FCA says that many firms have a poor understanding of the suitable target market for these complex financial products, meaning that the products may have been sold to unsuitable customers who do not fully understand the risks. For example, some firms relied upon broad investor definitions such as “experienced”. The FCA considers that a failure to fully define a target market has resulted in over 3/4 of the customers’ analysed losing money on CFDs between July 2015 and July 2016.
The FCA says that CFD providers did not execute adequate due diligence on CFD distributors. The FCA reports that some distributors pay staff on a “100% variable” basis which may encourage staff to mis-sell products to customers so as to meet sales targets. CFD providers should, according to the FCA’s findings, be assessing “how the CFD product will be distributed and the distributor’s knowledge and understanding of the product”.
The “Dear CEO” letter warns firms in no uncertain terms: “You should consider the issues we raise in this letter against the conduct of your firm as a CFD provider or distributor. If, when reviewing your arrangements, you identify any areas of concern, we expect you to have regard to the applicable rules and guidance in this letter and take action to ensure compliance.”
The FCA’s investigation and warning is not surprising. It follows a review by The European Securities and Markets Authority into the industry, which announced on December 2017 that it was considering “the use of product intervention powers to address risks to investor protection” which included the consideration of measures that would prohibit/restrict the sale of CFDs to retail clients.
It appears that some in the market may have responded to the regulatory warnings. Several firms who were reviewed by the FCA have announced that they have stopped distributing CFDs. The FCA will take further action against one CFD provider (which it identified as being particularly poor) and intends to conduct a follow-up review.
Firms that produce or distributing CFDs should review their procedures (particularly, oversight and control procedures) in light of the FCA’s warning and take appropriate action to ensure that they are effectively safeguarding customers’ interests.
Following on from the regulatory warnings, it now remains to be seen whether negligence claims by customers against firms relating to the alleged mis-selling of CFDs will increase in the future.