What are CFDs and why have they caused concern?
ESMA’s Consultation in January related to the sale, distribution and marketing of CFDs and binary options to retail investors. It was felt that the proliferation of these products posed a threat to retail investors. What came to be known as the ‘Significant Investor Protection Concern’ related to the fact that CFDs were complex and lacked transparency. The particular points of concern regarding CFDs are excessive leverage, structural expected negative return, embedded conflict of interest between providers and their clients, disparity between the expected return and the risk of loss as well as the issues related to their marketing and distribution. In the UK, the FCA was also concerned that retail customers were opening and trading CFD products that they did not adequately understand. In ESMA’s view, these concerns merited intervention to provide greater protection, especially since losses can often exceed the money invested.
CFDs are complex financial instruments, often offered through online platforms. They are a form of derivative trading and enable an investor to speculate on the rise of the price, level or value of an underlying asset class. They are typically offered with leverage, which means that an investor needs to deposit only a small portion of the total value of an investment. This ‘leverage’ can lead to losses that exceed the initial investment. For instance, when the euro fell dramatically against the Swiss franc in January 2015, many retail investors ended up owing extremely large amounts of money to CFD providers.3
Initial consultation versus the final measures
In the Consultation, ESMA proposed five measures relating to CFDs, namely:
- An imposition of leverage limits
- A Margin Close Out (MCO) rule of 50% on a position-by-position basis
- A negative balance protection on a per account basis
- A restriction on incentivisation of trading
- A standardised risk warning
In relation to binary options, ESMA proposed a prohibition on the sale of such options to retail clients.
All of these proposals have now been considered and will be implemented with just one change. In the case of the MCO rules, ESMA has chosen to impose these rules on a per account basis as opposed to a position-by-position basis.
The effect of the ESMA product intervention measures on CFD product providers
The temporary measures are to be reviewed by ESMA after three months to assess their impact. However, the FCA has already indicated that these measures may be permanently cemented into legislation in the UK at a later date.
Adapting to the new regulations and changing industry practice
Some initial practical considerations include:
- Leverage restrictions will have to be communicated to clients and built into systems.
- MCO systems will need to be reviewed and amended where necessary to implement the 50% MCO limit.
- Negative balance protection for all retail clients will need to be provided.
- New risk warnings relating to the percentage of investors that have lost money must be placed prominently on the provider’s website and also be displayed in any other advertising.
- Any bonuses or other similar incentives to trade will need to be reviewed/removed.
- Client agreements and Key Information Documents will need to be revised.
- Retail firms will need to review their capital adequacy status - for example, matched principal firms will need to consider whether their relationships with hedging counterparties can be adjusted to reflect the new relationship they will have on the client side of the trade. It is likely that some of these firms will need to have the limitation on their licence removed as they will no longer be able to comply with such limitations. Even full scope firms will need to revisit their Internal Capital Adequacy Assessment Processes to consider the financial impact of these changes on their business model and the implications for capital resources.
- Retail firms will need to consider whether any of their products fall within the ESMA definition of binary options.
Is there any escape?
- Elective professionals
Retail clients may opt to sidestep the ESMA restrictions by becoming an ‘elective professional’ and thus continue to receive current leverage amounts. In order to classify a client as an elective professional, a firm would need to demonstrate confidence that the relevant client has the experience and knowledge to trade in the particular area in which they are currently trading or to which the CFD relates. This is known as the ‘qualitative test’ and is a subjective requirement. The client would also need to meet a ‘quantitative test’ by passing objective qualifications in order to be classified as an ‘elective professional’ to which ESMA’s restrictions on CFDs will not apply.
- Creation of an offshore account
An alternative method that may appeal to some investors seeking access to greater leverage is to open a CFD account with a broker in a less restrictive jurisdiction outside the EU.
However, the downside for both these options is that the investor will not be afforded the retail investor protections of the FCA and other relevant regulators in the EU.
The effect of the ESMA product intervention measures in other European jurisdictions
- The position in Germany
BaFin issued a general administrative act regarding CFDs on 8 May 2017 (the Administrative Act) pursuant to section 4b(1) of the German Securities Trading Act (Wertpapierhandelsgesetz).
The Administrative Act limits the marketing, distribution and sale of financial CFDs. CFDs with an additional payments obligation (mit Nachschusspflicht) cannot be offered to retail clients. BaFin therefore used the option of product intervention for the first time to safeguard the interests of retail clients. BaFin has significant investor protection concerns in relation to unquantified losses that may occur following the purchase of CFDs.
BaFin has said that an additional payments obligation applies if the client is obliged to compensate losses it has suffered on its trading account in an amount larger than the monies that the client has deposited to its trading account (see BaFin’s guidance note for more information).
Pursuant to the Administrative Act, providers of CFDs with an additional payments obligation had three months from the date of publication of the Act (i.e. until 10 August 2017) to adjust their business models.
It is likely that the Administrative Act will be revoked or amended to be in line with the final ESMA position.
- The position in France
The AMF, after issuing several warnings on CFDs and binary options, took national measures to ban electronic marketing of certain speculative contracts involving Forex, binaries and CFDs, thereby offering a broader protection to individuals who are not considered as qualified investors.
In a press release dated 27 March 2018, the AMF has welcomed the initiative of ESMA and its measures regarding the provision of CFDs and binary options.
Although the French e-marketing ban regarding CFDs has a wider scope than the one introduced by ESMA, it should be noted that some of the new measures go beyond the current French legislation, notably with respect to the total prohibition of the distribution and sale of binary options to retail clients.
As a consequence, these new measures will apply in addition to the French e-marketing ban.
ESMA intends to adopt the product intervention measures after translation into the official languages of the EU before publishing an official notice in the Official Journal of the European Union (OJEU). We estimate that the timeframe from the date of the press release and publication in the OJEU will take approximately four to six weeks and, therefore, it is our understanding that the OJEU publication is likely to take place either at the end of April or beginning of May this year. It has already been stated by ESMA that two months after the publication of this notice, the CFD restrictions will come into effect and will need to be implemented (with a shorter lead time of one month for binary options). The CFD measures might therefore come into force around late June or early July 2018.