On 6 December 2016, the Financial Conduct Authority (FCA) published a consultation paper (CP16/40) proposing stricter rules for firms selling contract for difference (CFD) products to retail clients. In this context CFD products also include spread betting and rolling spot foreign exchange (FX) products, which are typically traded by retail clients through online platforms. The proposed changes seek to address regulatory concerns around how such products are marketed and provided to retail clients who fail to understand the risks involved and who (considerably) more often than not lose money when trading such products.
CP16/40 also sets out the FCA’s possible policies towards binary options (sometimes referred to as “binary bets”), which are currently supervised by the Gambling Commission but which will be brought into the FCA’s regulatory perimeter as part of MiFID II implementation. Such products are already treated as MiFID financial instruments in many other EU member states, and other EU national regulators have also been concerned about the consumer protection implications of such highly speculative products.
The FCA is now seeking views about its proposals and welcomes views from all stakeholders. Reponses are requested by 7 March 2017 and a policy proposal will be published in spring 2017.
Firms involved in the CFD market already had to contend with the significant changes that MiFID II and PRIIPs will bring about from January 2018, including in relation to meeting product governance, conflicts of interest and best execution requirements and producing Key Information Documents. The new proposals will, amongst other things, require firms to implement new client take-on, assessment and segmentation processes and systems, as they effectively divide retail clients into two new tiers (experienced clients and inexperienced clients). The proposals will also require new, prominent risk warnings and disclosures to be used, including showing actual profit-loss ratios amongst a firm’s clients. It seems likely that 2017 will be a challenging year for firms in the CFD market and some may even face an existential crisis.
In the context of a significant increase in the number of UK and EEA firms operating in the domestic CFD market over the past five years, the FCA has concerns that more retail clients than ever before are trading CFD products that they do not adequately understand. The FCA considers that firms are failing to fully consider if CFDs are appropriate for their clients, failing to provide sufficient risk warnings, and offering excessive levels of leverage. This is leading to a majority of clients (over 80% of those sampled by the FCA) losing money on these products.
The FCA is consulting on a package of measures intended to enhance consumer protection by limiting the risks of CFD products and ensuring that retail clients are better informed. The new measures include:
- Introducing standardized risk warnings and mandatory disclosure of profit-loss ratios to better illustrate the risks of CFD products;
- Imposing lower leverage limits of a maximum of 25:1 for inexperienced retail clients (i.e. clients with less than 12 months’ experience of active trading in CFDs or who fail to meet certain minimum trading frequency thresholds);
- Capping leverage at 50:1 for experienced retail clients and introducing lower leverage caps across different assets according to their risks;
- Setting a margin close out limit of 50% of initial margin required, so that a client’s open positions will be closed out if their net equity falls below this level at any time (although the mechanics of how this could work in practice are likely to be more complex than contemplated); and
- Preventing firms from using any form of trading or account opening bonuses or benefits to promote their retail CFD products and platforms.
Additionally, in light of its concerns over consumer protection and whether binary options can meet a genuine investment need for retail clients, the FCA is consulting on a range of possible policy measures including whether it would be appropriate to:
- Restrict the marketing of binary options to certain retail clients;
- Use intervention powers to address specific product features and/or the nature of marketing, sales and distribution techniques relating to binary options; and
- Use other approaches to ensure binary options are designed in a manner that meets the needs of the market, allows investors to understand their fair value and are capable of being appropriately distributed.
Despite the European Securities and Markets Authority (ESMA) and certain EU national regulators issuing various guidance (e.g. on appropriateness) to bring about improvements in the CFD market in recent years, and the positive response from some of the leading UK firms in relation to this, it is clear that significant regulatory concerns remain. Certain EU regulators still appear to be highly skeptical that the benefits of CFD products for retail clients outweigh their perceived complexity, risk and opacity. Whilst the FCA proposals fall short of proposing any outright ban, they clearly state the FCA’s views that mass marketing of CFD products is unlikely to be compatible with MiFID II, as CFD products will only be suitable for a small minority of retail clients. Measures have been taken or proposed in other EU jurisdictions to restrict the promotion and/or trading of CFD products with retail clients, and in Belgium, France and the Netherlands in particular.
It remains to be seen whether the FCA is too late in tackling such issues, as the likelihood of individual national regulators in the EU introducing an outright prohibition on trading such products with retail clients increases, particularly post-MiFID II. Although in practice EU national regulators have the means already to implement a de facto ban should they choose to do so, as demonstrated in Belgium.
Sticking with the domestic market, the proposals may present an opportunity to firms that have already addressed some of the FCA’s concerns, for example by investing in client education and training programmes and systems that allow them to segment their retail clients depending on their level of sophistication and experience. These firms may also look in due course to ask certain of their retail clients to upgrade to professional client status, where that is appropriate, so that the client can avoid the impact of some of the rules (e.g. on leverage limits). Firms have tended not to look to upgrade individual clients post-MiFID, but this may become more common for the small minority of clients who meet the relevant criteria to be categorised as a professional client.
The FCA’s proposals include a ban on financial promotions in the UK by firms from jurisdictions that do not meet equivalent standards of consumer protection, and so in theory the potential for overseas firms benefiting from regulatory arbitrage should be reduced. The vast majority of firms offering such products in the EU are based in the UK and Cyprus, and there has been much industry debate around the significant gap in standards between the two jurisdictions. Even though the Cypriot regulator (the Cyprus Securities and Exchange Commission (CySec)) recently introduced similar proposals to the FCA, some may question whether CySec would have the resources and/or appetite to be able to supervise and take action against Cypriot firms with the same degree of rigour as the FCA would in relation to UK firms. It is often galling for UK firms that incur considerable expense in meeting regulatory concerns to see no or ineffective action taken against those (often non-UK) firms who do not.
Reponses to the consultation paper are requested by 7 March 2017 and a policy proposal will be published in spring 2017. You can respond to the consultation by using the form on the FCA website that can be found at: https://www.fca.org.uk/cp16-40-response-form.