On 9 November 2018, the European Securities and Markets Authority (ESMA) renewed the prohibition of the marketing, distribution and sale of binary options to retail clients for another tree-month period, starting from 2 January 2019. This follows the renewal by ESMA of the relevant restrictions on Contracts For Difference (CFDs), which was formally adopted on 23 October 2018 and became effective on 1 November 2018 and for a further three-month period. ESMA also updated its relevant questions and answers.

ESMA introduced these product intervention measures in March 2018 to address concerns and risks of investor detriment. The ban on the offering of binary options to retail clients has been effective since July 2018, while mandatory requirements on the offering of CFDs have been applicable since August 2018. We have previously commented on these regulatory measures. According to ESMA, ‘a significant investor protection concern’ still exists, justifying this further intervention.

Risks of investing in binary options and CFDs

Binary options and CFDs are generally perceived as high-risk products. According to ESMA’s findings in March 2018, the complexity and the lack of transparency of CFDs makes them unsuitable for retail clients. CFDs are typically highly leveraged products, which means that investors may suffer considerable losses if prices go against them. According to ESMA, 74-89% of retail clients typically lose money on their investments. Despite the inherent risks, CFDs are usually offered to retail investors via online platforms, which usually lack the necessary safeguards to mitigate the risks for investors.

The International Organization of Securities Commissions (IOSCO) and the Financial Conduct Authority (FCA) have both issued warnings on the risks associated with binary options. Investors in binary options typically gamble on whether the value of an underlying asset will decrease or increase by a specific minimum amount within a generally short, specific timeframe. If they do not predict correctly, then they may lose the entirety of their investment.

The FCA describes binary options as ‘a form of fixed-odds betting’. Lower probability events attract higher returns and vice versa. To make a profit an investor needs to systematically ‘beat the odds’, which is highly unlikely. Like gambling, investing in binary options can cause addictive behaviour.

Therefore, the FCA has warned that consumers who invest in binary options typically lose money. IOSCO also emphasises that unsophisticated investors are especially vulnerable, given that they lack the technical skills to properly price the value of product, which is often negative.

Illegal or fraudulent binary options

In addition to the inherent risks, consumers are often deceived by illegal or fraudulent binary option schemes. According to IOSCO, only a small part of scheme transactions taking place in the relevant markets involves binary options that are listed on registered and regulated exchanges. The majority of marketing and trading takes place on internet-based trading platforms and social media that may escape regulatory oversight and that may fail to comply with regulatory requirements. Online solicitation, promotion and advertising or via mobile apps are common methods of approaching potential investors.

Victims of such schemes have suffered massive losses worldwide and have subsequently filed complaints with a number of regulators in several jurisdictions. However, even if the necessary enforcement action to stop the illegal activity is undertaken, investors may still not be able to recover their investment, IOSCO warns.

Binary option investment scams have been targeting UK consumers as well. To attract investors, scams typically promise higher than usual returns for non-existent bets as well as distorting prices and payouts. Investors are often unable to retrieve their funds or contact the providers. Following the EU-wide prohibition on binary options since July 2018, the FCA has warned that the majority of firms offering these products are, in fact, unauthorised or scams.

Regulatory response

ESMA decided to renew the prohibition on binary options, while maintaining the limited exemptions that were first introduced in August 2018. These exclude a small number of products that mitigate the risks for investors. In particular, these exemptions broadly involve binary options for which the lower of the two predetermined fixed amounts is at least equal to the total payment made by a retail client for the binary option, including any commissions, transaction fees and other related costs, provided that certain additional conditions are met. You can read more about the scope of the prohibition here.

Restrictions on CFDs include leverage limits on the opening of a position by a retail client; a margin close out rule on a per account basis; negative balance protection on a per account basis; a restriction on the incentives offered to trade CFDs; and a standardised risk warning, including the percentage of losses on a CFD provider’s retail investor accounts. You can read more about the CFD mandatory requirements here.

At an international level, regulators in several jurisdictions have also undertaken warnings, marketing restrictions and enforcement action.

Market reaction

This regulatory intervention appears to have already had a significant impact on the business of the relevant market participants. On 22 November 2018, the London-based spread betting platform CMC Markets published its half year interim results for 2018 that showed a loss of 76 per cent in its profits and a decrease in its net operating income of 21 per cent. According to CMC Markets this is due to low market volatility as well as to ESMA’s intervention measures. ‘Whilst trading in the first quarter outperformed the same period last year, as previously announced, the second quarter was particularly difficult. Volatility was low, and unusually the majority of asset classes traded in tight ranges. This was further compounded by the impact of European regulatory change that came into force on 1 August. As a result, overall profit after tax was significantly lower than the same period last year,’ said Peter Cruddas, Chief Executive Officer of CMC Markets.