The European Securities and Markets Authority (ESMA) has announced its intention to prohibit the sale of binary options to retail investors and to place restrictions on the sale of contracts for difference (CFDs). This is the first use of ESMA's new intervention powers under MiFID II.

In the past few years, ESMA has become increasingly concerned about the risk of harm to retail investors resulting from their investment in binary options and CFDs. Studies from various EU jurisdictions have shown that between 74% and 89% of retail investors typically lose money on their investments in CFDs with average losses ranging from €1,600 to €29,000.

We reported on ESMA's announcement in June 2017 that it was considering product intervention measures regarding this market, as well as reporting on ESMA's request for responses from the industry and investors to its specific plans in its Call for Evidence in January 2018. Its latest announcement this week sets out the changes that will be implemented for CFD and binary options providers in the coming months.

CFDs and Binary Options – What's the difference?

CFDs and binary bets are complex products that are, essentially, gambles on the entry and exit prices of an underlying asset within a given time. The asset can be anything that has a financial value, for example a currency, stock or index.

The payment to (or from) an investor with respect to a CFD depends on the actual difference in entry and exit price, so losses can exceed the amount invested.

In contrast, the payment with respect to a binary bet is set from the outset and, as the name suggests, the investor will either receive all of this amount or nothing at all if the bet goes against them.

Prohibition on Binary Options

ESMA has concluded that binary options are fundamentally unsuitable for retail investors as they do not meet any genuine retail investment needs, but are essentially gambling products that attract compulsive gambling behaviour. ESMA has, therefore, banned them entirely for retail investors as it considers that no less stringent measure would adequately address its concerns.

Restrictions on CFDs

On the other hand, ESMA considers CFDs do play a role in meeting retail investment needs. Therefore, instead of prohibiting them, it plans to implement the following measures to protect retail investors:

  • leverage limits on opening of positions by retail investors, which will vary depending on the volatility of the underlying asset

  • margin close out rule on a per account basis

  • negative balance protection on a per account basis

  • restriction on incentives offered to retail investors to trade CFDs

  • all marketing materials to contain a standard risk warning, setting out the percentage of retail CFD accounts that lost money with the CFD provider in the last 12 months.

The overall objective of these measures is to discourage retail investors from investing in CFDs in the first place and to limit their exposure to financial loss if they do. The negative balance protection in particular means that, for the first time, retail investors cannot lose more money than they invest.

Next Steps

ESMA is only able to use its intervention powers in this regard for a maximum period of three months. Therefore, it will have to consider at three monthly intervals whether to renew these measures or adapt them. However, it seems likely that restrictions of some form or another are here to stay in the CFD industry.

The FCA has been very vocal about its concerns for retail investors in this sector, in particular regarding investments that relate to cryptocurrencies. The FCA has confirmed its support for these measures and will likely be keen to enforce these restrictions in the UK on a permanent basis.

Therefore, CFD firms will need to be particularly nimble to adapt to these wide-ranging changes if they want to keep the FCA at bay.