At a Glance…
On 18 January 2018, the European Securities and Markets Authority (ESMA) published a call for evidence on potential product intervention measures relating to the sale, distribution and marketing of contracts for differences (CFDs) and binary options to retail investors. ESMA has asked for comments by 5 February, just 12 working days following publication. ESMA has not said when it will publish follow-up proposals, but the narrow deadline suggests that measures may be imposed sooner rather than later.
In a statement published on 15 December 2017, ESMA expressed its concern about the threat to retail investors’ protection provisions that the proliferation of CFDs poses. ESMA explained in the statement that it was considering the possible use of its product intervention powers under article 40 of MiFIR1 to address the concerns posed by the marketing, distribution and sale of CFDs to retail investors. It expresses the same sentiment in the call for evidence.
In ESMA’s view, CFDs:
- expose retail investors to significant risk of loss from trading and transaction fees, which is exacerbated by high leverage;
- lack transparent information at point of sale, limiting retail investors' ability to understand the risks involved in inherently complex products; and
- are subject to incentives and other aggressive marketing techniques.
ESMA believes that the objective of investor protection can be achieved by restriction rather than prohibition.
ESMA has observed a rapid increase in the marketing, distribution and sale of CFDs to retail investors across the EU. The inherent risk and complexity of these products, combined with their wide-reaching marketing, distribution and sale through online platforms, have led ESMA to express significant investor protection concerns. As a result, local regulators have taken steps to enhance consumer protection, with leverage limits being imposed in a number of countries. At one extreme, the Belgian Financial Services and Markets Authority, for example, banned the sale to retail clients of leveraged CFDs and binary options in the summer of 2016. (See the information at the end of this article for a more detailed review of the approaches to date in the UK, Germany and France.)
Call for evidence
ESMA has stated that it is considering restricting the marketing, distribution or sale of CFDs to retail investors by implementing the following restrictions:a. Leverage limits
The limits would range from 30:1 to 5:1, depending on the historical price behaviour of the underlying asset. A limit of 20:1, for example, implies that the retail customer must post an initial margin of 5 per cent of the initial total exposure of the CFD.
By contrast, the FCA put forward less stringent limits in its consultation paper, proposing CFD leverage limits of 25:1 for new customers and 50:1 for experienced customers.
ESMA is also reviewing its position in relation to CFDs on cryptocurrencies. ESMA is currently discussing whether an initial 5:1 leverage would provide enough investor protection, or whether the unique volatility of cryptocurrencies might demand stricter measures (such as an outright prohibition).
b. A margin close-out rule on a position-by-position basis
This rule would standardise the percentage of margin at which providers would be required to close out a retail client’s open CFD. It would mean that the position must be closed out on terms most favourable to the client at the time when the available sum remaining in the trading account falls below 50 per cent of the amount of the initial margin posted.
For example, a CFD with a leverage limit of 5:1, which requires a minimum initial margin of 20 per cent of initial total exposure, must be automatically closed out if the overall margin allocated to the CFD falls below 10 per cent of the initial total exposure.
c. Negative balance protection on a per account basis
ESMA proposes a negative balance protection on a per account basis rather than per position.
d. A restriction on incentivisation of trading
This restriction is intended to reduce the use of incentives to entice retail clients to use CFDs. It is proposed that providers will be banned from providing retail clients with a payment (other than a realised profit on any CFD) or a non-monetary benefit, to induce trading.
e. A standardised risk warning
ESMA is considering requiring CFD providers to provide a standardised warning in any communication to, or published information accessible by, a retail client relating to the marketing, distribution or sale of a CFD. One option is to mandate CFD providers to indicate the percentage of retail client accounts that posted losses in the previous quarter, which may provide a more tangible risk warning.
What happens next?
ESMA has asked stakeholders to outline the likely impact that the above proposals would have on their business. In submitting responses, stakeholders are invited to submit qualitative and quantitative data, to inform ESMA’s decisions.
While an outright pan-European ban is unlikely, ESMA may turn to the product intervention powers under article 40 of MiFIR if it appears that the risks to investor protection are not sufficiently controlled. The regulation provides ESMA with the power to require temporary prohibitions concerning financial instruments when the proposed action addresses a “significant investor protection concern in the Union”.
We now await ESMA’s decisions. While it appears that investor protection concerns can be addressed without banning CFDs (unlike ESMA’s considerations in relation to binary options), the resultant proposals – depending on their severity – may, of course, cause some providers to cease to offer CFDs to retail clients.
Some market participants have started to re-classify certain clients as professional clients rather than retail clients in a bid to avoid the restrictions proposed by ESMA. There is also a possibility that some clients will move their accounts to brokers in less restricted jurisdictions.
There has been a great deal of regulatory concern about these products in recent years but no strong European framework to act as a foundation (as evidenced by the patchwork approach taken by National Competent Authorities across the EU to date). ESMA’s proposals may serve to influence a uniform approach across member states.
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Read David Calligan's article "FCA proposes tougher rules for retail CFD, FX and spread betting providers" to learn more about this topic.