By David Calligan, Partner at Reed Smith
This March, the European Securities and Markets Authority (ESMA) announced that it intended to impose temporary measures to restrict the sale of Contracts for Differences (CFDs) to retail investors, after a consultation earlier this year. The temporary restrictions are likely to come into effect from late June/early July.
What are CFDs, and why have they caused concern?
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.
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ESMA’s consultation related to the sale, distribution and marketing of CFDs and binary options to retail investors. The consensus appeared to be that these products posed a threat to retail investors, primarily due to the fact that CFDs are complex and often lack 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. From the UK’s perspective, the FCA was also concerned that retail customers were opening and trading CFD products that they did not adequately understand. Ultimately, ESMA decided that these concerns merited intervention to provide greater protection, especially since losses can often exceed the money invested.
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
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.
What does this mean for CFD product providers?
Since these measures are temporary, ESMA plans to review them 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. It is likely that CFD firms will have to comply with these measures for the foreseeable future.
How can the industry adapt to the changes?
There are a number of changes that the industry, and CFD providers, will have to make as a result of ESMA’s decision. Leverage restrictions will have to be communicated to clients and built into systems, meaning that the amount of leverage risk taken on by clients will be clearer. Also, providers will need to offer negative balance protection for all retail clients, which again should shore up the security of the market.
One of the most noticeable changes will be the need for risk warnings, relating to the percentage of investors that have lost money, which must be placed prominently on the provider’s website and also be displayed in any other advertising. Similarly, any bonuses or other similar incentives to trade will need to be reviewed and removed if they are inappropriate under ESMA’s regulations, which will cut down on providers’ freedom to advertise.
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.
Is there any escape from these regulations?
Some retail clients may opt to sidestep the new regulations by becoming an ‘elective professional’, thus continuing 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.
An alternative method that may appeal to some ambitious 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, by foregoing these restrictions, the investor will also not be afforded the retail investor protections of the FCA and other relevant regulators in the EU.
How are other EU jurisdictions reacting?
In Germany, domestic regulator BaFin issued a general administrative act regarding CFDs in May 2017, limiting the marketing, distribution and sale of financial CFDs.
The regulator has professed significant investor protection concerns in relation to unquantified losses that may occur following the purchase of CFDs.
It is likely that the Administrative Act will now be revoked or amended to be in line with the final ESMA position, since ESMA has broadly agreed with the German attitude.
Similarly, 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 March press release, the AMF welcomed the ESMA initiative and its measures regarding the provision of CFDs and binary options, indicating that they too intend to honour them – even though some of the measures are more stringent than the French electronic ban.
When will this all fall into place?
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. This should take place in late April or early May, and two months from this point the CFD restrictions will come into effect and need to be implemented. The measures can therefore be expected to come into force around late June or early July. Given the current market, there will doubtless be a number of providers and platforms scrambling to comply in time.