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CFDs – Regulators Use New Intervention Measures To Provide Greater Investor Protection

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CFDs – Regulators Use New Intervention Measures To Provide Greater Investor Protection

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? 

David Calligan

David Calligan

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. 

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.

Trading

Barclays announces new trade finance platform for corporate clients

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Barclays announces new trade finance platform for corporate clients 1

Barclays Corporate Banking has today announced that it is working with CGI to implement the CGI Trade360 platform. This new platform will provide an industry leading end-to-end global trade finance solution for Barclays clients in the UK and around the world.

With the CGI Trade360 platform, Barclays will provide clients with greater connectivity and visibility into their supply chains, allowing them to optimise working capital efficiency, funding and risk mitigation. By utilising cloud based functionality for corporate banking clients, Barclays will also be able to offer a leading client user experience through easy access and real-time integration to essential information, combined with the latest trade solutions as the industry-wide shift to digitisation continues to accelerate.

This move underpins Barclays commitment to supporting the trade and working capital needs of their clients and reinforces a commitment to innovation that has been central to the bank for more than 300 years.

James Binns, Global Head of Trade & Working Capital at Barclays, said: “We are delighted to announce our move to the CGI Trade360 platform and to have started the implementation process. We have a longstanding partnership with CGI, and the CGI Trade360 platform will mean we can continue delivering the best possible trade solutions and service to our clients for many years to come.”

Neil Sadler, Senior Vice President, UK Financial Services, at CGI, said: “Having worked closely with Barclays for the last 30 years, we knew we were in an excellent position to enhance their systems. Not only do we have a history with them and understand how they work, but part of the CGI Trade360 solution includes a proof of concept phase, which is essentially seven weeks of meetings and workshops with employees across the globe to guarantee the product’s efficiency and answer all queries. We’re delighted that Barclays chose to continue working with us and look forward to supporting them over the coming years.”

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What’s the current deal with commodities trading?

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What’s the current deal with commodities trading? 2

By Sylvain Thieullent, CEO of Horizon Software

The London Metal Exchange (LME) trading ring has been the noisy home of metals traders buying and selling for over a hundred years. It’s the world’s oldest and largest metals market and is home to the last open outcry trading floor. Recently however, the age-old trading ring, though has been closed during the pandemic and, just a few weeks ago, the LME announced that it will remain so for another six months and that it is taking steps to improve its electronic trading. This news fits in with a growing narrative in commodities about a shift to electronic trading that has been bubbling away under the surface.

Something certainly is stirring in commodities. The crisis has affected different raw materials differently: a weakening dollar and rising inflation risks bode well for some commodities with precious metals being very attractive, as seen by gold reaching all-time highs. Oil on the other hand has had a tough year and experienced record lows from the Saudi-Russia pricing war. It has been a turbulent year, and now prices look set to soar. While a recent analyst report from Goldman Sachs predicts a bullish market in commodities for the year ahead, with the firm forecasting that it’s commodities index will surge 28%, led by energy (43%) and precious metals (18%).

Increasingly, therefore, it seems that 2020 is turning out to be a watershed moment for commodities, and it’s likely that the years ahead will bring about significant transformation. And whilst this evolution might have been forced in part by coronavirus, these changes have been building up for some time. Commodities are one of the last assets to embrace electronic trading; FX was the first to take the plunge in the 90s, and since then equities and bonds have integrated technology into their infrastructure, which has steadily become more advanced.

The slow uptake in commodities can be explained by several truths: the volumes are smaller and there is less liquidity, and the instruments are generally less exotic, essentially meaning it has not been essential for them to develop such technology – at least not until now. This means that, for the most part, the technology in commodities trading is a bit outdated. But that is changing. Commodities trading is on the cusp of taking steps towards the levels of sophistication in trading as we see in other asset classes, with automated and algo trading becoming ever prominent.

Yet, as commodities trading institutions are upgrading their systems, they will be beginning to discover the extent of the job at hand. It’s no easy task to upgrade how an entire trading community operates so there’s lots to be done across these massive organisations. It requires a massive technology overhaul, and exchanges and trading firms alike must be cautious in the way they proceed, carefully establishing a holistic, step-by-step implementation strategy, preferably with an agile, V-model approach.

The workflow needs to be upgraded at every stage to ensure a smooth end-to-end trading experience. So, in replacement of the infamous ring, these players will be looking to transform key elements of their trading infrastructure, including re-engineering of matching engines and improving communications with clearing houses.

However, these changes extend beyond technology. For commodities players to make a success of the transformation in their community, exchanges need to have highly skilled technology and change the very culture of trading. All of which is currently being done against a backdrop of lockdown, which makes things much more difficult and can slow down implementation.

What is clear is that coronavirus has definitely acted as a catalyst for a reformation in commodities. It is a foreshadowing of what lies ahead for commodities trading infrastructure because, a few years down the line, commodities trading could well be very different to how it is now, and the trading ring consigned to history.

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Afreximbank’s African Commodity Index declines moderately in Q3-2020

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Afreximbank’s African Commodity Index declines moderately in Q3-2020 3

African Export-Import Bank (Afreximbank) has released the Afreximbank African Commodity Index (AACI) for Q3-2020. The AACI is a trade-weighted index designed to track the price performance of 13 different commodities of interest to Africa and the Bank on a quarterly basis. In its Q3-2020 reading, the composite index fell marginally by 1% quarter-on-quarter (q/q), mainly on account of a pull-back in the energy sub-index. In comparison, the agricultural commodities sub-index rose to become the top performer in the quarter, outstripping gains in base and precious metals.

The recurrence of adverse commodity terms of trade shocks has been the bane of African economies, and in tracking the movements in commodity prices the AACI highlights areas requiring pre-emptive measures by the Bank, its key stakeholders and policymakers in its member countries, as well as global institutions interested in the African market, to effectively mitigate risks associated with commodity price volatility.

An overview of the AACI for Q3-2020 indicates that on a quarterly basis

  • The energy sub-index fell by 8% due largely to a sharp drop in oil prices as Chinese demand waned and Saudi Arabia cut its pricing;
  • The agricultural commodities sub-index rose 13% due in part to suboptimal weather conditions in major producing countries. But within that index
    • Sugar prices gained on expectations of firm import demand from China and fears that Thailand’s crop could shrink in 2021 following a drought;
    • Cocoa futures enjoyed a pre-election premium in Ghana and Côte d’Ivoire, despite the looming risk of bumper harvests in the 2020/21 season and the decline in the price of cocoa butter;
    • Cotton rose to its highest level since February 2020 due to the threat of storm Sally on the US cotton harvest, coupled with poor field conditions in the US;
    • Coffee rose 10% as La Nina weather conditions in Vietnam, the world’s largest producer of Robusta coffee, raised the possibility of a shortage in exports.
  • Base metals sub-index rose 9% due to several factors including ongoing supply concerns for copper in Chile and Peru and strong demand in China, especially as the State Grid boosted spending to improve the power network;
  • Precious metals sub-index, the best performer year-to-date, rose 7% in the quarter as the demand for haven bullion continued in the face of persistent economic challenges triggered by COVID-19 and heightening geopolitical tensions. In addition, Gold enjoyed record inflows into gold-backed exchange traded funds (ETFs) which offset major weaknesses in jewellery demand.

Regarding the outlook for commodity prices, the AACI highlights the generally conservative market sentiment with consensus forecasts predicting prices to stay within a tight range in the near term with the exception of Crude oil, Coffee, Crude Palm Oil, Cobalt and Sugar.

Dr Hippolyte Fofack, Chief Economist at Afreximbank, said:

“Commodity prices in Q3-2020 have largely been impacted by COVID-19. The pandemic has exposed global demand shifts that have seen the oil industry incur backlogs and agricultural commodity prices dwindle in the first half of the year. The outlook for 2021 is positive however conservative the markets still are. We hope to see an increase in global demand within Q1 and Q2 – 2021 buoyed by the relaxation of most COVID-19 disruptions and restrictions.’’

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