David Calligan, Partner, Reed Smith, writes on the European Securities and Markets Authority (ESMA)’s announcement that it intends 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 in July.
What is concerning about CFDs?
ESMA’s Consultation addressed the sale, distribution and marketing of CFDs and binary options to retail investors. The consensus is that these products pose a threat to retail investors, primarily because CFDs are complex and often lack transparency. The 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 trading in 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.
Final measures compared to the Consultation
In the Consultation, ESMA proposed five measures relating to CFDs, namely:
- Margin Close Out (MCO) rule of 50% on a position-by-position basis;
- Imposition of leverage limits;
- Standardised risk warning;
- Restriction on incentivisation of trading;
- Negative balance protection on a per account basis.
These proposals have now been considered and will be implemented with just one change. Regarding the MCO rules, ESMA has chosen to impose these rules on a per account basis as opposed to a position-by-position basis.
What next for CFD providers?
ESMA plans to review these measures 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 them for the foreseeable future.
What can the industry do to adapt?
A range of changes will need to be made by the industry and CFD providers, because 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 so that their losses cannot exceed the money invested.
There will also 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 advertisements. 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 them. 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.
Can the regulations be avoided?
Some retail clients may decide to sidestep the new regulations by becoming an ‘elective professional’, thus continuing to receive current leverage amounts. For this purpose, 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.
Another method that may appeal to investors, seeking 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 avoiding these restrictions, the investor will also not be afforded the retail investor protections of the FCA and other relevant regulators in the EU.
What is the European perspective?
In Germany, domestic regulator BaFin issued a general Administrative Act in May 2017, limiting the marketing, distribution and sale of financial CFDs. It 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.
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, although some of the measures are more stringent than the French electronic ban.
How long until implementation?
ESMA plans to enact the product intervention measures once they have been translated into the official languages of the EU; it will then publish an official notice in the Official Journal of the European Union. This is not likely to occur before the end of May, at the earliest, and two months after this the CFD restrictions will come into effect and require implementation. This means that the measures may come into force in July. If the current state of the market is indicative, then there will likely be a high proportion of both platforms and providers rushing to achieve compliance before it’s too late.
