Ivan Gowan, CEO at Capital.com, looks at the new regulations and asks whether they are all in the best interests of the consumer.
First the boring bit – or perhaps not. On 3 Jan 2018, the European Securities and Markets Authority (ESMA) received product intervention powers, as the Markets in Financial Instruments Regulation (MiFIR) came into force. This allows ESMA to temporarily dictate regulations across all 28 EU member states, either in support of or overruling the National Regulator – in the UK’s case the Financial Conduct Authority (FCA). On 27 March, ESMA decided to use these new powers to intervene in the market for CFD trading. As with many new regulations, the broad direction is to be welcomed – providing much-needed protection for consumers – but flaws in the detail could lead to unintended negative consequences.
The intention is to protect unwary and inappropriate consumers from taking on risks they don’t understand and suffering disproportionate financial losses. This is a laudable intention in anyone’s book and responsible CFD providers will already be compliant with much of the detail in these recommendations. CFD providers already have a responsibility to help retail investors manage their risk and align it to their ability to withstand any financial losses. ESMA’s temporary measures provide a salutary reminder and an improved yardstick for providers to measure themselves against getting this balance right.
The central aspect of a CFD which provides both the main risk and the main benefit is the ability to take a relatively large financial position with a smaller upfront margin payment – what’s called leverage. ESMA measures include putting a leverage limit on the opening of a CFD. This level varies according to the volatility of the underlying instrument, from as little as 2:1 for cryptocurrencies to 30:1 for major currency pairs. They also include a margin closeout rule of 50 per cent of the initial required margin, meaning the position must be closed as it moves against the client. Very sensibly, negative balance protection is mandated, which prevents a client from losing more than their deposit – this is already a common aspect of dealing with most reputable providers. ESMA also recognise the importance of new clients to the industry fully understanding the likelihood of success and are proposing the use of a specific warning that details the win/loss ratio.
This all seems very sensible, doesn’t it? So, where is the issue? Well, there are two interlinked issues here. What makes the CFD a popular way of trading the financial markets and hedging out other risks is the leverage it offers – the ability, as mentioned earlier, to take a relatively large financial position with a smaller amount of upfront margin. Clients enjoy using leverage sensibly. Coupled with the risk mitigation measures already offered by reputable providers in the industry, or now mandated by ESMA going forward, clients should be free to use appropriate levels of leverage commensurate with their knowledge and experience. The industry has a responsibility to help ensure they do not over-expose themselves to risk, which is done by way of thorough questionnaires designed to establish their understanding of the risks and practicalities of CFD trading. Responsible CFD providers are increasingly developing platforms that offer users an experience in line with their ability to manage risk. CFD providers can offer less experienced users lower levels of leverage as those users gain the necessary knowledge and experience to take on larger trades. This approach, though not mandated, could and should form part of the provision of a responsible trading environment.
The corollary to not offering appropriate and desired levels of leverage to more experienced users, and the main unintended consequence is that clients simply go somewhere else – somewhere where the protections are either lower or non-existent. But where? Well, in the world of the internet, unscrupulous trading providers abound – either real platforms, simply unregulated, where behaviours are questionable at best, or sophisticated financial scams, with no underlying trading ever taking place – think Wolf of Wall Street. Since February, the FCA has warned about three firms operating illegally in the UK, but unfortunately, the FCA website is not bedtime reading for many. But these providers appear to offer users the levels of leverage they seek, levels which the reputable providers are being forced to withdraw.
So, what is the answer? A mix of the above, with the best outcome for the consumer at the heart of all changes; regulations that allow and encourage compliant CFD providers to offer consumers what they seek, while presenting them with risk mitigation tools and targeted education to allow them to go on enjoying the trading experience in a controlled environment – while understanding the likelihood of ultimate financial success. Good regulations will encourage innovations which benefit the consumer, such as some of those we have seen in the recent past: stop losses and limits, which ensure that a trader’s position will be closed as soon as their losses or profits reach a specific point: alerts to notify them when a market hits a certain price, providing them with either an exit or entry point in a specific market: or the game-changing developments in mobile app trading.
So, in summary, the ESMA regulations will help to create a level playing field between responsible CFD providers and mandate a number of measures to protect consumers from irresponsible risks. However, the medicine here could be worse than the ailment if the impact of overly restrictive levels of leverage is to drive consumers offshore to unscrupulous operators, where there are no protections and the likelihood of losing your money is 100%. ESMA should consider the imposition of leverage restrictions not as a standalone, but in the context of the other protections in place. Insisting CFD providers make a responsible assessment of the level of risk that a retail trader can take, alongside negative balance protection and the margin closeout requirement, should enable levels of leverage which will keep traders onshore, protected by a compliant industry with a vested interest in sustainability and longevity.