Ricardo Esteves has seen business and economics through many lenses. He joined the Financial Services Industry in 2009, and has been a financial journalist since 2011. He holds a degree in Business Administration and has experience producing real-time news, from both buy-side and sell-side, as well as for retail traders, brokers and service providers. Esteves' work has appeared in a variety of online publications including FX Street and FinanceFeeds.
The European Securities and Markets Authority (ESMA) has announced that it will impose restrictions on contracts for differences (CFDs) to retail investors in the European Union (EU). The authority is receiving a flood of responses, from brokers and retail investors, in an attempt to dissuade the European financial watchdogs from putting the rules into effect, as scheduled.
The ESMA Controversial Rules
The new guidance includes the prohibition on the marketing, distribution or sale of binary options to retail investors, but the trading industry is particularly upset with the CFD restrictions. These include leverage limits on opening positions; a margin closeout rule on a per account basis; a negative balance protection on a per account basis; preventing the use of incentives by a CFD provider; and a firm-specific risk warning delivered in a standardized way.
ESMA argues that the rules are intended to respond to the typical scenario for retail traders: 74-89% accounts lose money, with average losses per client ranging from €1,600 to €29,000. The measures agreed by ESMA’s Board of Supervisors on 23 March 2018
“will for the first time ensure that investors cannot lose more money than they put in, restrict the use of leverage and incentives, and provide a risk warning for investors”, said Steven Maijoor, ESMA Chairman, who pointed to the inherent complexity of the products and their excessive leverage as the reason for the significant losses for retail investors.
Both retail brokers and traders are concerned with the newly announced leverage limits: 20:1 for non-major currency pairs, gold, and major indices; 10:1 for commodities other than gold and non-major equity indices; 5:1 for individual equities and other reference values; and 2:1 for cryptocurrencies. The regulator will be monitoring closely CFDs with cryptocurrencies as an underlying asset as they raise separate and significant concerns.
The Industry Responds to ESMA
Opinions within the capital markets industry vary according to geography, business structure, and market segment, among others. Many have not taken the guidance lightly and are asking the regulatory body to review its decision before it is too late. Others congratulate the decision as the right move for the long run, despite the potential negative short-term effects.
Dan Moczulski, CEO of Star Financial Systems, considers “the ESMA rulings to be so poorly thought out that [he] just can’t predict how the industry will change going forward”. While the intention of protecting the unsophisticated investor is clear, Moczulski says the new rules will not change that outcome because “the investor attracted to get rich quick, poor risk/return outcomes does not understand or seek regulatory protection.[…] These changes now guarantee that the unregulated, or lightly regulated industry has a more attractive message than the regulated industry.”
This simplistic view of the industry, according to Moczulski, fails “to acknowledge the lack of implementation of the local regulator’s existing powers. Other aspects of the introduced rules seem confused. For example, negative balance protection. By nature, this promotes running a b book on clients positions. Putting aside that a “b” book can be run for a positive client outcome, is this really what the regulator wants?”
A potential scenario is the avoidance of regulatory protection. Dan Moczulski predicts that new investors will “get encouraged to open with entities operating in unregulated territories, even if the ultimate broker handling the flow operates within the EU”.
I suspect that larger global firms, with wider product offering, will be the ones that succeed. Whilst I disagree with the changes, it should be a boon to ourselves. Star partners with FX brokers and empowers them to offer multiple trading platforms, offering thousands of different products. With the reduced leverage of FX, and all evidence suggesting that the more products a client has access to the more profitable they become, I expect us to become busier and busier!”, Dan Moczulski added.
Taking the opposite view is Admiral Markets, an FCA regulated broker that does not onboard retail clients. The company welcomed the unified regulation and called it “a good change”. Admiral Markets does not expect these regulatory changes to impact professional clients and a high percentage of their clients are experienced traders, according to the broker.
Natallia Hunik, Global Head of Sales at Advanced Markets, expects “to see some indirect impact due to the ruling’s effect on the business operations at many of [their] European clients.” Lower leverage may lead to a reduction in trading volumes over the short term, but Hunik believes that “in the long term, the market will adapt and reach an equilibrium where reduced leverage and responsible trading create an overall positive effect on industry transparency and profitability.”
Brokers fleeing offshore in order to avoid the rules is a scenario that Natallia Hunik doesn’t rule out, especially as there are jurisdictions outside of Europe which are held in very high regard from a regulatory. There are, however, others where oversight and regulatory governance are somewhat lax and traders that choose the latter may be unwittingly foregoing many of the investor protections afforded to traders in top-tier regulatory jurisdictions. “Additionally, bankruptcy laws in these offshore jurisdictions might be radically different from those in Europe”, the Advanced Markets executive added.
Extreme volatile events such as the one following the removal of the Swiss Franc peg in January 2015, which has wiped out many traders and brokerages, have led ESMA to believe retail traders may not always factor the potential for the extreme volatility that currency markets exhibit from time to time. “As a result, the regulator is now passing the responsibility of protecting clients from such market conditions over to the broker by forcing a guarantee of no negative account equity (where the client cannot lose more than they deposit)”, Hunik continued, adding that these rules will not stall market development and innovation but should help further stabilize and mature the market.
Natallia Hunik expects market consolidation as other consequence of the new ESMA rules. Reduced trading volumes due to lower leverage, more regulatory pressure and increasing capital requirements, will make it difficult for the smaller, less-established firms to compete.
Laurent Bellieres, Chief Risk Officer at Swiss-based broker Dukascopy, expects the EU market to shrink on account of the new regulation as the volume of transactions and hence trading income will be reduced.
“Due to existing competition it is unlikely that EU brokers will have any chance of compensating loss in business volume by higher spreads and higher commissions, so EU brokers will have to adapt to permanently lower income as a new reality, that is source of financial pressure and instability for the less profitable and less solid ones. The number of EU brokers shall shrink, the biggest ones will become bigger, some small ones shall disappear, a concentration of the market should happen”, said Bellieres.
The Dukascopy executive added that measures imposed in such an open world as the internet are hardly effective. The new restrictions will surely fuel a run towards less stringently regulated brokers and “ESMA will get the situation exactly opposite to the objective: clients will be exposed to higher risks”. The broker favours an alternative approach: regulating smartly, imposing higher ethical and risk management standards, raising the level of the industry and risk awareness within the public.
Headquartered in Switzerland, Dukascopy Bank will not be subject to ESMA rules but will take further precautions such as increased disclaimers. Its subsidiary Dukascopy Europe will have no option but to comply with ESMA restrictions, Bellieres explained.
“We are sad because the environment is always worsening: always more restrictions, less freedom, less individual responsibility, more police, more guilt”, he continued. “In our view, only mandatory enhanced risk warnings proposed by ESMA are meaningful because transparency is paramount. People willing to gamble should have the right to do so, in full knowledge of their risks. As a matter of fact, there is no way stopping human beings being human. Disclosing that “smoking kills” did not stop smoking but at least people willing to smoke take their responsibility.”
GAIN Capital, a US-based brokerage company that serves both institutional and retail clients, admits to disagreeing with a few aspects of the new rules but is strongly supportive of enhancing consumer protection in the FX/CFD market, including curbing aggressive marketing to inexperienced investors and mandating disclosure requirements. GAIN estimates that the new regulation places less than 5% of full year 2018 total revenue at risk.
IG Group, the UK-based CFD broker that created the website replytoesma.trading as a response to the regulator, claims that the proposed leverage restrictions are disproportionate as it does not appropriately account for “the potential unintended and counterproductive side effects on the retail market for CFDs of severe restrictions and the impact of such restrictions on well-informed retail clients for whom CFDs are a perfectly appropriate trading and hedging tool.”
Additionally, the CFD broker says the measures on per-position margining and per-account negative balance protection are over complicated. The intervention is opposed by large numbers of retail clients who currently trade CFDs with responsible firms: “98% of the more than 14,000 responses we received from retail clients across the EU opposed the measures, often in vehement terms.
In a survey conducted by an independent third party, 80% of the company’s EU retail clients said they were likely or very likely to consider a non-EU CFD provider in the event that the proposed leverage restrictions were to come into force.
Independent research house Investment Trends surveyed IG Group’s EU retail clients and concluded that 94% say leverage is either a “quite important” or a “very important” factor in their choice of CFD provider. Two-thirds of retail clients rated available leverage as more important than regulatory status. The report states that 57% of IG’s retail clients are very likely to trade with non-EU firms in return for higher leverage. 23% would be “somewhat likely” to do so.
When it comes to the protection of retail clients, the survey also showed that 98% of those who responded were aware of the potential rapid losses when trading leveraged products. When asked to estimate the probability of profitability of trading accounts at IG, the average response was 20%. The actual proportion of profitable accounts across IG’s European clients was 24% in 2017.
From all the feedback collected, it seems consensual that trading volumes are expected to drop in the result of the new regulation, which will hurt the business and promote market consolidation. Additionally, ESMA will fail, at least partially, in protecting retail traders from high leverage and aggressive marketing as they will find their way offshore.
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