By David Calligan (Partner, Reed Smith)
For several years the European Securities and Markets Authority (ESMA) has been frowning at the burgeoning market which provides Contracts for Differences (CFDs) to retail investors. ESMA’s mounting concerns have ultimately led to its exercise of new powers under which it will impose temporary measures to restrict the sale of CFDs. CFDs have caused concern to regulators because of 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 along with the issues related to their marketing and distribution. In short, ESMA was concerned that retail customers were trading in CFD products they did not adequately understand, a view also shared by the UK’s Financial Conduct Authority (FCA).
ESMA’s product intervention measures are:
- Negative balance protection on a per account basis;
- Margin Close Out rule of 50% on a per account basis;
- Imposition of leverage limits;
- Standardised risk warning;
- Restriction on incentivisation of trading.
ESMA plans to assess the impact of these measures after three months, although it is a widespread view that CFD firms will have to comply with them for the foreseeable future.
CFD providers will need to offer negative balance protection for all retail clients so that their losses cannot exceed the money invested. Providers will also have to communicate leverage restrictions to clients and build them into systems, bringing more clarity to the risk undertaken by clients.
Risk warnings concerning the percentage of investors that have lost money will also need to be placed prominently on the provider’s website as well as on any of its potential advertisements. Furthermore, any bonuses or incentives to trade should be reviewed and removed if considered inappropriate under ESMA’s regulations – cutting down providers’ freedom to advertise.
Retail firms will need to review their capital adequacy status. The relationship between matched principal firms and hedging counterparties may have to be adapted to reflect the new loss limits on the client side of the trade. This may result in firms having their licence amended which would lead to a higher capital requirement. Full scope firms may also need to revisit their Internal Capital Adequacy Assessment Processes to consider the financial impact of these changes on their business model and capital resources.
Avoiding the restrictions
Some clients may wish to sidestep the new restrictions by becoming an ‘elective professional’. For this purpose, a firm would need to demonstrate confidence that the client has the requisite trading experience and knowledge. The client would also need to meet objective qualifications to be classified as an ‘elective professional’ to disapply the ESMA restrictions. Another possibility may be to open a CFD account with a broker in a less restrictive jurisdiction outside the EU. However, this would mean that the retail investor will not be afforded the protections of the FCA and other relevant regulators in the EU.
ESMA intends to adopt the product intervention measures after translation into the official languages of the EU before publishing a notice in the Official Journal. This should take place, at the earliest, by the end of May and two months from this point the CFD restrictions will come into force.