CFDs are contracts between a trader and the provider of the product. Upon termination of the contract, the difference between the price at which the product was initiated at, and the price it was closed at, is exchanged between the two parties. When taking out the contract, a trader is able to speculate on whether the price is likely to move up or down. Whether they benefit from the price movement, or the provider does, is down to whether the market moves in their favour or against them.
A form of derivative, CFDs enable traders to gain exposure to a range of different markets, including commodities, cryptocurrencies, shares, indices, and Forex. However, many of these markets can be extremely volatile. As CFDs are highly leveraged, even with a small margin – the amount required to keep the trade open – a trader can very quickly suffer substantial losses that far exceed their margin value, if the market moves against them.
As an example, a trader can buy contracts based on the movements of FTSE100. With leverage levels of 300:1 (which is offered by many existing regulated brokers), with an initial margin of £100, clients can magnify their exposure to the market changes by up to 300 times. In this case, the value of their transaction would be around £30,000 with the outstanding amount borrowed from the provider. If the market moves against the trader by 2%, this can result in the value of their trade dropping to around £29,400, with a loss to the trader of around £600 if they have sufficient capital deposited in their account. It follows that if a trader does not adequately understand the effects of leverage, they can be devastated by such significant losses.
In spite of this, CFDs have become much easier for retail clients to access. One reason for this is that the industry has seen a boom in online platforms as new technology has lowered the operating costs for providers. The FCA have granted authorisation to an increasing number of CFD providers in recent years, and firms regulated in the EEA have taken advantage of passporting arrangements to offer their services to customers within the UK. In December 2016, there were 97 FCA authorised CFD providers and 130 EEA firms operating in the UK, with an estimated 125,000 registered clients (source: FCA CP16/40). In addition to this, there are also numerous platforms that can be easily accessed by traders in the UK, but do not hold authorisation to transact such products in the UK, which adds another layer of risk to the client.
This technology made it much easier for retail traders with little experience and knowledge to have access to high risk financial instruments without adequately understanding them. As reviews by the FCA and other regulators revealed, even when investors use regulated brokers who are required to adhere to the high standards set by their regulators, there are still inherent risks for less sophisticated investors.
Reviews by Regulators
In the lead up to releasing their proposals for change in December 2016, the FCA had detected evidence of poor conduct within the industry, which was becoming an increasing concern. Even regulated firms were not adequately warning their clients of the risks, and were allowing investors to begin trading without robust appropriateness assessments, such as anti-money laundering and suitability checks (COGS 10). Their review found that 82% of clients from a sample of retail CFD providers were losing money on CFD trading, with the average loss per client equating to around £2,200.
Other regulators throughout Europe were also arriving at similar conclusions. In their 2014 study, France’s Autorité des Marchés Financiers (AMF) found that 89% of consumers were losing money, with a median loss of €1,843 and an average loss of €10,887. In 2015, the Central Bank of Ireland (CBI) found an average loss to consumers of €6,900 with 75% losing money. In a follow-up study, the figures had reduced to 74% and €2,700, but there was still a long way to go.
On February 2016, the FCA issued a Dear CEO letter to CFD providers, warning them to tighten their processes around onboarding new clients. At the end of the year, the FCA released their proposals for new measures with regards to leverage, capping it at 50:1, with even lower leverage levels set for new and inexperienced clients. The directive also proposed to ban the use of bonuses to entice new clients into trading leveraged products.
Christopher Woolard, executive director of strategy and competition at the FCA, said at the time:
“We have serious concerns that an increasing number of retail clients are trading in CFD products without an adequate understanding of the risks involved, and as a result can incur rapid, large and unexpected losses.
“We are introducing stricter rules for CFD products to ensure the sector addresses the shortcomings identified, and that firms make sure that retail clients are aware of the high risks involved in trading these complex products.”
In November 2016, the Cyprus Securities and Exchange Commission (CySEC) issued a circular concerning the marketing and sale of such products, which led to them prohibiting firms from offering bonuses to retail clients. In addition, firms were required to offer a maximum default leverage ratio of 50:1, which only can be exceeded if the client specifically requests it and robust appropriateness testing has been carried out.
In Australia, the Australian Securities and Investments Commission (ASIC), backed a new bill that put constraints on the use of client money for OTC derivatives.
In France and Holland, an advertising ban has been imposed on leveraged products.
The Central Bank of Ireland proposed to ban the sale of CFDs to retail customers, or at least ensure that additional measures are implemented to provide better protection, which includes limiting leverage levels to 25:1 for retail clients and negative balance protection.
In Germany, the Federal Financial Supervisory Authority (BaFin) proposed changes with regards to negative balance protection on the 8th December 2016, and subsequently imposed the rule changes.
Whilst many welcomed the regulatory changes with regards to negative balance protection, they have implied that changes to leverage levels could have an adverse effect on their business. They have also presented the argument that the strict controls may lead to clients seeking the leverage from unregulated brokers. Few of the primary CFD brokers in the UK have implemented a bonus ban or changes to leverage limits since the proposals were announced.
The Future for CFD Providers
The consultation period for the FCA’s CP16/40 ended on the 7th March 2017 and the regulator have specified the areas they intend to focus on going forward. These include appropriateness testing, prudential requirements, client money, financial promotions and best execution. Although no specific details have been released yet with regards to leverage, there has been speculation that a soft leverage limit may be imposed, similar to that offered by CySEC, which would allow more sophisticated investors to increase their leverage upon request.
The European Securities and Markets Authority (ESMA) released a public statement on 29th June 2017, providing an update on their position with regards to CFDs and other speculatory products. The statement confirmed that their concerns for the industry remain, and warned that the possibility of using their product intervention powers under MiFIR Article 40 is under discussion.
Measures proposed by regulatory bodies throughout Europe, including lowering leverage limits and banning financial promotions, will be taken into account. If used, these intervention measures may be applied after 3rd January 2018.
The CFD sector is in a period of transition, with many more changes looking likely to be applied within the industry in the coming months and years. Brokers who respond well to the changes, adapting their processes and controls to promote client protection are better placed survive the upheaval and lead the market forward. Whereas it seems increasingly likely that governing authorities are going to use their intervention powers to make an example of those who are not compliant with the regulatory changes.