The pressure on derivatives that are considered high risk for retail investors is increasing. Already under growing scrutiny, now ESMA, the European watchdog, has emphasised its concerns about CFDs, including spot forex, binary options and cryptocurrency derivatives that could lead to regulatory measures including an outright ban of the instrument.
Contracts for Difference are increasingly concerning the regulators. The latest in a number of signs that authorities are considering to tighten the screws was today’s announcement by the European Securities and Markets Authority (ESMA). The Paris-based agency has published a call for evidence on potential product intervention measures relating to the provision of contracts for differences (CFDs), including rolling spot forex, and binary options to retail investors. The consultation also touches on the use of CFDs for cryptocurrencies and whether these should be involved in potential measures as well.
Risky business
Like other derivatives, CFDs give an investor the possibility to speculate on rising or falling prices in financial instruments like shares, bonds or commodities, but often with a significant leverage that multiplies potential gains or losses. Because of the complexity of many of these derivatives, the resulting lack of transparency and the leverage effect make these instruments particularly risky and they should be used carefully. In addition, ESMA has noticed that the marketing of CFDs in different formats has become more and more aggressive. Binary options (BO) in particular have moved into the focus of the regulator.
Binary options are based on a simply black-and-white scenario: either the underlying is at certain level at determined moment in time (usually within a short time frame ranging from seconds to minutes) or not; if it is, the investors bags the difference between the price of the option and its set value (which is higher than the actual price of the BO); if it isn’t the BO becomes worthless and the investor looses all the invested money. Because of this structure, BOs are often considered gambling rather than investment. In the UK, for instance, until the beginning of this year the activity was supervised by the Gambling Commission and only from 3 January 2018 on do UK firms offering binary options have to be authorised by the FCA. Scams using the promise of higher than average returns for bets that never occur plus manipulating software to distort prices and payouts as well as the use of celebrities endorsing BO platforms without their knowledge are on the rise. The US regulators CFTC and SEC categorise the increasing number of complaints they receive into at least three categories: refusal to credit customer accounts or reimburse funds to customers; identity theft; and manipulation of software to generate losing trades.
As a result, the authorities are under increasing pressure to take action and while a number of regulators in the EU member states already have taken actions to address risks to investor protection, ESMA is not satisfied that these actions are sufficient.
New Powers
Thanks to new powers introduced by MiFID II/MiFIR, ESMA is now considering restricting the marketing, distribution or sale to retail clients of CFDs. This would be possible since in accordance with the new MiFID rules the three European supervisory authorities have been granted temporary intervention powers to address a significant investor protection concern. The measures ESMA seeks input on range from the limiting leverage to introducing a margin close-out rule on a position-by-position basis to demanding a negative balance protection on a per-account basis to limit potential losses to an outright restriction on incentivisation of trading provided by a CFD provider. CFDs providers may also have to publish a standard risk warning that would stress the high probability of losses if ESMA has its way.
With regard to Binary Options, the regulator’s mind seems even more set on the prohibition on the marketing, distribution or sale of binary options to retail clients. ESMA highlighted that in particular the pricing structure would mean that on average an investor was going to lose its money and therefore such drastic measures would be necessary.
The end of Cryptocurrency CFDs?
At the very end of its consultation paper ESMA asks whether the public believes that restrictions concerning CFDs in cryptocurrencies should be introduced as well. However, while this may give it the aspect of a side note of less importance, the impact on the sector, considering the limited availability of hedging tools for cryptocurrency portfolios, would likely be bigger than for other financial instruments and should be of particular interest not only to CFD providers but more so to the different kinds of cryptocurrency investors.