ESMA CFD intervention: EU regulations of CFD trading

The European Securities and Market Authority is safeguarding the EU’s financial stability to enhance investor protection. The finalized CFD regulation and forex regulation measures will have to be implemented by each member state of the EU mandatorily.

As mentioned earlier ESMA is a pan-European authority, thus the measures will affect brokerages under EU jurisdictions. Without listing all, some of the other major players are affected: Saxo Bank, CMC Markets, XTB, and City Index.

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ESMA regulation are binding to all members of the EU. The process of Brexit is ongoing, with a planned withdrawal dated to 30 March 2019. Given it steps into force, the UK will no longer be part of the EU. Currently what is known that the FCA expects to consult on whether to apply ESMA measures on a permanent basis to firms offering CFDs and binary options to retail clients.

ESMA is awaiting reactions from the CFD brokers and also welcomes client feedback before putting the final text in the Official Journal of the EU, after which the regulations would start to apply within two months.
The new measures will first apply for three months, at which point they may be renewed.

Binary options brokers will be prohibited to market their services to retail clients from 2 July 2018. Fx and other CFD traders will face the new regulatory conditions from 1 August 2018.

We suggest traders to review if their opened positions comply with new margin requirements set by ESMA. Clients having stretched CFD positions risk having a margin call on their investment accounts. The maximum leverage setting will be 1:30 for major Fx pairs and even smaller for less liquid CFDs.

Most importantly, the ESMA CFD regulation introduces maximum leverage caps, based on the volatility of the given instrument.

• 30:1 for major currency pairs
  (EURUSD, GBPUSD, AUDUSD)
• 20:1 for non-major currency pairs, gold and major indices
  (EURPLN, USDRUB, US500)
• 10:1 for commodities, non-major equity indices
  (Silver, Oil, Czech Stock Index)
• 5:1 for individual equities
  (Google, Apple, BMW)
• 2:1 for cryptocurrencies
  (Bitcoin, Ethereum, Ripple)

Currently, most online brokers allow trades 100, 200 or even 1000 times the amount available as trading capital. Furthermore, such leverage settings can be set as default.

With the new cfd regulation, traders will have to place at least 3.3% of their capital as a margin deposit in case of major FX pairs and even more for other instruments. This means that for a typical mini lot position (0.1 lot = 10.000 USD value for an fx pair) will be required to have at least 333 USD on the account.

Analysing retail trading accounts ESMA concluded that 74-89 percent of clients lose on their investments. The average loss per client amounts are substantial, ranging from €1,600 to €29,000.

High leverage leads to oversized positions, especially in case of novice traders who have little discipline in following general risk management rules.

For example a trader with only a €1000 deposit is able to open an fx position worth of €100.000. Given the market moves only 1 percent against the trader (typical major currency daily range) the entire investment goes under water.

The stricter leverage settings imposed by the new ESMA CFD regulation will create better survival chances for novice traders, and separate CFD trading from pure gambling.

There were PR reactions on brokers side- generally positive - and also a market reaction - mixed - in case of the publicly traded CFD brokers like Plus500 or IG.

In case of the LSE listed Plus500 the market reaction was clearly positive, as the brokerage came out with a supportive statement on the new regulations affecting CFD trading.

Some of the official reactions:

“Saxo strongly welcomes and supports the proposals set forth by ESMA and believes that consistent, harmonised regulation at a European level will be positive for clients and the industry as a whole.”

The new regulations are broadly as expected and can be implemented rapidly by Plus500 due to our industry leading in-house technology. We are already compliant in most of the areas targeted...

IG is disappointed that ESMA has chosen to proceed with its proposal to impose disproportionate leverage restrictions which will unduly restrict consumer choice, and risk pushing retail clients to providers based outside of the EU... 

Besides the leverage cap other changes are:

• Negative balance protection, providing an overall guaranteed limit on retail client losses.
  This feature came to spotlight after SNB announcement of letting the CHF to appreciate, where an instant 20 percent move wiped out several retail traders and even pushed brokerages (FXCM, Alpari UK) to the brink of bankruptcy.
• Margin close-out rule. If the position drops below 50 percent of the margin deposit value, broker has to close the position(s) automatically. Such rules existed, but at various levels. This gets standardized as well.
• A standardised risk warning, including the percentage of losses on a CFD provider’s retail investor accounts.

BrokerChooser believes that all steps to be implemented by ESMA are well-founded and will help the CFD trading industry to shift to a more client-centric business model and client profitability will improve.

On a high level, we have the following observations about ESMA's effort:

• We very much agree with the prohibition of binary options and the restriction of CFDs
• Also, limiting maximum leverage based on underlying is a good direction

BrokerChooser thinks there are several factors to consider

Most clients are not familiar with CFDs, after being explained, they are able to decide. ESMA could ask for more client education from brokers.

• Clients usually do not prefer or disregard a broker whether it is a CFD broker, but search investment opportunities
• We think customers face risks not just in the inherent risk of CFDs, but in the fact that customers do not understand how CFDs differ
• Additionally to the standard risk warning proposed by ESMA, retail investor could benefit from what CFDs are and how they differ from "traditional" investment products

• Majority of clients do not seek leverage when selecting a broker
• They are also not familiar with the leverage concept and the leverage level provided. Hence risks, costs and benefits are also unknown to them
• At some brokers, it is not possible to easily set leverage levels either on a trade level or on an account level.
• In most cases, brokers set default leverage amount to the highest level
• Besides setting a limit on the maximum leverage amount, retail investors would benefit from:
  • a low, e.g. 1:1 leverage level as a default
  • an easily usable feature on the platform to be able to set leverage per trade basis
  • linking available maximum leverage level to tested financial knowledge

Costs of CFDs are very hard to compare. ESMA could define a standard cost measure  and ask brokers to implement

• At BrokerChooser, we compare CFD broker trading fees including spreads, commissions, and finance rate
• These fees in some cases are hardly accessible
• Even if they are accessible, it is very hard for retail investors to compare
• Retail customers would benefit from an aggregate cost measure

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Minor, side point: Crypto CFD regulation should also consider risks of crypto exchanges

• BrokerChooser does not want to facilitate retail crypto investments, but we experienced a strong demand for cryptos in November 2017
• We have started to investigate crypto investment service providers and found that crypto exchanges are hardly regulated
• We think CFD brokers are a better alternative for retail investors to take a position on cryptos than crypto exchanges as
  • CFD brokers are regulated by the regulators
  • CFD brokers operate a more stable and more secure tech stack than crypto exchanges
  • Investors are protected up to the country's investor protection amount in case CFD broker defaults/commits fraud, whereas this is not the case for crypto exchanges

We selected our top forex and CFD brokers for you. Just to get a better picture of the selected brokers, we compiled the following summaries.