Binary Options and CFDs - living on borrowed time
Contracts for Difference (CFDs) and Binary Options have been in the regulatory cross-hairs for well over two years. In February 2016, the FCA issued a Dear CEO letter which raised concerns regarding the take-on process for non-advised sales of CFD products. This concern deepened into a wider review of CFDs in general, which did little to allay regulatory fears over retail customer exposure. Fast forward to June 2017 and ESMA issued a statement stating that they too were concerned at the marketing and distribution of CFDs, in addition to the sale of Binary Options to retail customers. ESMA were of the initial view that standard National Competent Authority (NCA) supervision tools might not be enough to stem the flow of negative consumer outcomes. A wider intervention was first touted.
On 15 December 2017 ESMA published a statement explaining that it was considering using product intervention powers under Article 40 MiFiR to restrict the marketing, distribution and sale of CFDs and to prohibit the sale of Binary Options to retail investors. On 23 March 2018 ESMA's Board of Supervisors agreed on a collection of measures. The FCA agreed to enact these same measures.
These new restrictions and prohibitions are effective from 2 July 2018 in respect of Binary Options and from 1 August 2018 for CFDs. Firms that are in the business of providing Binary Options to retail consumers or CFDs more generally, are advised act now so as to not fall foul of FCA rules.
Stop and think: what are the restrictions and what has been prohibited?
CFDs
Analysis by NCAs across the EU showed that between 74% and 89% of retail accounts typically lose money on their investments in CFDs. ESMA concluded that there existed a significant investor protection concern. It therefore agreed upon the following measures in relation to CFDs:
- The following leverage limits on the opening of a CFD by a retail client, depending on the volatility of the underlying asset
- 30:1 for major currency pairs;
- 20:1 for non-major currency pairs, gold and major indices;
- 10:1 for commodities other than golf and non-major equity indices;
- 5:1 for individual equities and other reference values;and
- 2:1 for cryptocurrencies.
- A margin close out rule at 50% of minimum initial required margin (on a per account basis);
- Negative balance protection on a per account basis;
- A restriction on the incentives offered to trade CFDs; and
- A firm specific risk warning, including the percentage of losses on a CFD provider's retail investor accounts.
Binary Options
The marketing, distribution and sale of binary options to retail investors is now prohibited. Firms engaged in this business must cease providing these to retail investors by 2 July 2018.
What does this mean for my business?
If your firm is in the business of selling binary options and CFDs you must act now to ensure compliance with the new product intervention. In respect of binary options, where you have made a business selling these to retail consumers - put simply, this must end. The severity of the product intervention should also serve as an indicator of how little sympathy the regulator is likely to have for firms falling foul of this prohibition. In communications made to businesses, the FCA has stipulated that it fully expects certain firms to wind-up as a result of this.
If you are in the CFD business, the ramifications are more nuanced, but will still cut deep into some businesses and require immediate attention.
Full scope IFPRU 730k firms
For full scope IFPRU 730k firms trading as principals, it is likely that they will need to assess how much capital they hold in order to satisfy the need to protect against negative client balances. Furthermore, systems and controls ensuring adherence to the new leverage limits, margin close out rules and marketing requirements would need to be implemented and tested.
Matched principal broker firms (eg IFPRU 125k)
Owing to the fact that a firm would begin to bear risk the moment a client's account balance becomes negative, it is difficult to see in practice how a firm would be able to meet the new requirements on negative balance protection whilst also continuing to adhere to matched principal broking rules. However, if you are able to implement a process whereby you can protect clients against negative balances whilst ensuring you are not exposed to market risk, the FCA may be satisfied.
But this may be difficult to achieve in practice. What is more likely to be a viable and more simple route forward would be to either vary existing regulatory permissions to remove CFDs as a regulated instrument or to remove the retail permission. If you have a limited amount of CFD business on your books, this could be a sensible way of continuing without a substantial re-structuring and re-authorisation as a full scope IFPRU 730k firm.
However, if you determine that CFDs form a substantial element of your business – you may want to consider applying for authorisation as a full scope IFPRU 730k firm. This would impose increased capital requirements and governance requirements upon your firm, but would free your business of the matched principal restrictions on bearing market risk. Owing to the greater protections necessarily afforded to consumers by a IFPRU 730k firm as compared to a IFPRU 125k firm – it is arguable that amongst the available options, this would be the FCA's preferred one.
Next steps: what should you do now?
Senior management must review the business and assess its likely exposure as soon as possible. Continuing to sell binary options to retail investors or selling CFDs without adhering to ESMA's restrictions, could result in enforcement action being taken by the FCA (or other relevant national competent authority). It is worth noting that the product interventions come into force on 2 July 2018 (Binary Options) and 1 August 2018 (CFDs) respectively, and will last for three months. Therefore the intervention will need to be renewed again by ESMA to continue to take effect. Firms are advised to keep an eye on the FCA or ESMA website for further updates, where more information on the details of the current intervention is also available.
If you find your firm is exposed at present, it might also be worth considering early engagement with the FCA. Five questions to ask yourself in regards to your business might be:
- Do we market, distribute or sell binary options to retail consumers?
- Do we have matched principal business permissions or are we a full scope firm?
- What proportion of our business is currently devoted to CFDs?
- Do we anticipate that this level of CFD business will remain the same in future?
- Who is our supervisory contact at the FCA?
Help is available
Taylor Wessing is well placed to advise businesses on how to comply and remain compliant with the new product intervention. We are also able to advise on other issues pertaining to regulatory business. If you are in any doubt as to your compliance with regulatory provisions, you should seek advice as soon as possible. Failure to comply with the Financial Markets and Services Act 2000 can be a criminal offence, punishable by imprisonment, a fine or both.
