This article was written by David Calligan (partner) and Charlotte Collins (professional support lawyer)
On 6 December 2016, the FCA published a consultation paper containing proposals to enhance the conduct of business rules for firms providing contract for difference (CFD) products (including spread betting and rolling spot FX contracts) to retail clients. The FCA has asked for comments by 7 March 2017, and aims to publish final rules next Spring with a view to them coming into force shortly afterwards.
The proposed package of measures is designed to address long-standing concerns about the risks that CFDs pose to less sophisticated consumers. While the general move to tighten regulation in this area will come as no surprise to market participants, the FCA's proposals include measures that could have significant practical implications for firms and their business models, and therefore warrant careful examination.
The FCA is proposing a range of measures relating to leverage limits, disclosures and promotions. These are aimed at addressing key investor protection concerns associated with the provision of CFDs to retail clients.
The FCA is proposing to require leverage limits to be imposed by firms, depending on a client’s level of experience and the nature of the underlying assets. The FCA observes that, at present, some firms offer leverage as high as 500:1 (i.e. a client could put down £100 and take a position worth £50,000) and that the risk of loss can be exacerbated by the use of automatic close-outs by firms.
Under the FCA’s proposals, firms will have to categorise retail clients as either ‘experienced’ or ‘inexperienced’. The FCA is proposing that a retail client may only be deemed experienced for these purposes if they have:
- conducted at least forty trades in CFDs on a leveraged basis in a continuous 12 month period (with at least two trades in each calendar quarter) in the previous three years; or
- conducted at least ten trades in CFDs on a leveraged basis per calendar quarter, for at least four calendar quarters in the previous three years.
The difficulty will be evidencing this as the FCA proposes that a firm cannot rely on a self-certification by a retail client; it must receive and record evidence of previous accounts and trading from the client. Therefore, it could be problematic for firms to receive evidence of experience where a client has not previously traded with that firm. The requirement for concrete evidence of experience is intended to address perceived shortfalls in the appropriateness test; the FCA has previously noted that CFD firms often do not take a robust enough approach to assessing clients’ knowledge and experience.
The maximum leverage limits proposed for inexperienced retail clients are as follows:
- 25:1 for major FX pairs
- 20:1 for major stock market indices and gold
- 10:1 for minor indices and other commodities
- 5:1 for single stock equities and all other assets
For experienced retail clients, the proposed maximum leverage limits are doubled, as follows:
- 50:1 for major FX pairs
- 40:1 for major stock market indices and gold
- 20:1 for minor indices and other commodities
- 10:1 for single stock equities and all other assets
The FCA also proposes introducing a 50% margin closeout requirement in relation to all retail clients.
Whilst it may be tempting for some firms to consider whether there may be scope for ‘experienced’ retail clients to be re-categorised as elective professional clients (and therefore taken out of scope of these obligations), there still would be some way to go for such clients to meet the “quantitative test”, and firms would also have to be robust in applying the “qualitative test” to avoid challenge from the FCA.
The FCA is proposing to require firms to provide both a standardised risk warning and mandatory profit-loss disclosure to retail clients.
Not only would the standardised risk warning need to be provided, the firm would also be obliged to receive acknowledgement (using prescribed wording) of the warning by the client before it can open a trading account for that client. This acknowledgement would need to be separate from any acceptance of the firm’s terms of business.
The proposed profit-loss disclosure would need to state the percentage of client accounts that made a net profit or loss, both in the previous calendar quarter of trading activity and over the last 12 months. This would need to be provided on every page of the website or mobile application of the firm containing any reference to the benefits of CFDs, or provided in a durable medium before the firm carries on any business for the client, if the client is not using a website or mobile application. There are prescriptive requirements around how the calculations must be made, and how the disclosure must be presented. If this proposal is introduced, it will be a challenge for firms to ensure these disclosures are accurate, suitably presented, and kept up to date (although the rules do not make clear how promptly disclosures must be updated at the end of each quarter).
Ban on promotional offers
The proposals would prevent firms from using special promotions, such as introductory bonuses or other incentives, to market their CFD products or platforms to retail clients. The FCA is of the view that these are inappropriate, even where the attached terms and conditions are clearly disclosed to potential clients, and that consequently nothing but an all-out ban will do.
What about overseas firms?
Those familiar with the industry will know that many overseas firms access the UK market by, for example, offering online platforms that can be used by clients in the UK.
Although the proposed requirements would not be capable of applying directly to European firms passporting into the UK on a cross-border services basis (conduct of business regulation being a matter reserved to the Home State regulator), the FCA is proposing to place a restriction on financial promotions by such firms relating to retail CFD products unless they comply with measures equivalent to the new requirements outlined above (including applying leverage limits that are at least equivalent to the UK rules).
The new rules would also prohibit authorised firms from approving any financial promotions relating to retail CFD products unless they comply with these new requirements. It is clearly intended that CFD firms outside Europe that are not authorised in the UK but target UK retail clients (perhaps relying on the overseas persons exemption) would not be able to get around the new requirements.
Keeping up with the pack
The FCA’s move does not come in isolation. Following the expansion in firms offering CFD products and the increased accessibility of these products for retail clients, there has been a steady stream of supervisory and enforcement work by the regulator (and its predecessor) over the past six years. Despite some serious conduct concerns arising (most recently those set out in the February 2016 Dear CEO letter), this has not previously led to tighter rules being imposed in the UK. Yet several overseas regulators have already taken steps to enhance consumer protection, with leverage limits being imposed in a number of countries.
Other European jurisdictions have already taken action to tighten controls over CFD firms and, at a pan-European level, the European Securities and Markets Authority (ESMA) has been conducting work in this area in a bid to help secure a common regulatory approach across Member States.
ESMA has issued a number of warnings to investors about the risks of CFDs to try to increase awareness, and has also published Q&A under MiFID on the supply of CFDs to retail clients, which were last updated in November 2016. The Q&A are addressed to local regulators, to help achieve a uniform approach across Europe to the regulation and supervision of CFD firms by ensuring that regulators have common guidance to follow.
At present, however, there is no strong European framework and there are varying reactions from regulators to the investor protection concerns. Various Member States have been conducting their own supervisory work, including France, the Netherlands and Ireland. The regulator in Cyprus (where many CFD firms reside) has doled out a number of fines to CFD firms in the past couple of years.
Some regulators are also taking more stringent measures. For example, the Belgian regulator banned the distribution of CFD products via online platforms in July 2016, the French regulator is proposing to ban the advertising of CFD products with a leverage ratio greater than 5:1 through media such as email and website banners, and the German regulator announced yesterday that it also proposes restrictions on the marketing, distribution and sale of CFDs to retail clients in certain circumstances.
Last week, when the latest ESMA Q&A were published, the Cypriot regulator published its own interpretation of the new guidance, determining that firms should by default impose a leverage limit of 50:1 at most, unless the client agrees to raise the limit, and that firms should stop offering bonuses or other incentives to retail clients.
As Cyprus is a major centre for CFD firms in Europe and appears to permit firms to offer leverage above 50:1 (if requested by the client), it seems likely that retail clients seeking higher leverage will be more attracted to those firms (although rules in their home jurisdictions may in practice prevent them accessing that higher leverage). The variety of different restrictions and leverage limits (where imposed) across Europe does not enhance the impression of a single market in financial services, and the increasingly fragmented approach will no doubt lead to firms and their clients to favour more lenient jurisdictions.
Away from the EU, several jurisdictions, including the US, Japan, Singapore, Hong Kong and Israel, have also made moves to tighten the regulation of retail CFD products. Some of these impose leverage limits, and others have imposed bans on distribution or restrictions on marketing to retail clients.
Therefore, as things stand, arguably the UK is some way behind in its regulation of this market, particularly given the proliferation of CFD firms in the UK. Although there are various new European measures already in train that will help increase investor protection in relation to retail CFD products, such as the PRIIPs Regulation and MiFID II (both due to come into effect at the beginning of 2018), the FCA clearly feels that these will not do enough to address its concerns in full.
The UK is known for being a ‘safe’ jurisdiction and often leading the pack on regulatory reform, and so it is not altogether surprising that the FCA is proposing to tighten up its rules, though the exact timing and content of the proposals have created a shock.
The bets are off?
The FCA consultation also discusses proposed policy options for the regulation of binary bets (products that allow clients to bet on whether the price of a financial instrument will be higher or lower than a fixed point at a certain time – the result is binary so the client either wins a fixed pay-out, or loses their entire stake). These are also an area of concern for the regulator given their likeness to gambling and the high risk of conflicts of interests arising between firms and their clients.
Binary bets (also known as binary options) are due to be brought into the regulatory perimeter as part of the transposition of MiFID II. As the relevant UK legislation making this change has not yet been passed, however, the FCA is not able to present formal proposals at this stage. It plans to consult formally when the legislation has been finalised, but will take into account feedback received on this discussion.
The FCA floats several ideas, including restrictions on marketing to certain retail clients, use of product intervention powers, or other measures to help ensure appropriate product design and distribution. Although no detail is provided, this does at least provide an indication of the FCA’s thinking and potential direction of travel, putting firms offering such products on notice that there looks likely to be much tighter regulation in the near future.