The implementation of MiFID II in January triggered a significant change in the blanket treatment of FX forwards in the UK and, as a result, non-deliverable forwards (NDFs) became regulated products and overnight were reclassified as contracts for difference (CFDs). Any FX brokers that wished to continue offering NDFs were forced to apply to the FCA to obtain the relevant investment firm regulatory permissions in order to continue providing the same range of FX products they had always offered their clients.
Unfortunately for those FX brokers, the difficulties haven’t ended there. Pan European financial regulator ESMA, along with National Competent Authorities (NCAs), recently concluded that there exists a significant investor protection concern in relation to CFDs and binary options offered to retail investors due to their complexity and lack of transparency.
While we understand the authorities’ concerns over the sale of binary options and speculative CFDs with high leverage terms, we are of the view that any regulation which restricts the sale of NDFs is disproportionate in its application – NDFs are widely recognised as a valuable and effective FX hedging tool.
Further, we believe that in a post-Brexit environment where UK companies seek to access new markets, NDFs will become ever more useful as UK firms, many of whom will be classified as retail clients, look to trade in jurisdictions with thinly traded currencies.
Many of the FX brokers that were forced to obtain investment firm regulatory permissions have no appetite to sell speculative products and regard the imposition of a restriction on a product which has proved of value to many retail clients over many years as unnecessary and unfair.
However, despite receiving significant industry pushback, on 22 May ESMA adopted two temporary product intervention decisions:
- A temporary prohibition of the marketing, distribution or sale of binary options to retail clients which came into effect on 02 July 2018.
- Restrictions in relation to marketing, distribution or sale of CFDs to retail clients which came into effect on 01 August 2018.
The measures will remain in force for a period of three months from the date of application. In brief, the measures adopted in relation to retail clients are as follows:
- binary options are banned;
- forex and CFD leverage will be limited to 30x, and that’s just for major currency pairs. Lower leverage (see more detail below) will be enforced on non-major currency pairs, gold, indices, other commodities, individual equities and cryptocurrencies;
- a margin close out rule on a per account basis;
- a negative balance protection on a per account basis;
- restrictions on incentives; and
- standardised risk warnings.
CFDs – measures from 01 August 2018
The product intervention measures ESMA has adopted under Article 40 of the Markets in Financial Instruments Regulation (MiFIR) include:
1. Leverage limits on the opening of a position by a retail client from 30:1 to 2:1, which vary according to the volatility of the underlying:
- 30:1 for major currency pairs;
- 20:1 for non-major currency pairs, gold and major indices;
- 10:1 for commodities other than gold and non-major equity indices;
- 5:1 for individual equities and other reference values;
- 2:1 for cryptocurrencies.
2. A margin close out rule on a per account basis. This will standardise the percentage of margin (at 50% of minimum required margin) at which providers are required to close out one or more retail client’s open CFDs;
3. Negative balance protection on a per account basis. This will provide an overall guaranteed limit on retail client losses;
4. A restriction on the incentives offered to trade CFDs (such as deposit bonuses); and
5. A standardised risk warning, including the percentage of losses on a CFD provider’s retail investor accounts.
Fortunately, for those FX brokers that only offer NDFs for hedging purposes, the impact of the above measures is unlikely to have been too material as:
- they probably already apply much lower leverage limits than those imposed by the measures;
- the percentage of the margin at which the FX broker would normally close out an NDF is likely to be much lower than 50%, negating the need for negative balance protection; and
- the FX Broker is unlikely to offer incentives to clients to trade NDFs.
Standardised risk warning
The measures do however prohibit firms from directly or indirectly sending a communication to, or publish information accessible by, a retail investor relating to the marketing, distribution or sale of an NDF unless it includes an appropriate risk warning.
In the risk warning, the firm is required to provide the percentage of its retail investor NDF trading accounts that lost money over the last 12-month period. The calculation must be performed on a quarterly basis and cover the 12-month period preceding the date on which it is performed. For these purposes, an individual retail investor NDF trading account is considered to have lost money if the sum of all realised and unrealised net profits on NDFs connected to the trading account during the calculation period is negative. Any costs relating to the NDFs connected to the trading account must be included in the calculation, including all charges, fees and commissions. The calculation should not take into account:
- any trading accounts that did not have any open NDF positions within the calculation period;
- any profits or losses from products other than NDFs even if these are connected with the trading account; and
- any deposits or withdrawals of funds from the trading account.
For newly established firms or firms that did not provide NDFs in the last calculation period, a standard risk warning which refers to the percentage range of losses found by NCAs in their analysis (74-89% of retail investor accounts lose money when trading CFDs) should be used instead.
This calculation may pose a challenge for firms who will need to consider whether they:
- base the calculation on the last 12-month period, which would predate the MiFID II implementation date, and include all NDFs sold during the 12-month period despite previously not being classified as CFDs;
- base the calculation on the last 12-month period, but only consider those NDFs sold post 03 January 2018 on the basis that before that date, NDFs were not classified as CFDs; or
- use the standard risk warning provided by NCAs.
In the absence of clear guidance on how firms should apply the calculation, it is our view that the most prudent course of action would be to base the calculation on either the last 12-month period and include all NDFs sold during the 12-month period or use the standard risk warning provided by NCAs.
We appreciate that firms may wish to avoid using the standard risk warning provided by NCAs as this is likely to present excessive losses which are not indicative of the losses actually experienced by thiretail clients of FX Brokers that only offer NDFs for hedging purposes. Therefore, it is our expectation that most firms will opt for the first calculation.
In accordance with MiFIR, ESMA can only introduce temporary intervention measures on a three-monthly basis. Before the end of the three months, ESMA will consider the need to extend the intervention measures for a further three months.
For its part, UK regulator the FCA stated that it supports ESMA’s application of EU-wide temporary product intervention measures. The FCA expects to consult on whether to apply these measures on a permanent basis to firms offering CFDs and binary options to retail clients.
We are aware that the FCA is considering instituting a retail client restriction on CFD permissions to the effect that “the firm may only carry out the investment activity Contracts for Difference (CFD) with retail clients in relation to a Non Deliverable Forwards (NDFs)”.
In our view, the application of this restriction is a sensible resolution to the problem, as it protects the provision of valuable hedging tools for FX brokers and their clients, without preventing competent authorities from implementing appropriate regulation in areas where they have legitimate concerns.
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This post contains a general summary of advice and is not a complete or definitive statement of the law. Specific advice should be obtained where appropriate.