UK Financial Conduct Authority proposes enhanced disclosure requirements for derivatives being marketed to retail investors who may not be aware of the risks.

Concerned that more and more retail customers are offering and trading contracts-for-differences (CFD) products without an adequate understanding of the risks and potential for “rapid, large and unexpected losses,” in December 2016 the UK Financial Conduct Authority (FCA) proposed stricter rules for FCA-regulated firms selling CFD products (including spread bets and rolling spot FX contracts) to retail customers. The FCA has three key proposals:

1. The introduction of different leverage limits for inexperienced and experienced retail clients

2. A requirement for firms to publish standard risk warnings and disclose profit-loss ratios on client accounts

3. A ban on bonus promotions

The deadline for feedback on the FCA^[1] consultation paper is March 7, 2017, and the FCA plans to publish a policy statement confirming final rules in the spring. The FCA is not alone—several EU countries, including Belgium, Cyprus, France, Germany, and the Netherlands, have already introduced or announced intentions to introduce financial promotion bans on CFD retail products. The European Securities and Markets Authority (ESMA) reissued a warning notice about retail CFDs in July 2016. Several non-EU jurisdictions including Hong Kong, Japan, Singapore, and the United States have also recently enhanced their regulation of retail CFD products.

CFDs in Summary

CFDs are highly leveraged, risky over-the-counter (OTC) derivatives that are nonstandardized and are often marketed and sold on a nonadvised basis. The consultation paper highlights that although CFDs were traditionally marketed to sophisticated retail investors, in recent years CFD firms have used promotional offers and mass media advertising, including football team sponsorships and adverts in free newspapers, to attract investors from the broader retail market. The FCA reports that the number of CFD providers in the United Kingdom has around doubled since 2010, and there are approximately 125,000 active clients in retail CFD products in the UK currently.

CFDs are usually traded on online platforms, which means that the firms providing the products cross-border have a limited jurisdictional presence and are particularly difficult to supervise. The FCA notes that, among other factors, the appeal of CFDs for retail clients appears to lie in online access to trade, the opportunity to invest in high-value equities for a notional amount of margin, and potential tax benefits. The consultation paper highlights that, as the popularity of CFD products has increased, there has been a rise in complaints to the Financial Ombudsman service. As part of its regulatory approach, the FCA proposes to introduce a ban on bonus promotions, which induce retail investors into the market in return for “free cash.” The FCA notes that these promotions often have misleading terms and conditions, and any additional cash is added to the client’s margin, making the potential for loss even greater.

Appropriateness

The consultation paper highlights concerns that in addition to unauthorized firms offering CFDs, there is widespread failure among authorized firms in giving adequate risk warnings to retail investors. Despite FCA findings that more than 80% of clients made losses in the course of one year, the FCA raises concerns that CFD providers continue to promote the positive aspects of the trade with insufficient risk warnings. Both the FCA and ESMA highlight that firms are failing to adequately assess the appropriateness of CFD products for retail clients, instead relying on self-certification and focusing on less relevant areas such as age and length of time at current address, as opposed to a client’s actual experience.

Conflicts of Interest

Both ESMA and the FCA note that there is an inherent conflict of interest within many CFD providers because many firms trade as principal without hedging the trades—meaning that firms will directly benefit from client loss. Furthermore, even where firms do hedge, conflicts still exist where hedging is carried out with intragroup/affiliated entities. There are also concerns that firms are benefiting from asymmetric price slippage to the detriment of clients. CFDs with high commissions generate further conflicts, and ESMA notes that many of the risks for retail clients lie in the business models adopted by CFD firms, which often link staff or affiliate remuneration solely to the volume or value of trades placed by CFD clients. In its updated Q&A on the provision of CFDs and other speculative products to retail investors under the Markets in Financial Instruments Directive (MiFID), ESMA reminds local regulators that when assessing a firm’s application for authorization, they should ensure that the applicant firm can demonstrate it has considered potential conflicts of interest and how these will be identified, managed, and mitigated in line with the firm’s obligations under Article 13(3) of the MiFID. Regulators should also take into account such other relevant factors as the proportion of a firm’s business and revenue streams, which is linked to the provision of investment services and activities relating to CFDs or other speculative products.

Standardized Risk Warning and Profit-Loss Disclosure

In light of the concerns outlined above, the FCA proposes to enhance disclosure requirements through the introduction of a standardized risk warning and mandatory profit-loss disclosure, which must be prominently displayed on any website or mobile application that refers to the benefits of CFDs, or in a durable medium where the client has not approached the firm through a website or mobile application. The disclosure will state the percentage of client accounts that have made net profits or losses, both in the previous calendar quarter of trading activity and over the last 12 months, in order to provide transparency on the firm’s historical performance. The disclosure must include actual profits or losses and the current level of profit or loss from equity in open trading positions, and the firm must retain for five years records of the retail client accounts used for these calculations.

Leverage Limits and Margin Closeouts

The FCA also proposes drawing a distinction between inexperienced and experienced clients, based on whether a client has active CFD trading experience of 40 trades conducted over at least four quarters in the previous three years, with at least two trades per quarter. The firm must receive and record evidence of the client’s previous accounts and trading—experience in demonstration accounts or self-certification will not be sufficient. Some leverage levels for retail clients currently exceed 200:1, and the consultation paper highlights that the ability of retail clients to take short positions in the products means that they are vulnerable to potentially unlimited losses which may far exceed a client’s deposited sum. The highly leveraged nature of CFDs also impacts costs and charges that are based on the notional investment and not the initial margin, meaning that clients are even more likely to be left with losses. The FCA notes that this current highly leveraged nature of CFDs poses a risk not only to retail clients, but also to CFD firms themselves; thus, the FCA proposes introducing a maximum 25:1 leverage limit for inexperienced retail clients, with a maximum 50:1 leverage cap for experienced retail clients (with lower leverage caps for experienced clients to be set according to asset risks). Firms will retain the discretion to set leverage caps for professional clients. Both inexperienced and experienced retail clients will also be subject to a 50% margin closeout requirement, although the FCA notes the risk that excessive market volatility may still mean that firms will be unable to close out client positions immediately.

CFD Providers Across the European Economic Area (EEA)

According to the FCA, there are almost 100 UK-based CFD providers regulated by the FCA, and around 130 CFD providers operate in the UK cross-border from other EEA countries, with the majority in Cyprus, under MiFID passports. Authorities in other member states have already taken a range of actions related to CFDs and other speculative products, and ESMA has coordinated a group consisting of host regulators and the Cyprus Securities and Exchange Commission (CySEC), which has been successful in imposing administrative fines and reaching settlement agreements. The FCA notes other examples of member state regulatory action taken toward CFDs, such as a ban in Belgium on the distribution of binary bets, CFDs, and rolling spot FX contracts via electronic trading platforms, and a minimum margin requirement of 1% for retail investments in OTC derivatives in Poland, with a 100:1 leverage limit for both FX and CFD products. Because firms operating on a passporting basis remain solely the responsibility of their home regulators, the risk warning and profit-loss disclosure requirements, leverage limits, and 50% closeout margin requirements set out in the FCA consultation paper will not apply to these firms. However, the FCA will restrict financial promotions issued by any firms that do not meet an equivalent standard.

Incoming Legislation

The FCA consultation paper reminds firms that they must continue to abide by their EU obligations, and firms will need to prepare for incoming EU legislation set to come into force in early January 2018. Requirements under the Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation were originally set to apply to member states from December 31, 2016, but application of PRIIPs has been delayed by one year until January 1, 2018. The application date of the second MiFID Directive (MiFID II) has also been delayed by one year, from January 3, 2017 to January 3, 2018.

The PRIIPs Regulation will introduce a new product disclosure document that will assist retail clients in assessing investment products, and MiFID II will bring enhanced requirements on best execution, cost transparency, and product governance (which are likely to restrict the ability of firms to market CFDs to the general retail market). Under the Markets in Financial Instruments Regulation (MiFIR) member states will have conditional powers to prohibit or restrict marketing, distribution, or sale of certain financial instruments, types of financial activity, or practices. Providers and distributors of retail CFDs and binary bets will need to assess their business models in light of these proposals, and CFD firms as well as trade and consumer bodies will need to continue monitoring any policy developments.

^{[1] Consultation Paper (16/40): Enhancing conduct of business rules for firms providing contract for difference products to retail clients.}