ESMA to use new powers to attack the sale of CFDs and binary bets to retail investors

ESMA has launched a public consultation on measures to protect retail investors investing in contracts for difference (CFDs) and binary bets. Potential changes include wide-ranging restrictions on the marketing and sale of CFDs, and a complete prohibition on the sale of binary bets to retail investors. An intervention would mark ESMA's first use of its new powers under MiFID II, which came into force on 3 January.

We have previously reported on ESMA's plans to address the risks to retail investors in the CFD sector, and more recently the FCA's own crack-down on particular firms offering these "high-risk" products. 

In its call for evidence of 18 January 2018, ESMA notes that it and several national competent authorities have taken actions to address the risks.  However, it says, these actions have not significantly reduced the risk to retail investors.  Using its new powers to intervene under MiFID II, ESMA is considering placing a prohibition on the marketing, distribution or sale of binary options to retail investors, and restricting how CFDs may be offered to retail investors. 

The FCA had separately announced its own proposals on restricting the marketing and sale of CFDs to retail investors in December 2016 (CP16/40), which were markedly similar to those now put forward by ESMA.  However, the FCA announced it would hold off on implementing these measures until after ESMA announced its proposals, as we reported last summer.  Therefore, it appears likely that the FCA's own proposals will now be dropped in favour of ESMA's, but the FCA has yet to confirm this.

CFDs and binary bets

CFDs and binary bets are, essentially, gambles on the entry and exit prices of an underlying asset within a given time.  The asset can be anything that has a financial value, for example a currency, stock or index. 

The payment to (or from) an investor with respect to a CFD depends on the actual difference in entry and exit price.  In contrast, the payment with respect to a binary bet is set from the outset and, as the name suggests, the investor will receive all of this amount or nothing at all.

The risk

ESMA considers that CFDs expose retail investors to a significant risk of financial loss, which is exacerbated by high leverage.  According to ESMA, retail investors are currently subjected to "aggressive marketing techniques" which include the offer of incentives to trade CFDs.

ESMA finds that binary bets expose retail investors to very high levels of risk and an inherently negative expected return.  Additionally, the short duration of trades and all-or-nothing nature increases a retail investor's exposure to losses and encourages addictive behaviour.

ESMA notes that both CFDs and binary bets are complex products, and it has found a lack of transparent information at the point of sale which limits retail investors' abilities to understand the risks involved.

Restrictions on CFDs

ESMA believes that investor protection can be adequately achieved for CFDs by restricting the marketing, distribution and sale of CFDs to retail investors.  In particular, ESMA wants to introduce:

• leverage limits.  These would range from 30:1 for major currency pairs to 5:1 for individual equities;

   

• a margin close-out rule, which would mean that retail clients would be routinely protected from losing more than they have invested; 

   

• negative balance protection, which would provide an overall guaranteed limit on retail client losses;

   

• a restriction on incentivisation of trading; and

   

• a standardised risk warning, potentially requiring firms to disclose the percentages of clients making losses and profits in previous quarters.

   

ESMA has not yet decided where cryptocurrencies fit within the MiFID framework and is considering imposing a lower leverage limit of 2:1 or 1:1, or even prohibiting cryptocurrency CFDs altogether given the higher risks involved in these instruments.

Prohibition of binary bets

ESMA notes that, unlike CFDs, the inherent features of binary bets mean that restrictions would not sufficiently address the concerns it has around retail investor protection as it does with CFDs.  It is, therefore, considering prohibiting the marketing, distribution and sale of binary bets to retail investors altogether.

The consultation period