The Financial Conduct Authority (FCA) is proposing rules to address potential harm to retail consumers from the sale of certain complex derivative products with the publication of two consultation papers. CP18/37 proposes permanent rules to prohibit the sale, marketing, and distribution of binary options to retail consumers by firms that carry out activity in, or from, the UK. CP18/38 proposes restrict the sale, marketing, and distribution of contracts for difference (CFDs) and similar products to retail customers. The FCA also published a Technical Annex, supplementing CP18/38 with a detailed assessment of the costs and benefits of leverage limits for consumers.
In relation to CFDs, the FCA’s proposed package of policy measures is of the same substance as ESMA’s temporary restrictions on CFDs, spread bets, rolling spot forex products, although the scope of the proposal is wider as it would apply to closely substitutable products such as the so-called turbo certificates or “CFD-like options”, which share many of the same characteristics as CFDs. At the moment, only 2 FCA-authorised firms offer access to turbo certificates in the UK. This would stop firms from getting around the restrictions by offering retail customers CFDs in slightly different legal forms but posing the same risk of harm. The FCA is proposing to require firms to permanently:
Limit leverage to between 30:1 and 2:1, depending on the volatility of each asset class, by collecting minimum margin as a percentage of the overall exposure that the CFD provides. The proposal is that the initial margin should be based on the value of the underlying asset when the client enters the trade, rather than the CFD’s value (the “implied” leverage, as required under ESMA’s measures);
- Close out a customer’s position when their funds fall to 50% of the margin needed to maintain their open positions on their CFD account. There is no indication if firms have discretion to require additional margin;
- Provide protections that guarantee a client cannot lose more than the total funds in their CFD account;
- Stop offering monetary and non-monetary inducements to encourage trading;
- Provide a standardised risk warning, which requires firms to tell potential customers the percentage of their retail client accounts that make losses.
The FCA acknowledges that UK CFD providers have used financial promotions and client communications to suggest retail consumers opt up to ‘elective professional’ status, or haver encouraged retail clients to trade with firms outside the EU in third country jurisdictions. It also acknowledges firms have complained that ESMA’s intervention measures have been inconsistently applied across products, leading firms to consider offering substitutes tor CFDs.
Chapter 4 introduces a discussion on the risks of harm from futures and their distribution to retail clients, indicating the FCA’s intention to apply consistent limits to futures as those proposed for retail CFDs. The FCA will consult separately in early 2019 on a potential ban on the sale of derivative products referencing cryptocurrencies, including CFDs, to retail consumers.
In CP18/37, the FCA indicate that binary options are primarily for speculative purposes and that firms offering these products usually benefit from client losses. In addition, because of their inherent complexity and lack of transparency for calculating pay-outs, binary options pose a risk of widespread mis-selling to less sophisticated clients, also in light of information asymmetry, which makes it difficult for retail consumers to judge the value of their investment. The FCA also notes that binary options are unlikely to satisfy a genuine investment need due to the short maturities of the bets, which might encourage addictive behaviour in vulnerable consumers. The FCA’s prohibition would also cover securitised binary options, to prevent a possible means of arbitrage for firms seeking to avoid the prohibition by manufacturing alternative binary products. This initiative follows the German BaFin’s plan to prohibit binary options for retail clients. The ScamSmart campaign on binary options educates consumers on how unauthorised binary options firms operate, how to avoid falling victim to a scam and what to do if they are scammed.
The binary options Consultation Paper is open until 7 February 2019. The CFD Consultation Paper is open until 7 February 2019 for feedback on the proposed measures and 7 March 2019 for feedback on the discussion of other complex derivative products. The FCA aims to publish a Policy Statement (PS) and final Handbook rules by March 2019, with rules to come in to force shortly afterwards.
The FCA estimates that the proposals for CFDs could reduce annual losses for retail consumers of UK firms by between £267.4m to £450.7m. A permanent ban on binary options could save retail consumers up to £17m per year, and may reduce the risk of fraud by unauthorised entities claiming to offer these products. According to the standardised risk warning of firms, an estimated 78% of active retail clients lose money. However, the analysis of these data does not reflect that some retail traders did or will move into trading as professionals, into trading in third country jurisdictions, or into trading substitutable products.
In 2016, the FCA launched a similar consultation, (CP16/40), whose results were never published in favour of awaiting the outcome of ESMA’s product intervention. At that time, the FCA received almost 2,300 responses, most of which were not in favour on leverage limitations and margin closed out rules. CP16/40 was to introduce a different approach to “inexperienced” and “experienced” retail clients, which were defined by their frequency of trading. This proposal was not followed up in CP18/38.
The FCA states that academic research shows that “leverage limits improve consumer outcomes by reducing the negative effect of their overconfidence by placing limits on their trading exposure”. Limiting trading exposure does not necessarily make investors responsible for their trading decisions (as this graphic shows), nor does it ensure their protection from other speculative products that might come to the market. A different option to approach overconfidence could be education and awareness rather than restriction.