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March 28, 2018 12:57 PM UTC

EU Markets Watchdog Sets Leverage Limits On CFDs, Cryptocurrencies

The European Securities and Markets Authority (ESMA) has announced leverage limits as temporary product intervention measures on the provision of contracts for differences (CFDs), including those using cryptocurrencies, for retail investors in the European Union (EU). ESMA also announced measures for binary options. The measures…

The European Securities and Markets Authority (ESMA) has announced leverage limits as temporary product intervention measures on the provision of contracts for differences (CFDs), including those using cryptocurrencies, for retail investors in the European Union (EU). ESMA also announced measures for binary options.

The measures will be published in the official journal of the EU and will take effect one month for binary options and two months for CFDs, following publication in the official journal.

The product intervention measures for CFDs include leverage limits on the opening of a CFD by a retail client from 30:1 to 2:1, which vary according to the volatility of the underlying asset. The leverage limits are: 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; and 2:1 for cryptocurrencies.

Other intervention measures include the following:

  • A margin closeout rule per account. This will standardize the percentage of margin at 50% of minimum initial required margin, mandating providers to close out one or more of a retail client’s open CFDs.
  • Negative balance protection per account basis. This will provide a guaranteed limit on retail client losses.
  • A restriction on the incentives offered to trade CFDs.
  • A risk warning, including the percentage of losses on a CFD provider’s retail investor accounts, delivered in a standardized way.

Why The Measure

CFDs that offer leveraged exposure to price, level or value changes in underlying asset classes have existed as a speculative short-term investment product for several years. In recent years, however, national competent authorities (NCAs) have raised concerns about the growth of CFDs to a mass retail market, despite these products being complex and inappropriate for most retail investors.

NCA’s analysis shows that 74% to 89% of retail investor accounts lose money on their investments, with average losses ranging from €1,600 to €29,000. While some NCAs have taken measures in this area, ESMA provides the most efficient tool to provide a common minimum level of protection.

The pricing, trading terms and settlement of such products are not standardized, undermining investors’ ability to grasp the terms of the product. In addition, CFD providers often require investors to acknowledge that reference prices that determine the value of a CFD can differ from the available price.

It can also be difficult for retail investors to check the accuracy of the prices received from the CFD provider.

Cryptocurrencies Draw Concern

CFDs with cryptocurrencies as an underlying asset raise significant concerns.

ESMA and NCAs are concerned about the integrity of the price formation process in underlying cryptocurrency markets, as they make it difficult for retail clients to value these products.

Due to the specific characteristics of cryptocurrencies as an asset class, the market for financial instruments providing exposure to cryptocurrencies, such as CFDs, will be closely monitored.

Lack Of Clarity Cited

Retail investors find it difficult to assess the expected performance of a CFD, the statement noted.

In addition to transaction fees, spreads and other charges can be applied.

The application of leverage, which is common to CFD components, can also increase the probability of a larger loss to a greater extent than the probability of a larger gain. High leverage also increases the likelihood that the investor has insufficient margin to support their open CFDs by making the investor’s position sensitive to small fluctuations in the price.

Automatic margin close-out provides a degree of protection for investors as it reduces, but it does not eliminate, the risk that the investor loses all or more than their initial margin. The interaction between high leverage and automatic margin close-out increases the probability that an investor’s position will be closed automatically by the CFD provider in a short time frame or an investor has to post additional margin in the hope of reversing a losing position.

Furthermore, the offer of CFDs to retail investors has increasingly featured aggressive and misleading marketing practices. A common feature of CFD marketing and sales techniques has been the offer of bonuses to attract and encourage retail investors to invest in CFDs. Such bonuses can act as a distraction from the high-risk nature of the product.

Such offers to open CFD trading accounts often require investors to pay the provider and conduct a specified number of trades over a specified time period.

Conflicts of interest have arisen and may arise from the fact that some CFD providers are counterparties to investors’ trades without hedging their exposure, therefore placing their interests in direct conflict with that of their investors.

Also read: IMF urges international cooperation on cryptocurrency regulation

ESMA To Monitor

ESMA intends to closely monitor whether similar detrimental consequences for retail investors develop from these products on a pan-European basis.

Securitized derivatives that are CFDs are not explicitly excluded from the definition of CFDs. While ESMA is not aware of securitized CFDs at this stage, the wrapper of a security and the tradability on a trading venue do not change the key characteristics of a CFD. Such products will be in the scope of this measure.

ESMA will assess whether stricter measures are required.

Binary Options Prohibited

ESMA has decided to will impose a three-month prohibition on the marketing, distribution or sale of binary options to retail investors since the risks related to the inherent features of binary options, such as an expected negative return and inherent conflicts of interest, make these products unsuitable for retail investors.

Unlike options which can serve a valuable role in hedging exposure to certain assets, binary options do not meet any genuine investment needs for retail investors. Such options can also attract compulsive gambling behavior.

Featured image from Shutterstock.

Last modified: January 24, 2020 11:12 PM UTC

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Lester Coleman

Lester Coleman is a media relations consultant for the payments and automated retailing industries.

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