ESMA Update: Restrictions and bans extended, impacts, and what now?

The European Securities and Markets Authority (ESMA) has acted again to extend its ban on binary option trading out to the July timeframe. Its restrictions on the CFD business may soon follow suit. The reasoning is the same as with previous extensions: “ESMA has carefully considered the need to extend the intervention measure currently in effect. It considers that a significant investor protection concern related to the offer of binary options to retail clients continues to exist.”

Financial impacts on the brokerage community are finally starting to firm up in the industry. Unfortunately, many firms have underestimated the damage over the long run, but it is still unclear how, when and where a new equilibrium will decide to form. In any event, if ESMA wanted to reshape the trading industry into a new dynamic, it seems to be achieving its objective.

The prevailing opinion is that the retail trading industry had rushed down a path that, regardless of what people might like to think, seemed to be more like gambling than actual trading. As one insider, a former CEO of a major brokerage put it: “In the industry we say that brokerages went through a process of ‘gamification.’ We saw a shift where companies started acting more like marketing machines than financial brokerages.”

What were these “marketing engines” pushing to an unaware and unsuspecting public? They were pandering directly to a person’s innate greed and desire to get rich quick. The immediate result was a self-dealing type of model where the House wins big time, as in casualty rates exceeding 80%. Profits were enormous, in the billions, and with such high customer turnover rates, firms had to resort to aggressive marketing tactics in order to reel in new clients every month. Virtual “casinos” sprung up over night in accommodating jurisdictions, far from any regulatory control or oversight.

On a domestic basis, regulators were inundated with complaints without a good handle on the sources or patterns of loss profiles. When industry exposés began to appear, regulators got the picture – the binary industry for one was behaving more like organized crime, operating in foreign jurisdictions where the arm of the law could not reach. New rules were implemented to curb marketing excesses and halt trading in truly high risk products until further determinations could be made. Domestic firms, which had responded to the competition, soon paid the price and are still adapting to this “brave new world”.

ESMA, the FCA, CySEC, and other major regulators are not finished. As far as they are concerned, there are more boxes to check, more rules to be made, and more excesses to curb before they regard the public as protected. Brexit, whether it happens or not, must be factored into the equation, and the cryptocurrency debate is still ongoing. Will regulators be receptive or restrictive to this new wave of innovation? Based on previous missteps, regulators are noticeably gun shy and cautious.

What are the actual bans and restrictions that were extended by ESMA?

In mid-February, ESMA extended for the third time its ban on binary options, this time out to 2 July 2019. The general consensus in the industry is that ESMA will more than likely continue to extend its bad for quite some time. Whether it decides to make the ban permanent is up for speculation, but theoretically, extensions achieve that same purpose.

ESMA has yet to extend the restrictions on CFD trading. The current set of rules, five in all, are in force through April 30^th. These rules were as reported:

• “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:
  1. 30:1 for major currency pairs;
  2. 20:1 for non-major currency pairs, gold and major indices;
  3. 10:1 for commodities other than gold and non-major equity indices;
  4. 5:1 for individual equities and other reference values;
  5. 2:1 for cryptocurrencies;
• 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;
• Negative balance protection on a per account basis. This will provide an overall guaranteed limit on retail client losses;
• A restriction on the incentives offered to trade CFDs; and
• A standardised risk warning, including the percentage of losses on a CFD provider’s retail investor accounts. The standardised risk warning will continue to allow use of the additional abbreviated risk warning introduced in the previous renewal decision for cases where the standard terms of a third party marketing provider have a character limit which is lower than the number of characters comprising the full or the abbreviated risk warning, provided that the advertisement also links to a webpage of the provider on which the full risk warning is disclosed.”

As we reported last October, “ESMA also carved out an “exception” to these rules. If the consumer met their test for being a “Professional Trader”, then the rules would not apply. What were these requirements? In order for a “Candidate” to be treated as a “Professional Trader”, he had to meet two out of three of the following criteria:

• The candidate’s trading volume is of at least 10 deals (each worth at least €150) per quarter, and for the last four quarters;
• The candidate’s financial portfolio, all included, exceeds €500,000;
• The candidate needs to have at least a year of relevant experience in the financial field.”

The smarter and quick-to-react brokerage houses immediately focused on canvassing and categorizing their clients to meet the “Professional Trader” criteria, but the benefits of these one-time actions have run their course. The large publicly traded firms in London continue to record revenue shortfalls, compared to 2018 results.

New rules did not stop with these actions. ESMA also published MiFID II, which contained an entirely new set of regulations designed to modify marketing behavior across the entire brokerage industry. Per one analyst: “The updated rulebook affects every corner of the continent’s financial services system. According to one report, commissions paid to brokers dropped 28 per cent in the UK during the first quarter compared with the same quarter in 2017.” Old incentive strategies were out, and new methods of attracting and retaining clients within the rules were a necessity.

What has been the financial damage to these large London brokerages?

Share prices for each of the “Big Three”, i.e., the IG Group, Plus500, and CMC Markets, have taken a beating over the past year, and, unfortunately, each time either of the three companies reports a shortfall, expected or not, the share prices plummet once more in unison.

Here are the latest reports of damage:

• The IG Group: This broker responded quickly to the new rules, especially in the area of categorizing its clients as professionals. Revenues for its second quarter of its fiscal year were still down 8% and profits off 18%: “In the second quarter of the year (Q2 FY19), when the ESMA measures were in effect throughout, the Group’s net trading revenue of £122.1 million was 8% lower than in the same period in the prior year. Revenue in the ESMA region in Q2 FY19 was 18% lower than in the prior year. This was offset by the 9% growth in revenue from the Group’s OTC leveraged derivatives business outside ESMA.”
• Plus500: The firm had a good year in 2018, compared to prior periods, but it is wrestling with estimates of how to explain what 2019 might bring. The latest missive from reporters is not positive: “Plus500 said that new rules from the European Securities and Markets Authority (ESMA) limiting the amount of leverage that can be given to retail customers would mean profit would be “materially lower than current market expectations” this year. Revenue is also expected to fall.”

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• CMC Markets: This broker was more frank with its warnings. As a result of its clarification in late February, shares plummeted 22% and also dragged down values for IG and Plus500 by 5%, as well. The reported guidance was: “The spread-betting specialist has warned that revenues for Q1 2019 will even miss its previous weak expectations, with tighter restrictions on the sale of leveraged products to retail investors having a more severe impact than initially anticipated. CMC Markets expects its proceeds from CFD and spread bet trading to be lower by 25 percent to 35 percent from a year ago, and relative to its previous guidance that called for a 20 percent reduction year-on-year.”

While Plus500 and CMC Markets are more domestically focused, the IG Group has made inroads in other markets, which have lessened the impact of ESMA restrictions. There will more than likely be more blood to let going forward in 2019 until the market settles down. Typically in situations like these, the market over punishes the firms that fall short of expectations. At some point in the future, these firms may offer a good buying opportunity, if market reactions have been too harsh.

Concluding Remarks

ESMA is determined to change the “face” of the retail trading industry within the confines of its member state constituents. As a matter of fact, the FCA in the UK has also expressed that, regardless of what happens with Brexit, it will continue to follow the lead of ESMA and may even get tougher, if it deems necessary.

In the estimation of the regulators, trading firms flew too close to the “gambling” sun, so to speak. As one pundit noted: “Advertising, in particular, was an area in which firms really let out the ‘gambling’ side of their operations. Sign up bonuses, massive leverage and competitions were all played up in exactly the same manner that betting websites and bookmakers advertise their services. ESMA’s rules negate any of the impact that those things had. Casino-style marketing is gone.”

Without “massive” leverage and instruments that could produce huge rewards in a short period of time, brokers are witnessing a migration of customers to foreign brokers, where ESMA rules do not apply. The result is higher risk for the consumer, but regulators knew this result would materialize, based upon prior experiences.

As for the response from the public, which has been disenfranchised to a degree, this one opinion is telling: “If the 2000s was the era of ‘gamification’ then perhaps the 2020s are going to be the years of ‘degamification.’ That will probably lead to better services for the average trader but, for those of us that like a flutter, it could be rather dull.”

Chris Lee

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