CFDs IN 2019 IS THE CFD INDUSTRY FACING THE PERFECT STORM?

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1 CFDs IN 2019 IS THE CFD INDUSTRY FACING THE PERFECT STORM?

2 CFDs IN 2019 BDO LLP WILL 2019 SEE THE PERFECT STORM FOR THE CFD INDUSTRY? CONTENTS Ban on inducements 01 Cash-only payments and the prevention of credit lines 02 Leverage limits for retail clients 03 Ultimate impact on the retail market 04 Brexit 04 Although the UK-based Contracts for Difference (CFD) industry has weathered European and domestic regulatory pressures so far, 2019 brings new challenges. Will the combined impact of Brexit and the Financial Conduct Authority s (FCA) proposed reforms create the perfect storm? Impending regulatory changes such as those set out in the FCA s December 2018 consultation paper (CP18/38) and the future geopolitical environment could have a major impact on the CFD sector. So how might the industry respond? Following a series of successful CFD breakfast forums over the past few years, we held our latest breakfast forum in January 2019, bringing together chief executives, heads of compliance and other senior representatives from major international players and fast growing start-up firms. Our discussions focused on: the proposed ban on inducements and what actually constitutes a non-monetary benefit what forms of payment should be allowed for CFD products whether the proposed leverage limits would achieve the FCA s objectives whether the intended benefits for the retails sector will actually be realised how firms might service clients after a hard Brexit I hope you enjoy reading this report and find it a useful resource when developing your own firm s strategy for the year ahead. Please do contact us to discuss how any of the issues might affect you and the industry. Kind regards, LORRAINE BAY Partner

3 BDO LLP CFDs IN BAN ON INDUCEMENTS ARE YOU CLEAR ON WHAT YOU WILL AND WILL NOT BE ABLE TO OFFER IN TERMS OF MONETARY AND NON-MONETARY INCENTIVES? Are you clear on what you will and will not be able to offer in terms of monetary and nonmonetary incentives? 64% Yes No 36% Almost two-thirds of all participants in our January forum were still uncertain about what they will be able to offer clients in terms of monetary and/or non-monetary benefits. This confusion stems from the proposal in the FCA s consultation paper (CP18/38) to ban both monetary and nonmonetary benefits that incentivise customers to trade CFDs. NON-MONETARY BENEFITS Forum participants discussed what actually constitutes a nonmonetary benefit and the many detailed considerations. For example, when does research become a benefit? Are narrower spreads for certain customers acceptable? Getting a clear understanding on where the lines are drawn around inducements is far from straightforward. The forum s consensus was that there is not a black and white definition of a non-monetary benefit. Determining what is a non-monetary incentive is subjective. For example, buy/sell research via third-party service providers offered to all customers through the trading platform would not be considered an inducement. But the line could be crossed if that research is done by the firm or is only offered to some clients. DIFFERING SPREADS Many firms rely on varying spreads as part of their current business model s unique selling point (USP). If narrower spreads for certain customers are prohibited, some may struggle to remain commercial and competitive. In fact, many forum participants felt that if inducements such as this were not allowed, firms would have to adopt a commission-only model, which would not be sustainable. For this reason, most market players have not made any changes to their current spreads offering and are simply waiting for definitive rules from the regulator. Offering different spreads for customers of different value does seem to be acceptable practice. For example, a new client based in Zurich depositing 10,000 in month one and a further 30,000 in month two will cost significantly more to on-board in a safe and compliant way than an existing client with an ongoing trading history of 500 per month over the past year. Therefore, offering differing spreads would make commercial sense and is likely to be accepted from a regulatory perspective. The key factor is whether you can justify the application of different standards to the FCA and whether you have applied your approach objectively. However, although spreads can differ, firms must ensure they do not take the form of a rebate. Any rebate must remain consistent across all customers.

4 02 CFDs IN 2019 BDO LLP CASH-ONLY PAYMENTS AND THE PREVENTION OF CREDIT LINES The FCA proposes to limit payment (types) for entering into a CFD contract solely to cash. The intention is to reduce the indirect client detriment by banning the use of collateralised assets as forms of payment. WHICH VIEW DO YOU SUPPORT? That this is a positive step, reducing the potential for client detriment 7%. That this is a negative step, with no real impact on the ability to reduce client detriment 27%. That a middle ground should be implemented, where payment is allowed, but only by a narrower range of permissible means 64%. Very few forum participants saw the FCA s proposal as a positive step. Around two-thirds could see the reasoning behind it, but thought the current proposal too draconian preferring a middle ground that would help to safeguard customers, but avoid a nanny state environment. Most industry leaders agreed that cross-collateralisation of funds was not appropriate for funding CFD trading activity. However, in reality such requests from customers are infrequent and typically only made by the larger professional players, as opposed to the retail market. CASH V CREDIT Although there was some uncertainty among forum participants, the regulator has proposed prohibiting firms from offering any form of credit to CFD customers. However, customers can use credit lines from other external sources, such as credit cards, to pay for CFDs. The availability of credit cards is welcome because of the level of security they provide in relation to online transactions, mitigating some of the inherent financial risks associated with CFD s being traded via platforms (i.e.non face-to-face). Banning their use could have the unintended consequences of exposing customers and firms to more risk. Such a ban could also increase the use of prepaid cards, which creates further challenges for firms in relation to anti-money laundering (AML) procedures and would make it impossible for firms to verify whether the funds used for payment represent cash or credit or a mixture of the two. DUTY OF RESPONSIBILITY How far does the duty of responsibility for CFD firms extend? Can they be expected to act as gatekeepers to accept or decline client deposits by having to determine the underlying nature of payment, as well as fulfilling existing AML responsibilities in respect of Sources of Funds (SoF) and Source of Wealth (SoW)? This is another challenging area for firms. Given the variety of ways that customers can gain credit and make payments (e.g. through prepaid cards and e-wallets), CFD firms often lack a clear line of sight as to whether customer funds arrive ultimately from deposits or from credit. Forum participants generally agreed that, rather than acting as gatekeepers themselves, a more sensible approach would be to rely on credit issuers checks and controls. However, it was also suggested that the industry could employ best practice from the gambling sector: if a customer switches from debit payments to credit, a 48 hour cool off freeze on their account automatically ensues. RETIREMENT SAVINGS One of the accusations levelled at the CFD industry is that the product has the potential to cause severe losses and those losses could potentially be suffered by customers retirement savings. CFD sector leaders thought that this was over the top. The potential harm to retirement pots is no more real or controllable than clients choosing to go on a round the world cruise, or buy that dream car they have been coveting. Investment in other financial instruments also carries risk and they therefore saw no reason why CFDs should be treated differently.

5 BDO LLP CFDs IN LEVERAGE LIMITS FOR RETAIL CLIENTS Over two-thirds of our forum participants felt that applying the same leverage limits to all retail clients whether experienced or inexperienced would not achieve the FCA s desired effect in terms of reducing customer losses. This has been a long debated issue and whathas become clear since the FCA s last consultation paper is that the European Securities and Markets Authority (ESMA) is putting increased pressure on the UK regulator and the UK Competent Authority does not appear to be demonstrably advocating for the UK CFD industry. Most forum CFD executives thought that applying the same leverage limits to all retail customers would be ineffective. They expect to see the same customer losses incurred, but over a longer period. It was also felt that unfortunately, the FCA is very unlikely to change its stance in this area. Instrument EXPERIENCED CUSTOMERS Leverage ratio Minimum margin Major FX pairs & certain government bonds 30:1 3.33% Major stock market indices, minor FX pairs & gold 20:1 5% Minor indices & other commodities 10:1 10% Single stock equities & all other assets 5:1 20% Cryptocurrencies 2:1 50% Even if the FCA was to consider differentiating between experienced customers and others, it is difficult to see how that could work and be policed in practice. The main challenge would be to prove that certain clients had a higher level of experience. For example, many customers trade across multiple platforms and there is no reliable reporting between firms on individuals trading history. There are also complexities around deciding what experience relates to specifically: For example, should customers need to have prior experience with derivative products, or would experience of simply trading in the underlying assets be sufficient? Is demo account experience sufficient? The general consensus among forum participants was that it would not: experience shows that trading decisions materially change once the money involved becomes real.

6 04 CFDs IN 2019 BDO LLP ULTIMATE IMPACT ON THE RETAIL MARKET The FCA s goal is to ensure that CFDs are offered and sold only to an appropriate target market customers who understand the risks and are capable of bearing the potential trading losses. We asked the executives attending our forum whether they felt the package of measures set out in CP18/38 would achieve the FCA s aim. Not a single person did. Only a third thought the measures would even partially meet the FCA s objective. Do you think the measures set out in the FCA s consultation paper will achieve its objective? 66% SO WHAT WILL HAPPEN? Yes Partially No 34% 0% BREXIT PLANS The subject of relocation cannot be discussed without mentioning Brexit. How is the UK CFD industry responding to the threat of a hard Brexit? Over half of the forum participants said that, in the event of a hard Brexit, they still intended to continue servicing European clients. However, one in five would cease doing so. REVERSE SOLICITATION Many CFD firms that plan to continue servicing European clients post Brexit will need to rely on reverse solicitation. This means that clients would initiate enquiries for the firm s services, rather than the firm itself conducting proactive marketing. Although reverse solicitation is recognised through the MiFID II regulation, firms will not be able to market their services to European clients. However, the definition of reverse solicitation has been implemented differently across the EU and firms must make sure they are aware of individual country requirements. It was widely agreed by our participants that the FCA s proposals would cause a surge in CFD firms moving operations to less regulated markets outside the UK. This will potentially expose UKbased customers to more risk but it appears that the UK regulator is aware of this possible outcome. In fact, there was suggestion that the FCA may see this as the lesser of two evils. The perception of many forum participants was that the FCA has no appetite for continued CFD business within the UK. Assuming a hard Brexit, do you plan to service existing European clients? 21% 21% Yes No Yes, with restrictions 58%

7 BDO LLP CFDs IN NOTES

8 FOR MORE INFORMATION: LORRAINE BAY PARTNER FINANCIAL SERVICES +44 (0) (0) The proposals contained in this document are made by BDO LLP and are in all respects subject to the negotiation, agreement and signing of a specific contract. This document contains information that is commercially sensitive to BDO LLP, which is being disclosed to you in confidence to facilitate your consideration of whether or not to engage BDO LLP. It is not to be disclosed to any third party without the written consent of BDO LLP, or without consulting BDO LLP if public freedom of information legislation applies and might compel disclosure. Any client names and statistics quoted in this document include clients of BDO LLP and may include clients of the international BDO network of independent member firms. BDO LLP, a UK limited liability partnership registered in England and Wales under number OC305127, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. A list of members names is open to inspection at our registered office, 55 Baker Street, London W1U 7EU. BDO LLP is authorised and regulated by the Financial Conduct Authority to conduct investment business. BDO is the brand name of the BDO network and for each of the BDO member firms. BDO Northern Ireland, a partnership formed in and under the laws of Northern Ireland, is licensed to operate within the international BDO network of independent member firms. Copyright February 2019 BDO LLP. All rights reserved. Published in the UK. HB011849