How will the tightening of FCA rules affect Traders and Brokers in the UK’s CFD industry?
Yesterday, the Financial Conduct Authority (FCA) proposed to significantly tighten the rules for firms offering Contracts for Difference (CFD) products to retail clients. This announcement came only days after CySEC imposed very similar measures for Cypriot brokers. Both regulators told us these changes will ensure that consumers are adequately protected, as many investors are thought to not fully understand the products and risks involved.
For those who are less familiar with these definitions, Contracts for Difference are financial derivatives ranging from Forex to Stock Indices, Commodities, and Shares, etc., that are offered to retail traders for speculative purposes with high levels of leverage. Up to now, the leverage available for CFD trading often reaches between 100:1 and 400:1 (or more) depending which brokers one uses. This means that investors can effectively move up to 400 times more money in the markets than their actual cash balance amount.
So, what changes is the FCA proposing to make exactly?
On the 30th of November 2016, the Cyprus Securities and Exchange Commission (CySEC) announced that they were acting to cease new bonus promotion schemes, whilst urging investment firms to let their existing offers lapse. What’s more, they are imposing a leverage cap of 50:1 for all CFDs, or complex tradable financial products. And finally, they have also made it mandatory for Cyprus Investment Firms (CIFs) to process all client withdrawal requests on the same day.
On the 6th of December 2016, the FCA followed suite with a proposal for very similar changes. The UK Regulator equally plans to ban any forms of trading bonuses and promotions, to make it less tempting for customers to engage CFD trading in the first place. Furthermore, they want to cap the maximum leverage to 25:1 for novice traders with less than 1 year experience, and 50:1 for experienced traders for all products, whilst ‘introducing caps across different assets according to their risk’.
The Pros of trading with Leverage
In theory, if you know what you’re doing and are a consistently profitable trader, then leverage can be very beneficial to you. It means that you could profit from situations where you believe to have an edge, by taking advantage of leverage to run positions that are slightly larger than what your cash balance would otherwise allow, and thus achieve higher profits as a result. This has definitely worked well for some, as there are numerous retail traders out there who are known to have made fortunes speculating in the financial markets using Contracts for Difference and Spread betting products.
The Cons of trading with Leverage
The problem is partly that although leverage can help traders achieve superior profits in some cases, the same is true for losses. The financial markets can be very volatile at times, and any CFD trader who finds the market running against him when the exposure wasn’t managed appropriately, CFD traders run the risk of potentially raking up significant losses pretty quickly. In absence of a sound risk management strategy for instance, if a large position was to run against you, it would be possible to end up on margin call, meaning you’d be asked top up your account with additional funds. Failure to react quickly and comply with such a request could lead to your positions being force closed by your broker, and therefore significant loses.
It should also be said that these days, CFD brokers are everywhere and anyone can open an account in a matter of minutes, whilst few of us have a good idea of what we are doing. The FCA stated in their press release that their ‘analysis of a representative sample of client accounts for CFD firms found that 82% of clients lost money on these products.’
My initial thoughts were:
The FCA probably have a bit of a point to be honest there reducing leverage and banning trading bonuses and other promotions. But then again, it kind of begs the following question: how was this study conducted, using what sample, and over what time frame?
Most professional traders will tell you that it is a common mistake that people start trading with the wrong mindset, often thinking they’ll be able to get rich quick with little effort, just trading CFDs from home. But if you ask me if it is possible to become long term profitable trading the financial markets using CFDs, then absolutely, the answer is Yes! It should be said that trading CFDs for a living is a difficult profession, which certainly isn’t for everyone, and some individuals just won’t successful in their quest. But then again, isn’t that generally true in life?
My trading mentor once presented me with this analogy: if you started a course at university for instance, would you therefore become a qualified Engineer or a Doctor the next day, week, or month? Obviously not! First you would have to invest a few years of hard graft and energy into learning and testing yourself. What is more, you would also have to pay for your education before getting your degree, and only later go on to earn good money from your job. It should therefore come at no surprise to you that the same is true for anyone attempting to become a professional trader. I guess my point is that trading losses in the early stages of our trading career are almost inevitable, and should be considered as part of the cost of acquiring the skills and experience required to consistently make money in the markets.
What’s the verdict, are these restrictions good or bad for traders?
In short, the capping of leverage on CFDs in the UK is probably a good thing for traders. Although many experienced traders could get a bit frustrated over losing access to higher leverage, it will likely benefit less experienced traders by keeping them from taking on excessive exposure, and reduce the risk of them losing larger sums of money. With regards to more experienced traders, everyone has their own trading strategies and style, and those profitable traders that frequently use more leverage will certainly be unhappy. As far as I am concerned personally, I always thought that 100:1 was essentially enough. That said, if I just wanted to carry on trading the same sizes post leverage cap introduction, I will need to cough up at least double the cash to put in my trading account (basis of 50:1 only), which obviously isn’t great, and not everyone will be able to do that. Generally speaking though, professional traders tend to use less leverage and run tight risk management strategies, so this move by the FCA shouldn’t impact on them too much. Finally, everyone likes a bonus and they can be beneficial for any trader, but it is best not to rely on them and experienced traders tend to care a little less about incentives. On one hand, I think it’s a shame if bonuses were no longer available as they can help struggling traders improve their performance. On the other hand, promotions can also affect our behaviour, which isn’t always good, as we may be encouraged to trade more frequently and larger size than we otherwise would. Either way, we all need to learn how to be profitable without bonuses and promotions, so perhaps it’s not the end of the world if we lose them?
What are the implications for Brokers, and knock-on effects?
Having worked on the trading floors of some of the UK’s most successful CFD brokers myself, what I am a little worried about is the impact that the FCA’s proposal will have on the UK CFD brokerage industry. Here are some of my concerns:
- On the day of the new FCA proposal (the 6th 2016), two of the UK’s largest CFD brokers IG Group Holdings Plc (LON:IGG) and CMC Markets Plc (LON:CMCX) saw their share prices plummet by whopping -38% and -33% respectively. Between these two companies alone, much over 1 Billion GBP was lost in share value that day. This gives us a clear indication what investors make of the FCA’s proposal – basically, it’s devastating news for the industry.
- Small brokers will struggle: over the past years the largest firms have been offering fewer or no promotions, relying heavily on superior technology, strong brand awareness and large marketing budgets. Small to medium sized brokers on the other hand would have placed more emphasis on offering customers attractive trading promotions in a bid to win more business. If this option is taken away from them, they will be the ones who suffer the most.
- Less competition, ultimately means less choice: the CFD broker industry is a fiercely competitive environment. Should smaller outfits end up getting pushed out, then the result could mean less competition, and ultimately less broker choices for us traders.
- Then again, what would keep CFD traders from simply opening accounts with overseas brokers, which can continue to offer higher leverage and promotions? Could the FCA possibly keep such a phenomenon from happening? It seems rather obvious to me that that FCA regulated brokers will start losing business to overseas companies, which do not face the same restrictions. All in all, I believe the new restrictions will end up harming the UK’s CFD trading industry. Revenue and profits are bound to drop over time, which in term will negatively affect salaries and jobs in the City of London.
Firstly, here at Financial Trading Explained, we believe that many UK traders will look with disappointment at the new restrictive proposal of the FCA. It’s seems there will soon be no more trading promotions on offer, and a maximum leverage cap of 50:1 will be imposed. It is also clear that investors did not welcome this move, as two of the UK’s largest CFD brokers IG Group and CMC Markets each lost over 30% of their share value on the day the FCA announced its proposal. That said, whilst some retail traders may feel hard done buy for losing access to higher leverage, this may well play in favour of most market participants, especially novice ones. In the end however, it is still early days and rather unclear how these restrictive measure will be implemented and affect traders. Will it apply to UK residents only, or to all clients of FCA regulated firms? And will UK residents still be able to use brokers that are headquartered and regulated overseas? There are still more questions that need to be answered, and we will just have to wait and see what ends up being implemented.
Explained by Stefano Ceacmacudis