Quick Take: New ESMA Q&A sharpen supervisory tone of product intervention
One of ESMA's core mandates is to take coordinated and/or concentrated action to protect retail investors, i.e., consumers. The recent (temporary) bans on certain retail investor products has a direct impact on those investors' ability to access markets, including those beyond its borders. Even if ESMA considers this action measured, the limitation or, where indicated, the withdrawal of access is of course regrettable. More pressingly, the ban also has knock-on effects on a host of arrangements concluded in the wholesale market, which may require adjustments or unwinds. Moreover, the way in which ESMA is using its new product intervention powers will likely be of interest to all market participants, regardless of asset class or business strategy, in particular given the clarification on extra-territorial scope.
Participants offering and/or engaging in these products will want to take action to ensure any perceived and/or actual deficiencies are cleaned-up, shortcomings and remedial action evidenced and that new disclosures and consents are documented so that if this ban is lifted – post any extension, that there is a justifiable argument for providing a more robust offering that places the consumers' interest as part of the value creation process.
Protecting consumers from core products
On June 1, 2018, two decisions1 by the European Securities and Markets Authority (ESMA) were published in the Official Journal of the European Union, formally adopting new measures on the provision of contracts for differences (CFDs) and binary options to investors categorized as "retail clients."2 These new (temporary) restrictions entered into force at the start of July and August 2018 respectively yet were supplemented by revised "questions and answers" which were last updated 12 July (the July Q&A), i.e. this should be read as a "living document".3
In summary, the final measures and the July Q&A aim to protect retail investors, as consumers, from what ESMA perceives to be products, many of which have become core investment products permitting easy access to investment exposure, including on a cross-border basis, that are perceived to have adverse consequences for certain retail investors. The July Q&A reconfirms our prior analysis that the two ESMA Decisions and the final measures it introduces apply to clients established outside of the EU as well as non-EU nationals. In many ways this approach echoes existing extraterritorial reach that is contained in other core pieces of EU financial services legislation and aims to introduce an anti-avoidance element, as a punch to the power of these product intervention measures.
As explored in this Client Alert, the impact of these measures may have knock-on effects beyond the segments in which these retail investor products were offered. Consequently, as with ESMA's concurrent consultation on the "tick size regime"4, this development both in what it does and how ESMA does it merits a watching brief given the market-wide impact.
The final measures introduced by ESMA's two Decisions follow its consultation at the start of 2018 and the announcement from spring 20185 on its intention to introduce restrictions on the marketing, distribution and sale of CFDs and a ban on the marketing, distribution and sale of binary options to retail investors in the EU. It is the first time that ESMA makes use of its new temporary product intervention powers under Article 40 of the Markets in Financial Instruments Regulation.6 Some national regulators across the EU have been concerned equally with the development of the CFD market in recent years. Some regulators issued warning statements and imposed own measures to the marketing and sale of CFDs to retail investors. These concerns have also been shared by ESMA, which stated that given the increasing number of cross-border trades with these products, an intervention by ESMA is the most appropriate and efficient tool to protect this major investor protection issue.
International regulators have also followed suit with similar intervention. Whilst ESMA's intervention is currently drafted as being "temporary", certain EU Member States have indicated that irrespective of the review period after the three-month temporary ban, that permanent measures could be introduced. If this is the case, then this will possibly mean a further refocus by firms and investors in how they can engage with each other and where, as well as whether, any other products are caught by ESMA's definitions.
A binary option is defined as any cash settled derivative in which the payment of a fixed monetary amount depends on whether one or more specified events in relation to the price, level or value of the underlying occurs at, or prior to, the derivative's expiry (for example the underlying has reached a specified price ('the strike price') at expiry).7
Crucially, the July Q&A expands the definition by confirming that this includes contracts in which payment is contingent on multiple events occurring and/or products in which payment to the client increases if certain events occur.
Contracts for Differences (CFDs)
Contract for Differences or CFD means a derivative other than an option, future, swap or forward rate agreement, the purpose of which is to give a long or short exposure to fluctuations in the price, level or value of an underlying, irrespective of whether it is traded on a trading venue, and that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event.8 CFDs are often traded on a margin, which means that the exposure under the contract is leveraged. For example, in case the notional value of a CFD is €10,000 and the investor deposits €1,000 as initial margin, in this case, the CFD is leveraged at 10:1. As a result, supervisors are concerned that the financial leverage in the CFD's design can mean that losses can exceed the initial margin deposited.
So which measures have been taken?
The measures are effective from the date they come into application. This means that the ban on binary options applied prior to the measures on CFDs. The measures, including additional posting of margin, however, do not apply to products sold prior to the relevant implementation date. The July Q&A indicate that firms may choose to place contracts that were entered into prior to the implementation date into sub-accounts to be run-off or to extend the margin close-out protection and/or the negative balance protection provisions to existing positions. In each instance, firms are expected to provide their clients with the changes in the terms and conditions of their account in a durable medium in good time before the changes apply.
As a result, the impact of the measures are as follows:
Ban on binary options: The marketing, distribution or sale to retail clients of binary options was prohibited from July 2, 2018. The ban on binary options will last for three months, and, prior to its expiry date, ESMA will decide whether it will prolong the ban. The ban applies across the entire EU but also to non-EU established clients and non-EU nationals.
Mandatory requirements for CFDS: ESMA's use of its product intervention powers for CFDs consists of the same jurisdictional scope but the following specific restrictions.
- Initial Margin Protection: Leverage limits9 on the opening of a position by a retail client with the minimum requirement depending on the underlying asset. For example, in case of an underlying currency pair consisting of any two of the US dollar, euro, Japanese yen, pound sterling, Canadian dollar or Swiss franc, the leverage limit amounts only to 1:30, so the initial margin payment of the investor has to amount to at least 3.33 percent of the notional amount of the CFD. This looks very different for cryptocurrencies as underlying: here the leverage limit amounts to 1:2, so the initial margin payment of the investor has to amount to at least 50 percent of the notional amount of the CFD.
- A margin close-out rule of 50 percent on a per account basis: If the margin allocated to a CFD trading account falls to less than 50 percent of the minimum required initial margin of the open CFD position, the CFD provider must close out the position based on terms most favorable for the investor. This had previously been proposed by ESMA as applying on a position-by-position basis. NB the other clarifications in the July Q&A described below.
- Negative balance protection on a per account basis: Losses incurred by an investor are limited to payments already made into the account and any uncrystallized profits on open positions within the account.
- A restriction on the incentives offered to trade CFDs: Only research and information tools are allowed in relation to the marketing, sale or distribution of CFDs.
- A standardized risk warnings and disclosures: including the percentage of losses on a CFD provider's retail investor accounts. The risk warning10 obligations set out the conditions for where and how such risk warnings are to be displayed, including the mandatory use of standout boxes as well as specific content including as to costs disclosures.
These measures for CFDs apply from August 1, 2018 and will last for three months. As with the measures on binary options, ESMA will decide on a possible prolongation prior to the end of the three-month period.
Points to note
- The measures announced by ESMA will only apply to marketing, distribution and sale to retail clients. Binary options and CFDs may still be marketed, distributed and sold to so-called professional clients, including those clients who elect to be classified as professional clients. In its Frequently Asked Questions,11 ESMA warned retail investors to consider very carefully whether they should adopt professional client status and lose the extra regulatory protections afforded to retail clients. In any event the ban will need firms to review their processes carefully in relating to switching retail clients to elective professional clients as well as more generally regardless of client categorization will want to assess their client facing documentation, promotional offers, risk warnings and key information disclosure standards as well as how, to the extent applicable, any close-out of investors' positions are handled.
- The measures announced by ESMA were clarified by the July Q&A as 'only' applying to marketing, distribution and sale to retail investors regardless of nationality and/or location. These restrictions cut both ways: On the one hand, there is an extraterritorial aspect, since the measures also apply to firms that are based outside the EU, but which target EU retail investors. On the other hand, it is clear that the restrictions also apply to marketing, distribution and sale to investors outside the EU, but this may difficult to police by ESMA or national authorities.
- The changes may have an impact on risk and capital allocation measures as well as firms' business projections, risk tolerance levels and their internal capital adequacy assessment process (ICAAP) and resource planning in terms of capital but also hedging transactions.
- Products referencing cryptocurrencies as underlying assets: have long been in the supervisory spotlight; the CFD ban Decision speaks of these posing:
ESMA has indicated that further action may be taken that goes specifically beyond existing action, notably the joint European Supervisory Authorities Warnings on Virtual Currencies.12 It should be noted that the Decision does not define what it considers a cryptocurrency.
- Brexit: The product intervention measures taken by ESMA are applicable in all Member States of the European Union. Until March 30, 2019 (or later as the parties agree – to the extent possible) the UK is a Member State of the European Union. Therefore, UK product providers will be required to comply with ESMA's product intervention measures.13 The UK has however already indicated that notwithstanding ESMA's efforts, that it may introduce its own permanent measures.
- As long as they are not amended or withdrawn, decisions by national regulators with respect to binary options and CFDs remain in force and have to be taken into consideration by providers to ensure compliance. For example, the General Administrative Act of the German Federal Financial Supervisory Authority regarding CFDs14 from last year is currently still in force. However, it is likely that many national supervisors will withdraw their decisions in the light of the newly harmonized European approach.
- Implementation of the new requirements will be key. With respect to the ban of binary options, the main challenges consist of ensuring that all products qualifying under the ESMA definition are flagged so that it is possible to comply with the marketing, distribution and sales ban starting July 2, 2018. With respect to CFDs the task is somewhat more complex. The implementation of the required measures, such as the margin close-out protection and the negative balance protection will have to be undertaken by changing the terms and conditions of the CFD accounts. The clients have to be informed about these changes in good time before they apply.
Other clarifications in the July Q&A
The July Q&A details a host of items relating to payments and sum of funds available, aggregate liability and so on. These questions and responses were all dated 1 June 2018, which evidences some of the ambiguous nature in the original legislative drafting of the measures. Nevertheless, the clarifications are important for purposes of the margin close-out protection mechanics and the negative balance protection provisions. Depending on the circumstances specific to a client and its account, available funds may be limited to cash in an account and in specific circumstances unrealized net profits from open positions.
Other assets, including those that may stand as collateral, such as equity securities in an investment account standing as collateral to a CFD account (an increasingly common smart-collateralization model taken from the wholesale markets and being offered to retail clients) is not deemed to be compatible nor acceptable for purposes of reducing a retail client's aggregate liability in relation to negative balance protection. Whilst this restriction on valuation of all collateral exposure is unlikely to have adverse impact on firms' risk systems being able to calculate exposure amounts and whether the negative balance protections and the margin close-out protection need to be applied, it does mean explaining and backtracking on certain arrangements previously entered into with customers. This may require a number of practical examples to be illustrated to clients as part of their notification of changes as well as potentially a greater visual representation in terms of the customer interface in the respective trading platform in the form of pop-ups, shaded areas in charts or special announcements on relevant dashboards etc.
The July Q&A also addresses the practice and resulting requirements for those firms offering guarantee stop-loss orders or "limited-risk" positions in which the possible downside from an exposure is "limited" to a pre-communicated and determined amount of margin, which is ring-fenced, in respect of that position. The July Q&A confirms that the margin close-out rule applies on an account basis regardless of guaranteed stop loss orders and/or limited risk features in place. This not only raises the question as to the merits of these "protections" offered to retail clients in respect of position management, but whether this application of ESMA's measures in this manner needs to be further detailed to retail clients visually for transparency purposes. ESMA does mention its expectations quite clearly in that:
Outlook for possible solutions and opportunities
For firms and investors alike, a couple of solutions might exist such as (1) moving a client to (a currently) permitted product, such as spread betting, or (2) a retail client, at its initiative opting-up to an elective professional client – which will only be available to those that meet the qualitative and quantitative thresholds, or (3) moving the relationship, where possible, to a permitted jurisdiction, or (4) any combination of the foregoing.
Yet all of these come with a need to demonstrate appropriate justification as to why a measure has been taken and who has initiated it and how it does not offend the anti-circumvention measures ESMA introduced and the intent behind the drafting. Firms will need to be mindful that being "cute" in sidestepping a ban may open up more challenges in the longer-term. This is specifically the case as ESMA's bans have whole sections that look at the risk of the measures creating regulatory arbitrage and that the bans were thus drafted with a:
It is also conceivable that supervisory scrutiny will also look at how close-outs or novations vis-à-vis retail clients are actually being managed, communicated and complaints handled/disputes resolved. All of this comes on top of existing civil proceedings that are being disputed in various courts and dispute resolution proceedings on fair consumer treatment in relation to gains made from glitches in firms' risk parameters imposed on investors accounts or trades executed on real as opposed to demo platforms.
In any event firms could use the timing of the ban to work with their professional advisers and undertake internal remedial measures to improve the areas where ESMA has indicated there is room for improvement. Not all of that is down to reducing complexity and improving transparency, but also down to client engagement and improving risk management solutions availability for investors so as to ensure that these financial products, which a number of investors want and which contribute to more retail investor market participation, an EU aim in its own right, can be made more fit for purpose.
If you would like to receive more coverage in respect of these developments and the breadth of their impacts as well as remediation options, then please do get in touch with any of our Eurozone Hub Contacts to the right.
1. ESMA Decision (EU) 2018/795 (https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32018X0601(01)&from=DE) and ESMA Decision (EU) 2018/796 ( https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32018X0601(02)&from=EN ).
2. See ESMA press release of 1 June 2018 under https://www.esma.europa.eu/sites/default/files/library/esma71-99-973_press_release_product_intervention_euoj_publication.pdf
4. See our standalone coverage from our Eurozone Hub on this.
6. Regulation EU No 600/2014 (https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014R0600&from=DE ).
7. ESMA Decision (EU) 2018/795.
8. ESMA Decision (EU) 2018/796.
9. See Annex 1 of the CFD Decision: https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32018X0601(02)&from=EN
10. See Annex II of https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32018X0601(02)&from=EN.
11. FAQ ESMA 71-98-125 (page 4, 5) (https://www.esma.europa.eu/sites/default/files/library/esma71-98-125_faq_esmas_product_intervention_measures.pdf ).
12. See our separate coverage on this from our Eurozone Hub.
13. FAQ ESMA 71-98-125 (page 9).
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