On August 24, 2018, ESMA announced,1 in its first use of this power, an extension of the existing ban from October 2, 2018 for binary options for those products it has not exempted from the further extension. A corresponding extension to the CFD ban applies from November 1. The impact of these extended bans and the possible rationale in the Summer Findings and any further policy developments are explored in this Client Alert.
As covered in our earlier Client Alert,2 ESMA's use of temporary product intervention powers has had quite an impact on markets.These powers impacted firms by ordering greater disclosure via a standardized risk warning, limiting promotional incentives as well as restricting the sale of certain binary options and contract for differences (CFDs) to investors categorized as "retail clients." This in turn caused a direct impact on those investors' ability to access markets, including those based outside the EU. Both the binary option and the CFD bans were introduced in relation to products that gave rise to a "significant investor protection concern". These measures have also caused a great degree of uncertainty in exactly which instruments were prohibited. This led to these new (temporary) restrictions entering into force at the start of July and August 2018 respectively and being supplemented by revised "questions and answers" which were updated July 12 and on July 30 (the July Q&A), i.e. those July Q&A should be read as a "living document".23
Effects of the ban
The ban has had knock-on effects on a host of arrangements concluded in the wholesale markets but also across the board in the retail markets. This is very much in addition to the increased economic costs due to higher margining requirements imposed on retail clients to enter into these products, or into similar products such as "spread betting".
ESMA was quite late in publishing a press release communicating a renewal of the ban and even later in publishing the Official Notice confirming the extension to the ban; in addition, the details of how the amendments exempting certain binary options from the extended ban would apply was only published on October 1.4 Furthermore, an update to the July Q&A was made available on September 28, 2018 specifically in relation to "rolling spot forex" and the CFD ban in new Q&A 5.12.5
For investors, inasmuch as providers, the ban is frustrating as, even though one might excuse ESMA for tardiness in exercising its new statutory powers, it raises questions on whether this consumer protection measure was adequately communicated or in a manner permitting providers to treat their customers fairly and in a timely manner. It also raises questions as to when "temporary" product intervention powers cease to be temporary and whether individual national competent authorities in relevant EU Member States may step-up scrutiny on binary options, CFDs and/or similar products. It is also not yet clear whether ESMA considers that the bans have protected investors, notably where some of these products are used as short-term, effective and easily accessible hedging products for longer-term investment portfolios.
The extended binary option ban commenced on October 2 and runs for a further three-month period. Certain binary options products covered by the original ban are excluded from the extended ban and thus are permitted again. At the time of writing, those "re-habilitated" binary option products include those that:
- are sufficiently long-term (at least 90 days);
- have a pay-out profile for which the lower of the two predetermined fixed amounts is at least equal to the total payment made by a retail client for the binary option, including any commissions, transaction fees and other related costs – i.e., the investor incurs no transaction costs loss;
- are accompanied by a prospectus; and
- are fully hedged by the provider or another entity within the same group as a provider and that those entities do not make a profit or loss from the binary option other than in terms of transaction fees disclosed to the investor.
If these criteria are met, then ESMA considers these products to be permitted, as they do not lead to a "significant investor protection" concern.
One of the key issues is that this exemption is in itself only relevant to a handful of products and equally leaves the door open to wide interpretation as to whether standards of disclosure are appropriate.
The CFD ban applies from November 1, 2018. The new Q&A 5.12 in the September update to the July Q&A clarified that rolling spot forex products are in scope as "A forex derivative which uses the spot price as reference value and automatically rolls over at the end of the contract period and allows a party to terminate the contract other than by reason of default or another termination event is a CFD for the purposes of Article 1(a) of the CFD Decision."
The extended CFD ban also confirms that CFD providers from November 1, 2018 may use a modified short-form standardized risk warning stating that: " [insert percentage per provider] % of retail CFD accounts lose money." in advertisements with a link to a webpage of a provider where the full long-form standardized risk warning is set out for customers to take note of.
The decision to extend the ban, which was taken by the Board of Supervisors during August 2018, may have culminated with decisions to approve the following key documents that make up the "Summer Findings":
- ESMA's 2nd Edition of its Trends, Risks and Vulnerabilities Report (TRV 2),6 which is the first report of market evolution following the introduction of the EU's MiFID II/MiFIR Regime;
- ESMA's special focus in the TRV 2 on "Investor protection in Structured Retail Products"7 which found high levels of divergences in products sold and investor protections; and
- The Joint Committee Report on results of the monitoring exercise on 'automation in financial advice' (the Robo Advisory Report)8 – Robo Advisory often uses binary options and CFD products to build "automated investment portfolios" for retail clients.
With ESMA having to balance its investor protection mandate with the tasks expected of it to contribute to creating a more "single" Single Market for retail client investor market participation as part of delivery of the EU's Capital Markets Union project. Extending the ban, without providing a workable solution or industry-wide improvements is potentially a missed opportunity to deliver on those aims.
Spotlight on the Summer Findings
ESMA's statements in TRV2 concluded that market risk remained high in the second quarter of 2018 and that risks in securities markets remained very high posing elevated risks for investors notably from political and on-going economic uncertainty due also to BREXIT. Overall concern was expressed by the flat performance for investors' holdings from managed funds (active and tracker), exchange traded funds (equity and bond) compared with strong funds for alternative funds (particularly from distressed debt and relative value investments).
Moreover, ESMA noted that while EU household financial asset to liability ratios reached a five-year high, ESMA noted that the levels of complaints regarding investment advice being given in relation to debt securities affected by credit events (including resolution of banks) was a notable development, especially in a number of specific jurisdictions. Another area that the TRV expressed concern on was the marked jump of circuit breaker events that are designed to reduce rapid price movements within a pre-determined price range during periods of high volatility. These jumped to 400 in the week of 5 February 2018 and a sharp equity sell-off and are contrasted with the average in January being 104 per week. Coupled with a rise in settlement failures this posed an area of note.
The comments in the TRV2 also looked at the progress of compliance with the EU's Benchmark Regulation and the move to replacement rates (see our separate coverage from our Eurozone Hub on this). Of note was that the TRV2 referred to the decision of the ECB's Governing Council on June 28, 2018 to adopt the final methodology to calculate a euro short-term rate (ESTER) which is to be calculated entirely on money market statistical reporting.
The TRV 2 also rated new trends on products and ESMA's view on their levels of investor protection, financial stability and market integrity – this may present some insight as to where ESMA may make use of temporary intervention or any other supervisory powers going forward:
|Product||Investor Protection||Financial Stability||Market Integrity||Comments from ESMA|
Very High Risk
|High Risk||Very High Risk||
|Initial Coin Offerings||Very High Risk||High Risk||Very High Risk||
|Distributed Ledger Technology||
|Medium Risk||Very High Risk||
|Crowdfunding||Very High Risk||Medium Risk||Very High Risk||
|RegTech||Medium Risk||Low Risk||Medium Risk||
|Volatility Exchange Traded Notes (VIX ETNs)||Very High Risk||Medium Risk||Medium Risk||
In the context of ESMA's outlook on these products the TRV 2 also looked at the CFD and binary option intervention measures and the terms of the original ban before skipping through other developments to look at the state of play of the EU Structured Retail Products Market. Whilst ESMA notes that the systemic risk in and across the markets remain low, the evolution of the market points to increasing product complexity and that is another potential source of risk.
This comes on top of ESMA's comments in TRV 2 that the breadth of products available may be too much and too fragmented for retail clients to have sufficient clarity as to what they are purchasing and the terms. This is despite efforts, including by the European Structured Investment Products Association to create a more nuanced taxonomy of categorizing products beyond what the regulator has designated as a binary choice between those that are complex and those that are non-complex.
Furthermore, ESMA notes that greater comparability and harmonization of features, payouts and pricing would enable a greater move to delivery on the goals of the EU's Capital Markets Union project. Those comments are not new, but possibly the threat of ESMA intervening where it sees concerns may act as a catalyst for industry, and if not, then by policymakers in legislating the design features of common "basic" products. This would not be the first time that EU financial services policymakers have done this.
The Robo Advisory Report's findings also confirmed that while automation in financial advice seems to be slowly growing and the overall number of firms and customers involved seems to be quite limited, "the risks and benefits of this phenomenon, which had originally been identified in the development of the [2015 Joint Committee Discussion paper on Automation in Financial Advice and the 2016 Report on the same topic], have largely been confirmed by NCAs and seem to be still valid.
Developing trends were concentrated in automated sales and distribution of funds (mutual, AIFs and ETFs) as well as signal following sales of CFDs in securities markets and automated solutions consumer-relevant insurance contracts. Automated solutions were largely being advanced by incumbent financial services providers working together with FinTech firms and some increased use in "chatbots" for customer service engagement.
That being said, the Robo Advisory Report finding did point to the work of ESMA and its sister authorities, EBA and EIOPA where further protection or good standards may be required. Unsurprisingly these all relate to:
- improved customer disclosure standards as to product, features (incl. charges) and redress options;
- appropriate assessment of suitability of the solution to a customer and ensuring fair treatment of customer; and
- robust product governance standards.
Regulatory barriers that were identified as limiting a greater adoption of automated solutions included the lack of a "digital identity" of customers and harmonization of digital procedures for how to identify/verify a customer as well as the lack of a consistent legal definition of what constitutes "advice" across the banking, securities and insurance sector. Whilst this comment is potentially aimed at the EU Commission, as a longer term step in developing a Capital Markets Union this observation may fall back to the Joint Committee of the European Supervisory Authorities. This is especially the case as these authorities are not only the gatekeeper of this Robo Advisory Report but have also been mandated more generally to finalize regulatory approaches/policy on FinTech.
If that is the case, then these "barriers" are something that would only likely be put on the table for discussion from mid to late 2019 onwards and it is unclear whether market participants generally would be able to participate, or as fully, in shaping pragmatic solutions. While ESMA and its sister authorities concluded that no immediate supervisory or rulemaking action appears to be necessary, they confirmed that a new monitoring exercise "...will be done if and when the development of the market and market risks warrant this work." This would mean that incumbent financial services firms and those FinTech players could be left with an undesirable state of fragmentation in the interim and specifically in an area where harmonization would otherwise advance one further area of the EU's aims at reinvigorating its Capital Markets Union project.
Outlook and next steps
ESMA's extension of its temporary intervention powers marks an important moment in the targeted use of these new powers. In many ways, it, along with the Summer Findings, conveys a much stronger message in that supervisory scrutiny may focus on not only how products are sold but how the governance in the product design and approval focus, which is an area that the EU's MiFIR/MiFID II Regime had already reformed. The Robo Advisory Report, while highlighting identified barriers, may however yield some opportunities for certain market participants to develop or expand solutions that can bridge gaps in a meaningful manner ahead of further legislative action.
If you would like to receive more coverage in respect of these developments and the breadth of their impacts as well as possible options, then please do get in touch with any of our Eurozone Hub Contacts.
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