You must have been on that SpaceX rocket of Elon Musk to Mars if by now you haven’t heard about the new regulatory framework for Forex and CFD brokers. Just in case you don’t know yet, on Tuesday the European Securities and Markets Authority (ESMA) published its verdict on the conduct of brokers in the industry.
Unfortunately, as it many times happens, the mistakes of the few have impacted the many (or perhaps the other way around in this case, not so sure on this one). Unregulated brokers that have plagued the Forex and CFD trading industry, along with binary options brokers have prompted a drastic response on behalf of the supranational EU-wide industry watchdog.
The changes in short
Again… I am assuming you are not from Mars, but just in case Elon did manage to insert you inside the spaceman suit on that roadster, here are the changes to regulations in brief. Maximum leverage for trading FX has been cut to 1:30, indices and gold are at 1:20, other commodities are at 1:10 and shares are at 1:5.
Brokers are required to provide a negative balance protection and display clearly on their marketing message what is the percentage of their clients that lose money. Yes, exactly, that must read like something similar to: “come along and deposit some money with our brokerage, we hope you are not one of the 90 percent of poor folks that lose money.” (You might as well add a smiley face at the end, just for color.)
Impact for market makers
We are going to have a look at the impact on the industry from two different perspectives. The first one is that of brokers that are acting as principals and are internalizing their flow. The so-called ‘market makers’ are likely to get more materially affected by the changes mandated by the ESMA.
The reason for that is that such brokers are typically more reliant on direct marketing, trading incentives, and most crucially, their clients losing money. Higher leverage always means a shorter life-span for a retail trader’s account. Low levels of leverage are the preferred way to trade for institutional investors, where big drawdowns in the account balance are quite unwelcome.
Brokers have been offering high leverage to clients in order to lure them into the narrative that it is easy to make a lot of money with a relatively small deposit. The reality in the financial markets however, is that, as described by the ESMA, between 80 and 95 percent of retail clients are losing their deposits.
So when a market-making broker attracts a client with say 1:400 leverage, the likelihood that the holder of this account will be bust within three months is very high. A switch between fear and greed emotions in the brain chemistry is one of the most perilous enemies of a trader.
Trading the market is catering to these emotions and short bursts of dopamine when a trader is winning are driving their desire to trade more. Curiously, some social media users are experiencing precisely the same pattern that lures them into continuing to stick to that phone screen on the train.
The levels of leverage which the ESMA is mandating are automatically slamming the breaks on excitement levels. Suddenly a trader has to deposit $5000 to open a position sizeable enough to change one’s life. When previously $500 were enough, this makes a huge difference. Brokers will need to change their acquisition and retention strategy altogether to stay on top of their game when attracting clients.
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Impact for STP brokers
After we established some of the potential risks for market makers, let’s focus on STP brokers. Straight-Through Processing (STP) is a different mode of operation for the retail brokerage industry. Such firms are not relying in any way on the losses of their clients, as the money in those accounts is flowing into the market.
The revenue of the brokerage is relying on commissions. The more trades a trader makes within their lifespan, the more commissions the brokerage is getting. As a result, we can deduce that such brokerages are keen on their clients not losing money, because they will stop generating commissions to the brokerage the moment they lose their balance.
Such brokers are typically more inclined to provide their clients with added value tools that can drive a mediocre trader closer to success. The ESMA’s new regulations are going to have an impact on such companies in two major ways.
The first one is trading volumes. Granted, broker trading volumes will register a decline, and probably, at least initially it will be big. Leverage restrictions, however, have had a mixed impact on other markets. In Japan, for example, the official maximum leverage of 1:25 has not impacted the industry in the long run as local brokers are posting the highest trading volumes in the world.
Capital requirements is another issue. All brokers are now mandated to provide negative balance protection and the FCA was one of the first regulators that suddenly realized that having firms with a capital requirement of a couple of hundred grand was no longer adequate. All STP firms are very likely to need to apply for a 730.000 euro ($900.000) license and prepare to meet the capital requirements that come with that.
Loss percentage disclosure (Ouch!)
Last but not least, I want to pay some explicit attention to a subject that has not been discussed enough. That is the disclaimer that every broker has to accompany their advertisement messages with a line reading ’90 percent of our clients lose money!,’ or something of the likes.
The ESMA’s announcement has just created a great new incentive for brokerages and that is to attract the best possible traders. This will inevitably result in a paradigm shift for good practice in the industry. Suddenly attracting traders is not enough, brokers that want to remain in this industry for the long haul will have to attract the right kind of clients and strive to make their clients better traders all the time.
Not many brokers have been working in this direction, and even fewer have been successful in doing so. Education will no longer be an extension of retention. I am referring to a number of products that are branded as education but the only thing they do is confuse a trader even more and completely disconnect them from the reality of the market: it is very hard to make money trading.
I hope that many brokers manage to succeed in the quest to teach traders how to trade. It has been a long and hard way for the few that remain in this business. In the meantime, those phony educators that are acting akin to affiliates are now becoming something closer to a bad practice for every broker who is committed to having a good ratio of profitable traders.
As the final rules are published by the ESMA and as local regulators start chipping in with circulars, we will know more details. But for now, it is well worth thinking about how you are going to approach this brand new market starting from a couple of months from now.