The FCA’s handling of capital requirements by brokers is likely to reshape a big part of the FX and CFD trading industry. The UK regulator has highlighted in a letter to regulated firms that for many brokers that are using a matched principal license, the changes are likely to require a significant capital boost.
Unless brokers can present agreements with their onward providers that clients cannot incur a negative balance, the whole sector of the value chain will be affected by ESMA’s decision to mandate negative balance protection for all clients and guaranteed stop loss orders.
The European regulatory approach to require significantly more margin from the end clients fits into the equation. The regulators are unshelving some market issues that surfaced during the SNB crisis in 2015 and the flash crash of the British pound in October 2016.
Can Brokers Offload the Risk?
With the FCA mandating higher capital requirements to ensure that brokers adhere to the no-negative balance pledge, the firms that can’t afford a capital raise will need to find ways to offload the risk.
On their part, prime of primes have the option of accepting the risk of not going after the negative balance of their broker clients. Another one would be to deny service to brokers that are not adequately capitalized. On the surface, this seems less likely due to the already established client relationships. The case is very different though with new players.
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Are Leverage Changes Affecting Market Makers More?
While matched principal brokers are facing challenges regarding their exposure to market risk, market makers are even more exposed to black swans. This point was highlighted in the final quarters of 2017 when many brokers that were making liquidity for cryptocurrencies were hit dramatically by the relentless rally in some cryptocurrencies.
Leverage restrictions on the part of ESMA are by design made to discourage market making operations. The brokers that are running their books will also need to adhere to higher capital requirements and take risk management measures to contain their exposure to black swans.
On the other hand, if we look at the Japanese example – a cut in leverage to 1:25 in 2011 – the public outcry against this measure may be overblown. The risk here is that Japanese traders are more deeply involved in the retail forex trading space and have different behavioral patterns.
Insulation from Risk Events
While the new regulatory framework is mitigating some problems for retail clients, any ‘guaranteed’ no-loss schemes have a history of blowing up. If anything, the Swiss National Bank proved this by removing the floor that many traders used to make allegedly risk-free profits.
The inevitability of black swans in the financial market has been greatly mispriced by regulators historically. As watchdogs have been paying attention to one aspect of efficient market functioning, they have typically underestimated other elements. One such mistake gave us the birth of predatory high-frequency trading that is wide-ranging across different asset classes, after being born in the aftermath of the Reg NMS decision concerning the US stock market.
While regulators seek to protect retail clients at all costs, the fact is that many EU-based residents might choose a safe haven (or not so safe) outside of the European Union and direct their trading elsewhere. Any reclassification of clients into professional investors will also leave them unprotected against counterparty risks.