Don’t Let ESMA Ruin Your Holidays, Just Get Prepared

Adapting to new financial regulations has been a must for the brokerage business for decades.

Well, here we are: its almost 2018 and winter has come. ESMA plays the role of House Stark and is trying to ruin the relatively benign year for brokerages that didn’t play the crypto roulette.

Remember that the consultation period is still open and brokers and some of their clients have time to submit their feedback and prevent the harsh margin requirements being considered by the EU’s supra-national watchdog.

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As the European regulator debates whether to enforce a leverage cap at 1:30, remember that the industry has been here before. Granted, not in Europe, but in a very different market where retail investors are especially risk-hungry. I am talking about Japan and the two leverage caps in 2009 and 2011 to 1:50 and 1:25. That market has sailed through it well while maintaining the biggest market share of the industry by far in terms of volumes.

You will say that Japanese traders are different and the specific market conditions that are present in Japan aren’t present anywhere else, but you might be wrong.

Low European Interest Rates Could Drive Risk Appetite

The Japanese lost decades have been heavily impacting the investment appetite of local traders. As interest rates remained close to zero for a period of about 20 years, the behavior of clients in the country has changed.

Carry trades were flourishing until 2008 when the sharp spike higher in the yen drove FX flows back in the country. A number of investors lost their savings, prompting a reaction from the Japanese authorities that are seeking to limit the risks for retail traders.

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The same thing happened in Europe with the trigger for the action being the Swiss National Bank crisis. European traders have become hungry for risk as interest rates are being kept low by the ECB. Some of them are looking towards cryptocurrencies to engage in the asset class of the future, but who knows how long that is going to last.

In any case, brokers love two-way volatility, and not a one-sided market. Adapting risk-management to cryptocurrencies is a tough act, and it will take time on part of both liquidity providers and retail brokers.

Professional Clients

The main aspect that brokers will use to limit potential revenue losses from new regulations in Europe is likely to be client reclassification. Be careful with this one, as regulators will likely be very thorough in monitoring whether only suitable clients are reclassified.

The definitions in MiFIR on professional clients are loose, but once the regulators tighten the noose they will pay attention to what brokers are doing on this front. Clients are best left to reclassify themselves. Do inform them about the perks of being a retail trader and see them aware of the risks that are carried with professionalism. After all, it’s the regulators (the ECB and ESMA) that will be driving clients to take riskier financial decisions, but you will be on the hook.

Back to leverage, remember that risk appetite could increase if leverage is capped at lower levels. Of course, brokers that offer over 1:100 will feel the pain initially, but we have been aware for a year now that this time is coming.

Following the potential reductions to the available leverage, clients might readjust to the new restriction and could increase their deposits. Remember that any initial effect from this rule might be only temporary and will be readjusted to a new normal following a couple of quarters.

And last but not least, remember… the financial industry has been going through a tough regulation period for several years now, we are already in the new normal and should get used to it.

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