The new regulatory framework for forex and CFDs brokers is drawing closer, and there is one universal consensus expectation about a key aspect of the new rule that has not been discussed sufficiently. While discussions on leverage remain, brokers will likely need to provide guaranteed negative balance protection, something that has been voluntary for firms so far.
In a post-SNB world, as the volatility of the markets is compressed with levels of the VIX close to all-time lows, any rapid deviation from the status quo could quickly increase risks for brokers. With companies mandated to provide negative balance protection for their clients, they are being exposed to more risks.
This is the approach that the UK FCA is taking when addressing a key aspect of negative balance protection. According to the UK financial regulator, firms are effectively taking on market risk for any prospective client losses below the value of the account.
In accordance with the FCA’s Capital Requirements Directive, brokers are required to maintain a regulatory capital level that is consistent with mitigating their market risk exposure. The UK financial regulator has sent letters to firms to inform them of the necessary provisions to meet enhanced capital requirements under the no-negative balance rules from the ESMA.
License Variations and 125K Firms
The UK regulator is outlining its concerns about a particular set of companies that are likely to be impacted more. The firms that hold a 125K license, which permits them to act as riskless principals, will need to pass on the risk to counterparts that are handling their trades.
If they are not willing to commit to no-negative balance and guaranteed stop losses, the brokerage itself will have to cover the risk. The operations of the brokerage will, therefore, be significantly impacted as it would need to tie up regulatory capital that might otherwise be used as collateral for trades with the counterpart.
Out of 97 regulated CFD firms in the UK, 23 have a 125K license. Those companies are facing a tough transition since they are forbidden from handling market risk. The FCA has reportedly asked these brokers to consider whether their current license will allow them to provide a non-negative guarantee.
Should they fail to show that it does, they are faced with a tough transition to a 730k license, which allows them to take on market risk. Given that ESMA will likely only allow a short time for firms to become compliant with the rules, it is unlikely that these firms will be able to vary their FCA permissions in time. Also, these firms will have to carry significant extra capital to cover the market risk associated with a no-negative guarantee.
At present, some FCA-regulated companies are facing the risk of failing to demonstrate adequate capitalization under the no-negative balance rules from the ESMA. There is no specific information as to whether CySEC will take a similar approach to the one pioneered by the FCA and mandate companies to hold an extra capital buffer to cover the market risk.
Full Scope Investment Firms and Upgrading to a 730K License
The new rules might leave few choices for companies that are only holding a 125K matched principal license and are holding client money. While they do have the option to upgrade their license, the process is capital intensive and takes time.
Over the comparing months, more M&A deals involving FCA-regulated companies are expected to reshuffle the space further.
Brokers that have not been offering no-negative balance protection would be particularly vulnerable since they also need to establish the technical means for adhering to the ESMA rules.
‘Full scope’ firms that are dealing on own accounts and holding client money require €730,000 in initial capital and must follow the full capital requirements regulations.