Make or Break: How Brokers Can Cope with ESMA Restrictions

This article was written by Craig Paton, CEO of CraigPatonCapital LTD.

The European Securities and Markets Authority (ESMA) has agreed on measures on the provision of contracts for differences (CFDs) to retail investors in the European Union (EU). The most notable change is the leverage cap, 500:1 to 30:1 and even lower for different asset classes. So what does this really mean for retail brokers? Let's dive into it.

Cutting the Business Model by Over 400 Percent

If you are going to cut a business model by over 400 percent what implications will that have for the future business? When a retail client opens a trading account they will be placed onto 30:1 Leverage Leverage In financial trading, leverage is a loan supplied by a broker, which facilitates a trader in being able to control a relatively large amount of money with a significantly lesser initial investment. Leverage therefore allows traders to make a much greater return on investment compared to trading without any leverage. Traders seek to make a profit from movements in financial markets, such as stocks and currencies.Trading without any leverage would greatly diminish the potential rewards, so traders In financial trading, leverage is a loan supplied by a broker, which facilitates a trader in being able to control a relatively large amount of money with a significantly lesser initial investment. Leverage therefore allows traders to make a much greater return on investment compared to trading without any leverage. Traders seek to make a profit from movements in financial markets, such as stocks and currencies.Trading without any leverage would greatly diminish the potential rewards, so traders Read this Term with a required stop out margin level of 50 percent. Meaning that one standard lot of EUR/USD will require roughly $3,000 in margin, and if their margin level falls below 50 percent, they will automatically be stopped out.

Here's something else: when you are reaching your stop out level, the broker will cut half or a quarter of your position for you to stay in your trade (profit already secured for the broker) which takes you back above the required percentage for you to stay in your losing trade. They will repeat this until you have no capital left.

The attitude towards the new situation varies according to the brokers' business model:

• A-book is when your broker sends your trades directly to the market, i.e., a Liquidity Liquidity The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent Read this Term provider the real market. There is no conflict of interest when a broker uses A-book as they send the trades straight to the market and just make the spread off the client.
• B-book is when a broker internalizes clients orders and all trades placed by their clients are sorted in-house. Hopefully, you can see the conflict of interest already - the broker wants the client to lose. The broker is holding all the risk. When the client wins, the broker loses and vice versa.
• The hybrid model is how most brokers operate now. They carry both A-book and B-book lists of clients. They will put winning clients on the A-book and losing ones on the B-book. Your 90 percent business model just becomes 100 percent. Algorithms carry this task out by a number of factors - how many margin calls the client has had, duration of positions, risk-taking per account size and deposit size, etc.

These ESMA restrictions could be the best thing ever for my trading. Instead of spunking my account in a couple of days, I can do some edging and make it last for weeks.....

— Rob (@LAPLANDFX) July 30, 2018

Leverage and Margin

We have established that the business model of a retail broker will be impacted massively on two parts, leverage and margin. How will brokers counteract this crippling effect to their business?

First of all, they will put clients under different regulations that are not controlled by ESMA, such as the Central Bank of Bahrain or Securities Commission of the Bahamas, places where there are no restrictions on what leverage can be offered to a client. With that being said, how well do you know the regulations of the CBB or SCB? Can you make a formal complaint to the financial ombudsman as easily as in the UK?

If you are an existing client with a broker, and you registered before the regulations come into effect, I would seriously urge you to check with your broker to make sure you are still under the jurisdiction that you registered for.

The implications of being moved to a different jurisdiction can include not being covered by the financial services compensation scheme which protects your funds up to a certain amount, and companies not being obligated to segregate client and company funds, so if the company goes bust you still have your funds.

Small and Boutique Brokers Will Disappear

Hopefully, we are now beginning to appreciate and understand what implications brokers are facing and the potential drop in revenues as a result of this. Brokers will do everything in their power to make sure you have the highest leverage possible - why do you think there was a petition going around the various brokers in the city to overturn this ruling? There was even talk of a new instrument being created to skirt the lines, as these new regulations only affect CFDs and binary options. Brokers did not want these new regulations coming into effect, no business would. With the crackdown on brokers, where does this leave them? Pumping more into marketing? More TV adverts? More sponsorship deals? More pro clients?

#ESMA has listened to traders on margin close-out rules and adapted its policy. However, they have disregarded the weight of feeling against the proposed leverage restrictions. Changes are expected to come into force in July 2018. Read more:https://t.co/9vsraqmz6g pic.twitter.com/XnwsNLIMAB

— IG (@IGcom) March 28, 2018

If you have ever walked into a broker's office, you would have noticed that the biggest department is the marketing team. With an average client life of 60 days (more like 30) the constant need for clients and regular capital inflows does not come from the sales team, it's marketing. Paying one person or a team of people to interact with potentially thousands through blogs, emails, and posters is much more appealing than hiring a sales executive to speak to a retail client trading a mini lot. Brokers also use IBs and affiliates, where you pay someone to introduce clients to you, and what you pay them is dependant on how much volume their clients generate.

My personal opinion regarding the new regulations is that small and boutique brokers will disappear and only the big boys of the world will be left. From the information above, if you don’t have thousands of clients actively trading every day you won't be around for long.

The purpose of this article is not to tarnish brokers within the industry but merely to educate and protect retail clients from the wrongdoing brokers and what they can do to innocent retail clients. Stay sharp out there.