Last week the European Securities Markets Authority (ESMA), the pan-European regulator, decided to extend the ban of binary options for another three months. The news wasn’t a surprise, but it got some industry insiders thinking about what will happen to CFD leverage restrictions.
The discussion of whether ESMA’s leverage caps are temporary or not has been a popular topic of discussion as regards the new regulatory framework. Some industry participants have been hoping for the best. Others have been expressing skepticism and awaiting the verdict from the regulator.
The message we got about binary options reignited discussion of the matter. Hope has resurfaced because CFDs were not mentioned in last week’s message. But is there really reason to be hopeful?
ESMA’s Regulatory Framework Took 2 Years
If we take into account the set of complex rule-writing steps undertaken by European regulators in the past couple of years, we can come to the conclusion that ESMA’s on-off lever for leverage is not so easy to pull.
Almost two years have passed since rumours began telling of tough times ahead for retail brokers. Back in December 2016, the UK’s FCA became the first regulator to demonstrate this by reducing its initial 50:1 cap on leverage to 30:1.
The amount of work which the European regulators have put into devising the new regulatory framework speaks for itself. There would be little reason to waste so much effort just to introduce a regulation for three months. If anything, ESMA is using the three month product ban rule merely as insurance that all of its actions adhere to the pan-European financial regulatory framework.
Reasons for Changes to Leverage
The reason why regulators have changed leverage rules has little to do with client complaints. If there were any complaints against leverage we would have seen action much earlier. Rather, the trigger for ESMA and its European peers had much more to do with the profitability of clients.
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The requirement for brokers to publicly display the ratio between losing and winning clients makes all the difference in the world. Customers who have been losing money might not have submitted a complaint to the respective regulator, but data analytics must have provided ESMA with the reason behind the quick losses of retail CFDs traders.
As the French AMF, the FCA, the Polish KFN and others became aware of the relentless leverage ramp-up on the part of retail brokers, they decided that it was time to take matters in hand.
From 50:1 to 2000:1
I started getting interested in the financial market about 14 years ago. At the time, getting 100:1 leverage from a retail broker was at the high-range of offerings on the market. Spreads were much higher too. Trading the EUR/USD with a 3 point spread seemed normal and competition on the market was mainly done in this area.
As the market matured, and a number of new entrants have kept pushing spreads lower, retail brokerages decided that if their margins are getting thinner, they need to introduce higher leverage. Granted, not all companies have been pushing in this direction, but the most aggressive ones sufficed to change the market.
Once offerings with 500:1 became commonplace, the space became remarkably risky for unsophisticated investors and compulsive gamblers. Moreover, some people who weren’t gamblers in the first place developed the habit, which brokers welcomed. Fast forward to 2018 and financial regulators are taking measures to protect retail clients.
The customers themselves might now realise that high leverage is the core reason that they lose money on the market. But after analysing the data, regulators established that it is.
If you have any hope that ESMA is going to be playing with the leverage lever anytime soon, you had better come back down to earth and start thinking of what else you can do to change your business model.