ASIC deals massive blow to Australian CFD industry, but is it really that bad?
ASIC has dropped a massive bombshell, officially proposing severe restrictions on CFD products, labeling them ‘detrimental to retail clients’ and preparing to restrict marketing methods and leverage. Is it all bad? Probably not. Here is our full report
Today marks the day when the inevitable actually came to fruition.
Ever since the European Securities and Markets Authority (ESMA) completed its very comprehensive directive in the form of MiFID II which extended huge and detailed trading infrastructure regulations to all electronic trading entities ranging from ETFs to margin brokers, Australia’s non-bank financial markets regulator ASIC has been demonstrating signs that it may emulate the European rulings.
This has not happened, and ASIC is unlikely to emulate the European regulations in their entirety for two reasons, those being that ASIC is a regulatory authority that genuinely understands the FX and CFD industry properly, a facet that cannot be said of many other regulatory authorities worldwide, and perhaps more importantly, that ASIC has begun what can only really be described as a ‘clampdown’ in a completely different manner to that exercised by ESMA two years ago.
During interaction with Australian FX industry leaders over the past two years and certainly since the implementation of MiFID II in Europe, FinanceFeeds has been able to glean from opinion among senior executives that ASIC may potentially follow suit in terms of restructuring the means by which OTC trades are executed, reported and sold to retail customers, many of whom considered that leverage restrictions would be part of that remit.
Indeed, the speculation was correct and today ASIC has released a very detailed proposal in which the regulator demonstrates its clear intention to restrict the methods by which OTC CFDs are sold.
Currently, spot FX is not covered under the proposals, as ASIC has made its stance clear that, as far as regulatory research is concerned, its officials believe that a very high percentage of retail clients have been closed out of positions by their CFD provider automatically at low margin levels.
This differs tremendously from the MiFID II leverage and trade reporting stipulations in Europe, however the outcome is likely to be very similar in that leverage will be curtailed.
Australian retail FX and CFD brokerages are among the highest quality in the world, and are led by extremely experienced senior executives who have created a ‘halo effect’ within the entire industry globally in that most retail FX firms look to Australia as a bastion of success and good business ethic, and rightly so.
Many brokers in Australia have gained vast business via established networks of introducing brokers and affiliate partners across the nearby and very lucrative Asia Pacific region, largely due to a combination of perceived quality and Western business ethic by money managers and introducing brokers in Asia which combines with a close and well developed business relationship between Australia and the APAC nations, and the ability for clients to trade with 1:500 leverage whilst under the respectable auspices of ASIC which conducts real time surveillance on brokerages and has a technologically advanced approach to our very modern business sector.
Additionally, the world’s retail sector and its client base knows that Australian banks, infrastructure and business ethics are world class, with very few issues with retail firms, and those which have contravened being dealt with very severely by ASIC in the same way that the NFA and CFTC in North America censure firms, that being with a wind-up order and restitution to clients.
It was always such a good combination; leverage at 1:500 which is how the investors (not traders, investors), in China like it, in a very well organized package that comes with proper leadership, first class business and technological infrastructure and astute regulation.
ASIC had no reason to go down the route it has taken, and it certainly appears to the analytical eye that ASIC officials realize that too, especially considering the backtracking which took place recently when the regulator issued letters to all companies under its auspices to desist from onboarding clients from outside Australia, and subsequently stated that this matter may be revisited.
The new proposals, however, are somewhat concrete and are very stringent. Where they differ from European regulations is that whilst leverage restrictions on CFDs are central to ASIC’s remit which does indeed emulate that of Europe, cross-border sale of instruments is likely to be banned for good, decimating the well developed Chinese and South East Asian IB networks that many Australian brokers have made their core business and done extremely well from.
Last year, whilst large publicly listed retail brokerages in the Northern Hemisphere such as IG Group and Plus500 showed signs of extreme difficulties in making headway financially, Australian firms such as Pepperstone and IC Markets literally romped home with gigantic profits, largely due to their ability to provide the absolutely desirable package to massive Chinese and South East Asian partner networks.
The cross-border curtailing has put an end to this, and to that effect, has resulted in some Australian firms heading to offshore islands such as the Seychelles (!!!) instead of restructuring their business by using the massive revenues gained from China to be able to abide by the regulations and appeal to Western and domestic market customers. With revenues such as $500 million per month in some cases, there is no reason why some of that cannot be reinvested to make the company a rival to Hargreaves Lansdown.
What it says
The proposal is lengthy and detailed. Leverage is on the top of the agenda, however before everyone runs for the hills let’s take stock of previous events here. In 2011 when the Japanese FSA reduced leverage on OTC derivatives in Japan, the world’s most populous market with FX traders – Japan’s retail FX sector represents 35% of all international retail FX order flow, all processed by Japanese companies – everyone in the world thought Japanese traders would seek offshore, restriction-free companies and that massive giants doing over 1 trillion dollars a month in notional volume would cease to operate.
This did not happen, and indeed the contrary did. Japanese traders actually traded even more, and deposited more margin capital into the brokers, strengthening the assets under management of Japanese brokers and stopping any large numbers of client accounts being zeroed due to risk created by high leverage in a volatile market.
With that in mind, the Australian halo effect has been earned via very hard work on the part of Australian brokerages, therefore it is unlikely that customers would eschew that and go to an offshore firm, especially as many people in that region know full well what offshore firms with no regulations are like, as APAC has been a huge target for them over the years, usually with disastrous results.
Indeed, cross border transactions will likely be an issue, but for many high net worth APAC participants, trips to Australia are regular, and many have bank account facilities there, hence it may well draw more business into Australia.
In the usual very methodical style which ASIC has been well known for, the regulator states that CFD issuers usually set a ‘liquidation’ level, which is the level at which an open CFD position is closed by the CFD issuer if the retail client does not have enough money in their CFD trading account to cover adverse movements on their position or to respond to margin
The proposal continues to state that in some circumstances, the retail client’s loss on that position once it is automatically closed out may exceed their investment, which means they owe money to the issuer.
“In our 2019 review we found that during the period 1 January 2018 to 31 December 2018: There were over 9.3 million positions that were automatically closed out by CFD issuers for around 1 million active clients; there were over 41,000 CFD trading accounts that went into negative
balance (i.e. the retail client owed money to the CFD issuer); and the total negative balance (i.e. the total amount owed by those retail
clients) was over $33 million.”
Referring to Britain’s regulator for this particular part of the proposal, ASIC states that “Analysis by the UK FCA showed that for the currency pair USD/GBP, at a leverage ratio of 500:1 and a 50% automatic margin close-out, retail clients who do not make an additional investment over a two-hour span would be automatically closed out and on the losing side of the trade 81% of the time; and either lose all of, or more than, their initial margin 44% of the time.
“CFD issuers may offer retail clients certain types of orders, such as ‘stoploss’ orders or ‘guaranteed stop-loss’ orders, which are promoted as a means of capping potential losses. Generally, these types of orders allow a retail client to pre-set a price to close out their CFD position” says the proposal.
“Clients pay a fee when entering a guaranteed stop-loss order for a CFD position (similar to an option premium for a call or put option). Ordinary ‘stop-loss’ do not remove all the risk of significant losses. The retail client’s position may not be closed out at the nominated price
(e.g. if there is lack of liquidity in the underlying market, or if there are price ‘gaps’)” says the report. In this case, it appears that ASIC considers CFDs to be similar in structure to binary options, which is not a good sign at all.
Risk of losses which are greater than the retail client’s initial investment
In 2015, when the Swiss National Bank removed the peg on the EURCHF pair, causing tremendous market volatility which saw off some brokerages due to exposure to their liquidity provider, and cost others a fortune to the same effect, some retail clients were actually sued by their broker for negative balances. Many were not, however they theoretically would have had to pay the negative balance to the broker if the broker concerned had requested it.
Many brokerages wrote it off on the grounds of goodwill, largely so that they did not create a poor public image in the aftermath of sudden volatility causing unstable markets which could not have been predicted as the Swiss National Bank simply did it without warning.
In terms of margin calls, ASIC’s proposals include the issue of potential exposure to negative balances, among other areas.
“If changes in the market value of the underlying asset have a negative effect on the retail client’s open CFD position, the CFD issuer may require the retail client to deposit additional money into their CFD trading account (i.e. to meet their margin requirement). This is known as a ‘margin call’ and may be made by the CFD issuer at short notice to the retail client” says ASIC.
“Retail clients who fail to ‘top up’ their account within the relatively short timeframe provided may see their position automatically closed out by the CFD issuer. When ‘margin calls’ are triggered in close succession (e.g. if the underlying asset price continues to move against the position like in a ‘flash crash’), the amount of cumulative losses incurred by retail clients can significantly exceed the amount they initially intended to commit to the CFD position” says ASIC’s proposal.
“An example of this would be that a client receives a call from the CFD issuer to say that his CFD account balance is too low (being less than 50% of the initial margin) and he will need to top up his CFD account with additional funds. The client is reluctant to realise his losses and still believes in his forecast of the market. He deposits another $5,000 into the account, which means his
balance is now $9,716” says ASIC.
ASIC then states that liquidity (i.e. the volume of orders and trades) in the market for a CFD’s underlying asset can affect a retail client’s ability to trade CFDs over that asset. There is a risk that the CFD issuer may decline a retail client’s order oronly agree to execute the order at an inferior price.
ASIC’s concerns over lack of liquidity that can occur at the time of opening or closing a CFD position are also included. For example, a retail client could be left with an open CFD position which they are unable to close. This increases the likelihood of potential losses and may cause clients to have negative equity—meaning that they unexpectedly owe money to the CFD issuer. Additionally, ASIC has concerns about slippage and beleives that its curtailment of leverage will assist brokers in executing orders with less risk of slippage.
The ASIC proposals cover what ASIC demonstrates to be a rise in complaints about the practices of CFD issuers in Australia by retail clients, up from around 500 in 2015 to over 3000 in the first half of 2019, and looks at client loss risk.
Perhaps the most alarming prose used in the proposal is ASIC’s statement “Significant detriment to retail clients from CFDs” which then goes on to produce case studies of actual traders.
ASIC states that CFD issuers reported in the ASIC 2017 review that 63% of clients lost money trading margin FX; and 72% of clients lost money trading other CFDs.
“As outlined in paragraph 70, retail client losses from trading CFDs are a component of the $1.5 billion gross trading revenue CFD issuers received in 2018. Our evidence of client losses is broadly consistent with reported losses in other jurisdictions. For example, the FCA reported that an estimated 78% of active retail client CFD accounts were loss-making, with total loss estimated at £1.07 billion a year. The FCA noted that other regulators in Europe reported similar poor results for retail clients” says ASIC.
The report looks at account loss percentages in European jurisdictions as a reference point, showing figures of between 75% and 80% of all traders losing money on CFD trading.
Similarly, leverage of between 1:200 and 1:500 has been pilloried by the ASIC proposals, and this is likely to be one of the first things addressed should the proposals be implemented as actual law.
How OTC products are marketed is also a major part of the proposals. ASIC is concerned about the increase in marketing spend from $91 million to $131 million among retail margin brokers over a 2 year period and that clients do not seek financial advice before trading OTC derivatives with retail brokers.
“We have observed the aggressive marketing practices used by CFD issuers over many years. They are used to attract new clients as well as to entice existing clients to trade more. We have received reports from industry stakeholders that there is a significant turnover or ‘churn’ of retail clients, and some issuers are heavily reliant on aggressive marketing techniques to attract new retail clients” says ASIC.
We know ASIC is serious on this matter, as the regulator has closed down companies in the past for aggressive marketing practices.
Ultimately, ASIC has made a very detailed point here, however it may well be a stabilizing set of rules.
Australia, after all, is home to a very well capitalized and astute FX industry and is more able to adapt and perform well than many of its counterparts in Europe which did not have the same level of business acumen when ESMA unleashed the MiFID II rulings two years ago.
Additionally, support and governance from the Australian authorities will likely be handled very professionally, a contrast to the bungling by CySec two years ago.