Australia’s CFD leverage equation – Guest Editorial

By Justin Grossbard, co-owner of compareforexbrokers.com.au based in Melbourne, Australia

The retail FX brokerage sector in Australia is without doubt one of the success stories of online retail financial services.

For almost two decades, Australia has been steadily and pragmatically building its reputation and global standing as a benchmark for retail FX and CFD trading.

A first class business culture, thriving national economy, increasingly prudent and well structured regulations for electronic trading firms, and perhaps most importantly, close trade ties with the FX industry’s golden egg: China and the Asia Pacific region.

Recently, the Australian regulator of non bank financial services, ASIC, took the draconian step of issuing proposals that seek to restrict the method by which OTC derivatives companies can offer certain leveraged trading products from their operations in Australia which fall under the rules of the Australian Financial Services License (AFSL).

The most concerning aspects of the proposals to industry participants are the potential restriction on leverage of FX and CFD products, and the other being the restriction of the sale or provision of any OTC derivative product to overseas customers by Australian electronic trading companies.

Whilst this appeared to happen quickly, there has been speculation for some years that ASIC may take steps to follow the European rulings, and perhaps more specifically, Japan’s restrictions on leverage over 7 years ago.

Let’s take a step back, and examine how Japan, an equally conservative, domestic-focused market made up of dedicated and analytical traders responded when the national regulator restricted leverage. It created a more sustainable and certain environment which was embraced and welcomed, volumes went up and foreign firms still could not gain traction.

Contrary to the opinion of many brokers in Western jurisdictions at the time who had anticipated an influx of Japanese clients wanting to eschew the Japanese giants and break out of the highly domestic market-focused approach by Japanese clients who are absolutely loyal to Japanese FX firms in order to benefit from the leverage in Europe, Australia and Britain which was far higher than the 1:25 imposed by Japan at the time, the reality was that absolutely nothing happened.

No Japanese traders switched from the vast giants of Tokyo. In light of current nervousness surrounding the future of the Western retail FX markets in the immediate period following ESMA’s leverage restrictions that were recently set in force, and now Australia’s proposals, a feeling of uncertainty has permeated across small to medium sized brokerages, many technology providers whose solutions are provided to them on a volume capitalization basis, and even among major mainstream research and news entities on the basis of concern over potential market contraction and shrinking revenues due to less leverage, and advertising bans by Google and Facebook relating to certain product ranges.

Despite lack of international competition in Japan, business is booming for domestic retail FX firms, and no evidence of Japanese traders looking to trade with overseas firm has come about. Rather topically at the moment, it is worth looking back to early 2013 when the Japanese FSA implemented leverage restrictions on all Japanese market participants, spurring speculation that the Japanese traders doing such massive volume would seek overseas firms and that the rulings would damage the vast domination of domestic firms – but no such shift occurred and it was business as usual. This can be used as a yardstick to gauge current ESMA rulings.

Between January and March 2016, 15,413,316 trillion yen was traded on an OTC basis among Japan’s companies, a 50.2% increase over the previous quarter and a record until that point.

Therefore it is appropriate to consider that Japan is not a market to approach externally or internally by non-Japanese companies. Japan’s FX industry is completely centered on the domestic market, yet it accounts for between 35% and 40% of all retail FX volume in the entire world.

Immediately after the Japanese FSA implemented the leverage restrictions and took the view that 1:30 should be the maximum ratio, overseas companies made substantial attempts to bring some of the vast business from Japan’s retail market onboard, with very little ability to gain traction.

Quite the opposite occurred. Japan’s traders actually knuckled down and traded even more volume, placing an emphasis on raising the amount of margin that they trade with, instead of having a minimal margin and relying on leverage.

So strong is Japan’s domestic market that its own companies have pulled out of other markets. MONEX Group sold its US and Australian client bases of its subsidiary IBFX three years ago, and discontinued the use of the MetaTrader 4 platform completely on all markets, focusing on its proprietary Tradestation.

Therefore, if this can be taken as a yardstick, leverage restrictions should be not the gravest concern. Australia can consider itself as desireable to retail traders in Australia itself and the wider APAC region which looks up to Australian firms and holds them to a very high standard.

Actually, there is a very interesting equation in play here in that each Australian broker’s management must now stress test their operations for the benchmark risk factors and the impact on their balance sheet of three factors, those being 40% reduction in 80% of their clients losses while the 20% winners earnings remain the same, 25% reduction in turnover across the board and a 25% reduction in earnings.”

A risk consultant that we know well in Australia told us recently “Now this is based on 50:1 leverage and at 20:1, I am not sure there would be a linear relationship in financial impact. Of course, most run a one dimensional B Book to go a hybrid STP in B Book and use A Book risk management, either full no A book hedging or all A book, and for most this is out of the question as there is no resources, no cash, no capital.”

Therefore, maybe its time for full STP to make a come back, that way of course, they cannot offer turnover rebates to retail traders or IBs and then, of the 65 brokers, if it follows the path as per the restrictions that the US brokers experienced under the Dodd-Frank Act which prevented them from operating with overseas clients, having to stump up huge capital reserves for regulatory escrow, then which 8 – 10 brokers will remain?

There has been a recent dialog between consultants and academics that focus on how the regulatory reforms in the US have panned out and what may happen if other advanced regulators such as ASIC follow them.

A general consensus is that this was a win/win situation for many retail customers especially if they were novice traders, but the loser in that case was the FX margin brokers. Of course, Australia has around 65 FX margin brokers and leverage may well go down to somewhere between 20:1 – 30:1, so maybe the landscape for broker here will be affected but the large firms will simply follow the path of the ones that stayed in America such as your reference last week to Interactive Brokers, or will attract a different client who will put more margin capital in and carry on trading with less risk, as happened in Japan.

Indeed it did, FinanceFeeds has many times made the point that Japanese brokers reduced margin in 2011 and despite the speculation that overseas and offshore firms would suddenly receive a deluge of Japanese traders – something they all wanted because of the massive volumes traded on retail brokerages in Japan – however this did not happen and Japan’s big three, GMO Click, DMM Securities and MONEX carried on from strength to strength often trading over $1 trillion per month in notional volume post leverage restriction.

This may happen in Australia, as clients of Australian brokers in the APAC region fully appreciate the quality of the firms, their leadership and the regulatory and business structure in Australia which is among the best in the world.

Perhaps this is a time for brokers to focus on the quality of their brand and engendering client loyalty as the regulatory reforms take place.

The subject matter and the content of this article are solely the views of the author. FinanceFeeds does not bear any legal responsibility for the content of this article and they do not reflect the viewpoint of FinanceFeeds or its editorial staff.