Authorities drop a massive bomb on CFDs in Australia, limiting how they are sold and executed

Several years of regulatory wrangling has culminated in yet another blow to the CFD market, this time at the hands of Australian regulatory authority ASIC, which has today passed new regulations severely limiting how CFDs are sold, executed and marketed, and restricting leverage considerably.

Many FX brokerages in Australia had understood for a very long time now that this was likely to occur, the earliest example of which was explained to FinanceFeeds five years ago by Australian senior FX executive David Batten who raised some very important points concerning ASIC’s clampdown on margin electronic trading firms. 

A few years later, Britain’s FCA made significant restrictions to the method by which CFDs are marketed and sold, causing many of the large companies in the UK to form a lobby group, working with the regulator to attempt to reach a middle ground, one of which was IG Group, led by Peter Hetherington who resigned very soon afterwards after a quarter of a century with the firm. Perhaps the David and Goliath battle between the exchanges which were encouraging regulators to bear down on CFD firms so that they could get the retail client bases back onto exchanges.

This would have been the only method by which it would be possible to do that, as electronic trading firms are far more attractive to retail traders than expensive, slow and bureaucratic exchanges.

Now, Australia is following suit in a move that is likely to have a significant impact on the second largest CFD market in the world after the UK, meaning that now, all CFD providers, given that Australia and the United Kingdom are the main target markets, may well have to reconsider their product range.

As far as this new legislation is concerned, ASIC has made a product intervention order imposing conditions on the issue and distribution of CFDs to retail clients.

ASIC’s order strengthens consumer protections by reducing CFD leverage available to retail clients and by targeting CFD product features and sales practices that amplify retail clients’ CFD losses. It also brings Australian practice into line with protections in force in comparable markets elsewhere.

From 29 March 2021, ASIC’s product intervention order will:

• restrict CFD leverage offered to retail clients to a maximum ratio of:
  • 30:1 for CFDs referencing an exchange rate for a major currency pair
  • 20:1 for CFDs referencing an exchange rate for a minor currency pair, gold or a major stock market index
  • 10:1  for CFDs referencing a commodity (other than gold) or a minor stock market index
  • 2:1 for CFDs referencing crypto-assets
  • 5:1 for CFDs referencing shares or other assets
• standardise CFD issuers’ margin close-out arrangements that act as a circuit breaker to close-out one or more a retail client’s CFD positions before all or most of the client’s investment is lost
• protect against negative account balances by limiting a retail client’s CFD losses to the funds in their CFD trading account, and
• prohibit giving or offering certain inducements to retail clients (for example, offering trading credits and rebates or ‘free’ gifts like iPads).

ASIC also confirmed it will not require issuer-specific risk warnings or other disclosure-based conditions as originally proposed in Consultation Paper 322 Product intervention: OTC binary options and CFDs (CP 322).

The order strengthens protections for retail clients trading CFDs after ASIC found that CFDs have resulted in, and are likely to result in, significant detriment to retail clients.

ASIC reviews in 2017, 2019 and 2020 found that most retail clients lose money trading CFDs.

During a volatile five-week period in March and April 2020, the retail clients of a sample of 13 CFD issuers made a net loss of more than $774 million. During this period:

• over 1.1 million CFD positions were terminated under margin close-out arrangements (compared with 9.3 million over the full year of 2018)
• more than 15,000 retail client CFD trading accounts fell into negative balance owing a total of $10.9 million (compared with 41,000 accounts owing $33 million over the full year of 2018). Some debts were forgiven.

ASIC Commissioner Cathie Armour said, ‘Heavy losses sustained by retail clients trading in highly leveraged CFDs and ongoing market volatility during the COVID-19 pandemic highlight the need for stronger CFD protections in the product intervention order.’

‘The leverage ratio limits in the order aim to reduce the size and speed of retail clients’ losses by reducing CFD exposure and sensitivity to market volatility. This follows similar measures introduced in major overseas markets, including the United Kingdom and European Union’ Commissioner Armour said.

The order will remain in force for 18 months, after which it may be extended or made permanent. Civil and criminal penalties apply to contraventions of the product intervention order.

ASIC’s consideration of feedback on its proposal in CP 322 to ban the issue and distribution of binary options to retail clients is ongoing.

Back in September last year, FinanceFeeds spoke at length with Justin Grossbard, an FX indusry researcher based in Melbourne, who elaborated on how he saw the future of CFDs in the Antipodes.

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)” said Mr Grossbard.

“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” he continued.

“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” he said.

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 desirable 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?” said Mr Grossbard.

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.

Thus, it may well be that CFDs continue, and brokers adapt to the leverage restrictions and simply ask clients to put more margin capital in, which is one aspect regulators have been trying to achieve for some time now, or, as per FinanceFeeds recent research last week, NDFs could well be a possible replacement, as they are being revisited by many institutions and do not carry the same regulatory red flags that CFDs rightly or wrongly do.

Our opinion is that South East Asia’s NDF trading is booming and war-torn CFD providers could easily get in on the action as growth of this ignored alternative is absolutely obvious.

When looking at the timeline of the retail FX industry, in the general scheme of things it was not a very long time ago that many companies in the OTC derivatives industry were talking at great length about the possible rise to prominence of NDF contracts, and many firms sought to offer them, especially to a British client base, largely because of the flexibility of the proprietary platforms that British brokerages provide in order to facilitate CFD trading.

Unlike spot FX, an NDF has similar virtues that stand CFDs out as popular instruments, as an NDF is an outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount.

This type of trading has garnered its greatest popularity in regions in which forward FX trading has been banned by the government, usually as a means to prevent exchange rate volatility.

In established markets, NDFs were heralded as a means by which OTC FX firms could mitigate the risk of being exposed to, and exposing their retail clients to, sudden and unexpected bouts of market volatility.

Strangely, NDF trading did not catch on to quite the extent that CFD trading has done, with a loyal and dedicated client base in Britain trading CFDs with vigor on a largely domestic market, via established, often publicly listed British electronic trading giants, especially when you consider the global regulatory disdain for CFDs that ensued the disinterest by many FX firms in NDFs.

In emerging markets, however, things are somewhat different and have been for some time.

In South East Asia, a region which many brokers have been concentrating on with a view to conquering, NDFs have been overlooked.

Instead of attempting to onboard pyramid-like networks of IBs and sub-IBs with churnable spot client bases, NDF trading clientele would be well worth seeking out.

While the volume of spot trades have increased during the course of this year compared to four years ago, the expansion was less strong compared with other instruments hence the share of spot trades continued to fall, to 30% in 2019, compared with 33% in 2016. By contrast, FX swaps continued to gain in market share, accounting for 49% of total FX market turnover in April 2019. Trading of outright forwards also picked up, with a large part of the rise due to the segment of NDFs.

This has been a dynamic that has been consistent since 2016. For example, in Malaysia, the NDF market is such a pinnacle of interest that it created a massively disruptive influence, and attracted attention from the Bank Negara Malaysia – the nation’s central bank – and more specifically the Financial Market Committee (FMC) which oversees trading activities in Malaysia at central government level.

Yet brokerages looking to onboard strategic partners in Malaysia tend to focus, with a degree of futility, on spot FX and miss out on the NDF opportunity.

In the last year, trading in outright forwards rose by a notable 43% to $999 billion per day. Trading in medium-term tenors for outright forwards is more common than for FX swaps, and 61% of the turnover in outright forwards was in maturities of over seven days and up to three months. The US dollar was on one side of 88% of outright forwards transactions.

Within the various instrument categories within outright forwards, NDFs accounted for a significant share of the increase in trading between 2016 and 2019, reflecting in particular the strong activity in Korean won, Indian rupee and Brazilian real NDF markets.

It is worth a quick look at the Indian Rupee futures contract’s massive prominence on Dubai’s emerging DGCX exchange – it is by far the exchange’s most traded product.

One entity that has raised the subject of importance of NDFs this month is the International Monetary Fund.

Jochen M. Schmittmann and Chua Han Teng produced a full report just last week at the International Monetary Fund stating that Non-deliverable forward (NDF) markets in many Asian emerging market currencies are large, rapidly growing, and often exceed onshore markets in transaction volume. NDFs tend to price significant depreciation during market stress episodes.

The IMF says that spillovers from NDFs to onshore markets are a policymaker concern. IMF analysis shows that influences tend to run both ways after controlling for differences in timezones between markets. For the COVID-19 pandemic there is some evidence of NDFs leading onshore markets for a few currencies. Policy approaches to NDFs vary widely across Asia from close integration with onshore markets to severe restrictions on NDF trading.

The question of pricing relationships between NDFs and onshore FX markets is an empirical the IMF analyzed pricing relations for the Asian currencies with the most important NDF markets, the IDR, INR, KRW, MYR, PHP, and TWD.

The IMF employed a vector error correction approach to analyze the equilibrium and the lead-lag relationships between markets. The IMF innovates by exactly time-matching NDF and onshore price quotes, unlike most of the existing literature which uses end-of-day quotes across time zones. We show that this is crucial—with the traditional approach of using price quotes at different times of the day we find that influences tend to be from NDFs to onshore markets, but with careful time-matching of quotes, influences tend to run in both directions consistent with price discovery in onshore
and offshore markets. For the COVID-19 pandemic period, we find some evidence for an increased influence of NDFs on onshore markets for a few currencies.

Turnover data for NDFs is mostly available from surveys, given the over-the-counter nature of NDF trading. A shift to centralized trading and clearing in recent years also made data from clearing and settlement service providers available.

Data sources vary in coverage and frequency but the relative importance of currencies across sources is broadly consistent. Data on the investor base for NDF markets is not available, but it is thought to mainly comprise multinational corporations, portfolio investors, hedge funds and
proprietary foreign exchange accounts of commercial and investment banks.

The Bank for International Settlements (BIS) Triennial Central Bank Survey provides the most comprehensive information about the size and structure of global NDF markets but is only available on a triennial basis and for a limited number of currencies (in Asia: CNY, INR, KRW, TWD).

Major trading centers for NDFs publish surveys of trading activity in their jurisdiction with varying coverage and frequency, London and Tokyo being major centers.

With Asian currencies accounting for the vast majority of volume, its a clear read across for brokers wishing to avoid all of the bashing from regulators about CFDs whilst continuing to attract the APAC region’s client base.

Similarly, because NDFs are the darling of large entities and institutions rather than unique to retail margin brokers like CFDs are, it is unlikely that the regulators will attempt to quash this type of execution just to help the institutions do away with slick and efficient competition in the form of FX brokerages.

If you can’t beat ’em, join ’em.