Germany’s CFD proposals encourage the b-book: Insurance and no leverage limit means internalization of orders is the only way

By insisting that brokers insure a leveraged trading account against negative balances, Germany’s BaFin is by proxy encouraging brokers to go down the dealing desk market maker model, which is a retrograde step by some 10 years and is certainly not in client interests

MetaTrader 5 advances its hedging functionality

Just after the Financial Conduct Authority (FCA) in Britain struck hard with its proposals last week which are set to change the entire method by which contracts for difference (CFDs) are provided in a region in which they are a core business activity, other regions are now following suit.

At the end of last week, Germany’s national financial markets regulatory authority BaFin issued a consultation paper with regard to how CFDs should be provided in its domestic market.

The German directive is relatively straight forward, unlike the proposed British directive which sets out stringent leverage limits and imposes very limiting restrictions on the CFD market to the point that it has sparked controversy among very well respected senior FX industry executives to the point where, as explained to FinanceFeeds over the weekend, lobbying by large exchanges and a will to move the entire business onto listed venues has been one of the suspected resons.

Quite simply, BaFin, which is ordinarily a very bureaucratic, market-unfriendly authority, only intends to stipulate that CFD providers ensure that retail clients cannot lose more money than is deposited in their account, a functionality which is already available to CMC Markets clients in Germany, CMC Markets having some of the largest retail market share in Germany and being widely recognized as a very high quality electronic trading firm.

On the basis of the consultation paper, there are no other requirements from BaFin including no leverage limits, and where retail clients’ risk is limited to their deposits, there is no prohibition on marketing, distribution and sale of CFDs.

This really only leads to one important matter, that being the subject of how to mitigate negative client balances.

In its consultation paper, BaFin states that firms should insure their clients against exposure to negative balances, and therein lies the most peculiar byproduct of the regulator’s intentions.

Following the Swiss National Bank’s removal of the 1.20 peg on the EURCHF pair in January 2015, many retail brokerages were exposed to substantial negative client balances, which in the vast majority of cases could not be collected from clients, whether brokers realized that the legal costs of recovering the funds or the potential lambasting by the consumer protection associations and mainstream press would have been worse than writing off the losses, or whether they weren’t able to withstand the losses and actually went bankrupt as in the case of Alpari UK and LQD Markets to name just two.

As explained yesterday by AFX Group senior executive Francois Nembrini who heads the firm’s QuanticAM institutional asset management division and has 12 years under his belt as Managing Director of FXCMPro, the institutional division of one of the largest brokers in the world where he managed liquidity relationships with banks, brokers and hedge funds at Tier 1 level ”

“Scandals in the OTC industry, bankruptcies related to SNB type events and binary options scammers have given ample justifications to exchange lobbyists to argue against the OTC retail industry.” This is most certainly an accurate analysis, and it is quite clear that this could be a factor that led to the FCA’s action last week, however BaFin have done the opposite.

BaFin’s stipulation against negative client balance exposure will by default encourage all CFD firms offering service to German clients to simply operate a b-book execution model, and even worse, a b-book execution model that does not even take a price feed from a live market via aggregation of liquidity providers from a prime of prime brokerage.

FinanceFeeds maintains that there is absolutely nothing wrong with internalizing some trades on the grounds of risk management and limiting exposure to the company and its clients as long as the market prices are followed. This is prudent risk management and is common practice and completely normal.

The main difficulty with Germany’s proposals is that BaFin will likely insist that all retail traders are insured against negative balance exposure, which in turn means that brokers will not even be able to internalize trades by following the correct market price feed because that could also send them into a negative on their trading account and would have to be ‘written off’ in theory because although the order was internalized, a broker’s terms and conditions usually stipulate that traders can lose more than they deposit which means that even if the trade was internalized and the account ran into negative, this remains a negative balance on a client account until a further deposit is made.

The only way to avoid negative balances on leveraged retail trading accounts is to run a b-book execution model with an internal price generated by dealing desk market making, and that way if a stop loss is not set, the account can only go as low as zero. This is retrograde and takes the retail industry back to the darker days of ten years ago when many MetaTrader 4 brokers operated fixed spread accounts on a closed system and connectivity to liquidity from the live market was a pipe dream and the preserve of institutional desks only.

Given that absolutely no insurance company in the land will insure a leveraged FX or CFD account against exposure to negative balances, the only way to comply with BaFin’s proposals would be to go away from the now widely accepted agency execution model and back to the old fixed spread market maker model, which nobody, including most brokers, want.

London has become the home of Prime of Prime brokerages which offer their services to retail FX firms, and the entire OTC business has developed into a highly sophisticated emulation of the institutional world, so by taking this step, it would be likely that Germany’s customers would become disadvantaged and rather than acting in their best interest, BaFin would actually be causing them to become exposed to the you-against-me nature of a closed market operated by a broker’s dealing desk.

BaFin has in the past shown its lack of understanding with regard to the electronic trading business. Three years ago, the regulator considered imposing a ‘latency floor’ of a number of milliseconds on ECN platforms in order to avoid perceived advantages of using a faster system. EBS in anticipation considered implementing a self-imposed ‘wait time’ on execution.

In this case, whilst the FCA may well or may well not be acting in the interests of large listed venues or lobbyists, or acting in the wake of firm bankruptcies and client balances that are the wrong way up, it is clear which regulator understands the entire execution model of electronic trading and which does not.

Read this next

Retail FX

ThinkMarkets expands CFDs lineup to over 4000 ETFs and shares

ThinkMarkets has expanded its service offering by incorporating 2500 new CFDs on shares and ETFs on its ThinkTrader platform.

Retail FX

France regulator warns investors of Omega Pro, Businessempire.fr

France’s financial markets regulator alerted investors that scams related to Omega Pro Ltd are beginning to circulate, with the blacklisted firm capitalizing on the situation to run a range of “unrealistic” offers.

Digital Assets

Web3 platform Grand Time paid $2 million in token earnings to date

Community-driven Web3 platform Grand Time said its offering – which includes a multifaceted platforms and its native token – has been gaining significant traction highlighted by impressive operational metrics.

Institutional FX

FX volumes at MOEX halved in April as ruble gains gorund

Currency trading at Moscow Exchange (MOEX) halted its upward route in April as monthly volumes nearly halved from a month earlier.

Digital Assets

FTX US adds stock trading, fractional shares to crypto platform

FTX US, the American subsidiary of crypto exchange FTX has kicked off stock trading feature to its customers in an effort to compete with popular platforms such as Robinhood and eToro.

Industry News

UK FCA empowered to remove brokers’ permissions in 28 days

Businesses with permissions they don’t need or use, risk misleading consumers. These new powers will enable us to take quicker action to cancel permissions that are not used or needed.

Industry News

CFTC charges $44m Ponzi scheme but millions may have fled to foreign crypto exchange

The CFTC alleged that defendants transferred millions of dollars to an off-shore entity that, in turn, may have transferred funds to a foreign cryptocurrency exchange. None of these funds were returned to the pool.

Technology

Saxo Bank deploys Adenza to address Basel and EBA requirements

The integration of ControllerView will enhance Basel-driven capital calculations and reporting at Saxo Bank in support of the bank’s multijurisdictional capital and liquidity reporting requirements throughout Denmark, Switzerland and UK, with plans to expand into the Netherlands.

Executive Moves

ComplySci appoints CTO, CPO, and CLO to further regtech’s product expansion

ComplySci offers compliance software used by more than 1400 global institutions to identify risk and address regulatory compliance challenges.

<