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

Digital Assets

Masa and LayerZero: Bridging Blockchains for Data Sovereignty

Masa Network is poised to revolutionize the personal data landscape with its upcoming launch as a cross-chain platform, making it accessible on a variety of blockchains right from the start.

Digital Assets

Big Time Generates over $100M in Revenue since Preseason

Innovative game developer Big Time Studios announces that its highly anticipated free-to-play multiplayer action/MMO RPG Big Time, has generated $100M in revenue. According to the team, players transacted a total volume of over $230M, without selling a single token.

Digital Assets

Centralized exchanges are 10 times more popular than DEXs in Western Europe

Western European traders are found to prefer centralized exchanges over decentralized ones as CEX traffic outpaces DEXs by a factor of ten.

Market News

Stock Market Analysis: Is NVDA Losing Its Leadership?

Since the beginning of the week, the S&P 500 Index (US500) has seen a modest increase of about 0.58%, whereas NVDA’s share price has experienced a decline of approximately 3.8%. This recent divergence raises concerns among Nvidia stock investors — could it signify a loss of NVDA’s market leadership?

Industry News

ESG: Australian regulator wins first greenwashing court case against Vanguard

Vanguard admitted that a notable portion of the securities within both the Index and the Fund did not undergo the promised ESG scrutiny.

Fintech, Uncategorized

BitMEX integrates HALO from Solidus Labs for cross-market surveillance

“The recent approval of the Spot Bitcoin ETF has piqued the market’s interest. As a result of price volatility, the trading volumes for crypto derivatives have gone up substantially. HALO, with its advanced technology and crypto-native detection architecture, will enable BitMEX to smoothly and safely scale trade surveillance across its increased trading volumes and provide the necessary safeguards for new product launches.”

Reviews

IUX Broker Review

IUX, recently rebranded from IUX Markets, stands as a multi-asset Forex broker recognized for its regulatory compliance across various jurisdictions.

Industry News

Horizon Software rebrands to Horizon Trading Solutions

“Horizon Trading Solutions has seen accelerated global growth over the past year to meet the rising demand for our trading solutions and built-for-purpose technology offering. The choice to rebrand represents a key part of this development, while maintaining our heritage and history in the industry.”

Market News

USDJPY has surged to levels last witnessed in 2022. Should we consider opening a short position?

The recent resurgence of the US dollar has propelled USD/JPY to new heights, touching levels not seen since 2022. This surge comes against the backdrop of stable short-term yields and ongoing economic data that fails to signal a significant slowdown, prompting questions about the extent of current monetary easing measures.

<