Summary: We believe the new Esma rules on leverage represent a positive development that will make it more difficult for predatory firms to lead clients to trade beyond their means.
Esma originally proposed limits on leverage and a guaranteed limit on how much a client can lose in these trades after concerns that inexperienced retail traders do not fully understand the levels of risk involved.
Saxo Capital Markets has been a vocal supporter of the proposals set forth by Esma from the outset and we have always believed that consistent, harmonised regulation at a European level will be positive for clients and the industry as a whole. Esma’s intervention was a timely reaction to the very high leverage levels in general available in the market as well as a significant increase in companies taking advantage of free passporting across Europe. These firms operated from countries with low regulatory governance which focused their marketing efforts on less sophisticated customers and offering them high leverage and incentives to potentially trade beyond their means.
Prior to the introduction of the rules, the levels of leverage offered by some trading firms were disproportionate compared to the risk tolerance of an average retail client. In some cases, they were plain irresponsible, unethical and led to a race to the bottom in the trading industry. Parts of the margin trading industry were simply not sufficiently focused on protecting clients’ interests. It is important in this debate, however, to not to lose sight of the fact that this is a leverage problem – not a product problem. Responsible caps on leverage rather than outright banning of products is key to consumer protection.
That is not to say that we believe leverage should be banned altogether. Trading with CFDs and FX instruments brings a number of advantages, allowing traders to trade the full global macro cycle, build a diversified capital allocation and hedge their market exposure in a flexible and efficient way. Clients will often use the option to short a CFD as a hedge on a long stock portfolio or short a stock index as a hedge against general market moves on a single stock investment. Options have for a long time been reserved to institutional investors and HNWI-segments of the larger banks. Products such as CFDs democratise access to such possibilities and trading strategies, levelling the playing field between larger market participants and smaller retail investor. Leverage also opens the door to increased diversification for clients with smaller account sizes.
With too much leverage, however, the risks of trading these products can significantly outweigh the benefits; ironically, higher leverage can increase the chances of clients losing money, resulting in earlier stop-outs. Despite the initial reactions from parts of the industry to Esma’s changes, we believe the regulation will be a positive for trading firms across Europe. For several years, many firms have competed on leverage and often, through mis-selling, have used incentives to lure investors instead of focusing on the principal customer offerings of product, price, platform and service that lead to long-term client retention.
We continue to believe that offering very high leverage, which is out of sync with underlying market conditions at any given time, is irresponsible. Looking ahead, we fully expect that the regulations imposed by Esma will continue to impact the margins of some firms in our sector. In turn, marketing budgets will be cut as non-compliant firms fall into an unrecoverable decline. Some firms will look to sell their CFD client books which concurrently creates opportunities, but those companies that rely on high leverage, incentives and mis-selling will close down reluctantly, be forced to shut their doors or potentially try and find a buyer.
Regulations should not, however, deter high-quality firms with ethical and strong business models which adhere to the new regulations. They may find this to be an opportunity to acquire client books and embark on M&A activity.
From our own experience at Saxo Capital Markets, we know that running a profitable business and being a responsible market participant are not mutually exclusive. For the industry to survive and grow over the long term, it should welcome the move away from competition on leverage and embrace competition on quality of platform, price, product and service.
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