In our previous discussion about ESMA, we were praising the regulatory move by the EU for its potential to protect retail clients from irks. But, after taking a close look at the effect that the regulation was having on the operation of brokes, we became slightly skeptical. We realized that there were some issues with the regulation that we were not necessarily anticipating or aware of. Within that very blog post about ESMA, we talked about an interesting discovery - certain brokers with an international presence tended to redirect potential clients that were looking for high leverage trading opportunities, to their branches outside of the EU.

A surprise and some further research

The discovery came as a definite surprise. After doing some research, we discovered that some 10 rather large brokers were already proposing to potential clients that they create an account outside of the EU. Unfortunately, we are unable to disclose the information on these companies, as that would be sensitive information. What can be said is that there were brokers who did not bend the rules, and this is highly appreciated. In addition to this, the importance of online referrals cannot be underestimated in the retail FX industry, and when researching some of the leading financial sites in EU and comparing their top advertisers with the list of the brokers that offer the clients to open an account in the offshore companies, we have noticed that actually many referrals are promoting the “honest” brokers. When taking a look at Kryptoszene's guide to German stocks it becomes clear that the potential visitors are made aware of all of the risks and are recommended only EU-regulated firms. While this is certainly a positive aspect, today, we are going to talk about those that did try to bend the rules.

After finding out about these companies, we got in touch with representatives from certain local communities within the EU. Below, you will be able to see some of the commentary made by Polish and German representatives. We got in touch with a British representative as well, but unfortunately, due to the issues and lack of clarity associated with Brexit, were unable to receive a clear answer.

Both of the representatives had an issue with the new ESMA rules. They said that instead of protecting the users, the rules were scaring them away. Instead of minimizing losses, they were instead potentially lowering the losses, slightly. While those who did not know how to work with high leverage are now protected from making bad trades, those who knew how to trade and had a long experience now had lost access to the kind of trading they were doing previously. As a result, these traders are now looking to move accounts abroad. Just like some of the less prudent brokers offered them to do, and all this in order to gain access to high leverage trading. There have also been some additional, very interesting impacts on the trading communities, with justified criticism being thrown at the new regulation. Still, there are positive aspects that the community representatives mention, specifically negative balance protection. Marcin Nowogórski and Rafael Neustadt are both highly respected professionals in the field that we got in touch with. They both had interesting insights into the regulation that provides an interesting perspective on the effects it has had.

Commentary by Marcin Nowogórski, Trader & Industry Professional, an associate at Comparic Media Group and Invest Cuffs Foundation, private consultant of Retail brokers

I see ESMA’s policy towards CFDs to be rather beneficial for Polish retail traders in general terms, even though the shape of particular measures remains a discussion. I can’t resist the feeling that the regulator received a signal about some threat to the interest of the public and decided that they have to act. So they did ‘something’.

The discussed ESMA measures met two main targets:

1) protected the general public against (some) losses related to CFDs trading, and

2) fulfilled the regulator’s duty to react somehow to such generally defined problem. As usual, the devil is in the detail, and here quite a long list of improvements appears to be necessary in order to rebalance the situation on the retail trading market.

In general, we definitely see less pain from losses in the Polish trading community as current restrictions on marketing of CFD products tend to decrease the amount of completely unprepared people entering the community. But at the same time, those restrictions work in the same way as scary images on a pack of cigarettes aimed mainly at frightening people away from trading and financial markets. It supports a view that’s getting more and more popular these days capital markets are a practically fraudulent scheme. For example, artificial disclaimers forced on banners and sponsored education are not explaining, that next to 70% of clients who lost money there are 30% of clients who made money, and why this proportion is not the other way around. That would definitely trigger some debate on how capital markets work and where profits come from. So my main concern is that the regulator, in its attempt to protect the working class, is rather using a fear-mongering tactic. This is harmful in the long run, and educating the conscious society would have a better result.

As traders that we are ourselves, we find it somehow troublesome to justify stiff leverage thresholds for different sub-groups of CFDs. We would understand if they were somehow related to volatility on underlying assets, but it’s not hardcoded. Limiting leverage, in general, is positive for inexperienced traders. Their account lifetime has a chance to increase - probably 99,9% of retail traders don’t understand either the concept of leverage or market volatility. With this solution, while protecting the general public, we see issues on a more detailed level.

Many retail traders who have some experience were disappointed by the new restrictions, especially those related to leverage. ESMA didn’t actually provide any reasonable solution for them. A status of a professional trader is out of reach for most of them, and therefore they are stuck at the very basic level of trading while having the knowledge and the experience to manage their risks consciously. Those traders now have to deposit several times more in order to retain the desired trade sizes, hence increasing the amount of capital at risk. Some of them decided to look for alternative brokers from outside of the EU (especially to ASIC regulated companies) which makes them more vulnerable when it comes to counter-party risk and potentially decreases the level of protection.

One measure I see as mostly positive is the negative balance protection for CFDs, however, we still need some black swan event to stress-test the system where divergence in risks being taken by brokers (unlimited) and their clients (limited) would come up massively. This may result in a bill for state-backed compensation schemes as brokers may fail to meet their obligations to LPs.

Looking at most brokers active in the region I see that they are quite unhappy with the measures. Those who run global operations have shifted focus onto markets outside of the EU. Local brokers, limited by country borders or branch ranges, are in a very tough situation. They’ve seen an outflow of the most experienced retail clientele to offshore brokers and a significant drop in the volume of clients. Those brokers find it rather difficult to prove that their current business is worth continued work with, even though they are relatively more conservative and reliable in terms of safety for their clients (for example brokers who are subsidiaries of banks).

Rafael Neustadt, Executive Director of the CFD Association

The German CFD Association represents the interests of reputable German CFD providers. It opposes parts of the restrictions on CFD trading imposed by ESMA. According to Rafael Neustadt, Executive Director of the CFD Association: "The justified and desired investor protection is not strengthened by the measures of the temporary intervention power - but rather weakened. Since retail clients, regardless of their experience and knowledge, are not allowed to trade with large leverage, they are looking for other ways: Clients can be classified as professional clients or open CFD accounts with providers outside the EU, which can still allow trading with large leverage today. Both mean less investor protection for clients. The restrictions imposed by ESMA are therefore backfired".

In addition, a study by the Research Center for Financial Services of Steinbeis University in Berlin, mandated by the CFD Association, shows that reduced leverage has no effect on the profit ratio of retail customers. However, the association unreservedly supports negative balance protection.

The CFD Association is of the opinion that restrictions on the leverage in CFD trading serve no purpose and are wrong. Rather, it has to be ensured that only appropriate clients are allowed to trade CFDs and advanced retail investors with good knowledge shall have the right to be classified in a new sub-category with the ability to trade more leverage. In addition, unregulated providers must be pursued and strictly punished.

What can be done?

While the experts are saying they are noticing trends, there does not seem to be a comprehensive, statistical analysis that can provide us with specific details. One thing that the EU regulatory body could try doing is start researching the effects that the regulation is having on the industry. Finding out the information on:

• the change in the total number of EU clients for the brokers' EU entities

• the change in the total deposits from EU clients for the brokers' EU entities

• the change in the total number of EU clients for the brokers' non-EU entities

• the change in the total deposits from EU clients for the brokers' non-EU entities

• the change in the % of EU clients that lost money (within both EU and non-EU entities)

Would allow for a comprehensive statistical model to be created, which might show what direction the market is swaying right now.

So far, it seems that the regulation introduced, while quite all-encompassing, is acting as a barrier to what would effectively be successful traders. They are blocking potential traders from entering the markets for the fear of being defrauded, while also preventing those with experience and skill but no capital form trading. This is causing the market to enter a decline, which further causes the EU Forex markets to die. The need for changes in the ESMA regulation is obvious, but it is also relatively urgent. Otherwise, the EU citizens are slowly putting more capital at risk than they would have been doing earlier, simply by moving it abroad.