Darwinex’s take on the FCA’s proposed leverage caps & bonus ban

10 February 2017
The Market Owl

The FCA recently published a consultation paper proposing changes to the way it currently regulates CFD markets.

You can read press release & consultation paper directly from the FCA’s site – but in essence what it proposes is to:

  1. Ban the practice of offering deposit bonuses.
  2. Limit the amount of leverage that brokers and broker dealers offer retail traders.

Several people have already asked for our opinion on the matter, so here it goes!

If you prefer the spoken version – we delivered this on TipTV. For the written take, read on!

So what’s the fearful dragon?

The FCA’s paper references some analysis by both the FCA and other European regulators that look into cross-section data in several European markets (France, Poland, and the UK).

The conclusion is that traders who trade with high 100+:1 leverage etc. lose their shirts: the CFD market is a fearful dragon devouring poor retail traders, pronto.

Here we go - that's your dragon

Here we go – that’s your dragon

The consultation paper is quite interesting, and includes a broad overview of what’s going in the CFD market, not just UK-wise, but globally. It’s here, if you’d like to read it.

On taming the beast…

ESMA (the pan-european) regulator correctly identified that the CFD market had gotten out of hand, and seems to have started a pan-european regulatory crusade to tame the dragon.

This is GOOD.

It was about time, and also, it’s appropriate that it’s done in a concerted approach with all national regulators. If the FCA single-handedly took measures, and e.g. the Cypriot regulator didn’t, we’d be in an even deeper mess with even more Cypriot firms leveraging passporting rights to beat FCA regulated brokers with unfair advantage.

So – well done on coordination.

Banning the bonuses and hopefully, the binary bet casino, is great too. It’s good for everyone who means well for the future of the retail CFD market, because binary had really gotten out of hand. As to the leverage cap… mixed feelings.

On the plus side – there is such a thing as too much riskand it helps all involved (brokers included) if the FCA enforces rules limiting risk levels.

For an agency only broker like us, customer leverage introduces counter-party risk: whenever customers blow up, we have to pay up their negative equity – which is both costly and risky.

On the minus side – the devil is in the details, because Leverage <> risk (or not necessarily). To give you a few examples:

  1. What is experience? The FCA differentiates between experienced and inexperienced traders – and imposes different leverage caps (50:1 and 25:1 respectively) to either group. It has been suggested that an experienced trader is a trader who’s traded for a year or more… but what if that trader has traded with another broker before? What if he placed 2 trades over the last year? etc. It’s well-intentioned, but will likely require further details and clarification to enable effective implementation.
  2. What is the risk? What if an EA has a long trade EURUSD, and a hedging trade short EURUSD – so net risk is negligible (the spread)… and yet gross leverage is the sum of both positions. Does everyone now have to re-write their EAs because of the bluntness of leverage as a proxy for risk.
  3. Another variation: who has more risk, a scalper who opens 30 second trades with 100:1 leverage, or a novice trader who trades the EURUSD with 25:1 leverage on an NFP friday, and goes for lunch during the news release?

It’s going to be challenging to implement… but there’s more to this.

The question of “How much money do people lose?” will aid transparency, yes – but asking “Why do people lose so much?” may offer insights into why the former question requires asking to begin with, tackling the problem at root.

Why not slain it?

More on the question of “why do people lose?“.

A market maker engaging novice retail traders directly, enjoys two massive asymmetries:

  1. Capital: the house has deeper pockets than the retail trader – more, the more leverage is involved. Sooner or later, the small guy blows up, and the house picks up the pieces.
  2. Information: the market maker knows what all its customers are doing, and uses that information for its own benefit. None of the small guys know what others are up to – and this is a BIG disadvantage.

With those two advantages, it’s VERY PROFITABLE for market makers to bring retail clients to the table, a market maker will pay for anything (deposit bonuses, “free” education, IBs, referrals, sponsoring F1 / Football / anything that moves) that does the job. Regulated market makers pay upwards of GBP 1500 for the first trade by a new client… and still make a ton of money because the economics are:

  1. Pay up to GBP 1500 for new clients (feel free to reach out to us at info@darwinex.com and we’ll provide you with proof),
  2. Get the new client to deposit GBP 3000 average deposit,
  3. Take the other side of the new client’s leveraged trades until he blows up,
  4. Turn a GBP (3000 – 1500) = 1500 profit = 100% return on capital, in 3 months.

Yes, imposing a leverage cap indeed changes the economics of this butcher shop:

  1. New clients blow up not in 3 months but perhaps in 6 (ROI falls),
  2. Other forms of gambling become more attractive without the leverage, so the CFD market will shrink,

But the fact remains: most will still lose because beating the market on even lower, but still high, leverage is very tough even if you know what you’re doing.

If everyone around you (the broker, the IBs, the “educators”, the others) goes leverage, leverage, leverage, leverage, losing is guaranteed. Alas, the leverage CAP does not kill the perverse incentive (=the dragon) – it merely tames it. So – we believe tackling more than just leverage will possibly achieve more favourable outcomes.

How to slain the CFD dragon

And that’s the part that beats us.

Has anyone ever heard of a Futures / Equities broker offering 200:1 leverage, deposit bonuses, or anything close?

Exactly – futures are listed on an Exchange so that futures brokers have no way (=incentive) to deploy their capital or information edge against their own customers.

So here’s our proposed change: How about CFDs are forced on Exchange?

That would be the cleaner (and quicker!) way to solve the problem for good.