The Darwinex take on Bafin’s negative balance protection ruling

Die Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin, Germany’s financial markets regulator) has recently issued its definitive ruling on CFD regulation.

If you wish to read on more on the actual regulation, or an abridged summary on the subject, feel free to consult – the rest of this post outlines our take on it.

Will BaFin’s move make German CFD traders better off?

At best, not much. At worst, it will make proper CFDs less available in Germany.

In practice, it’s extremely rare for a provider that’s suffered a negative balance to chase the customer:

  1. Dealers who internalise all flow do NOT suffer a loss – the trader really owes the dealer NOTHING
  2. Brokers who do not will be in serious trouble to chase investors – did FXCM chase customers for the USD 300MM that took it down after the SNB event?

In economic terms, negative balance protection amounts to gifting customers a put option – and those providers who actually hedge the risk (brokers) will be put at a relative disadvantage against who do not (dealers). Imposing by law, a guarantee that negative balances won’t be prosecuted will carry a higher cost for brokers than it will from dealers (with broker-dealers somewhere in the middle).

In a nutshell: BaFin’s ruling:

  1. Will have limited impact (if any) on consumer protection
  2. Gives “bad” CFDs (those offered by pure market makers) an edge over “good” CFDs (e.g. those listed on an MTF, with link to the underlying market). It tilts competitive dynamics in the CFD sector (which is bad in itself), and on top of it, does it in the wrong direction.
  3. Sets a disastrous precedent: will BaFin force exchanges to guarantee to futures investors that they won’t lose more than their initial margin?
  4. Stigmatises a good instrument (CFDs!) without tackling CFDs real issues – issues that ought to be fixed but this ruling fails to tackle

So, overall, a waste of everyone’s time, and a large opportunity cost. This could have been the time to set the CFD market right, and it’s a missed opportunity.

If you want the video version of the above (and more), feel free to watch:

Why CFDs are GOOD in principle!!!

BaFin stigmatises a good instrument – one that solves a real issue faced by genuine investors!

Let’s say Matthias is a knowledgeable BMW engineer who lives in Munich and likes the stock market. He’s thoroughly researched different sectors, and is persuaded that DAX30 financials are overvalued, and industrial stocks are undervalued. He has buddies in several hedge funds boasting how their long (industry)-short(financials) options strategy has literally been blasting it for the last 3 months.

Matthias goes – wow – I think that’s a great strategy, I want to invest with you guys! What are the next steps?

Err… Matthias unfortunately we’re don’t take on “retail” customers, only institutions. And anyways our minimum investment size is 250k, sorry but we can’t take on your 10k punt. Cheers mate. See you at the next party. So what are Matthias’ options?

  1. Cash market: buy the long stocks, find some online broker who’ll allow you to short financials, get hammered on commissions and borrowing fees, to get the portfolio approximately right (How many individual stocks can you buy for EUR 10k?). Probably get hammered on taxes if you get it right.
  2. Actively managed Collective investment: find a collective investment vehicle that has exactly that thesis, the problem is you’ll never know because they’ll likely won’t tell you what they’re up to…
  3. Passively managed ETF: Matthias’ is a one-off time limited strategy… who’s going to incur the launch costs of a bespoke investment strategy for 10k?
  4. CFD: CFDs offer granular investment (you can buy exactly the proportions you want). It isn’t affected by stamp-duty and other taxes (taxes are only applicable to a taxable subject, since you don’t own the asset outright, the taxman can’t impose a stamp-duty on your bet). They can be readily shorted.

CFDS are the real deal, right? They overcome the limitations of cash-instruments NOT designed for trading by retail investors:

  1. Cash Investments are not fractionable, and in many cases they have a large size
  2. The default machinery is designed to manage the “real” asset, factoring in custody costs by default, even if holding periods have been getting shorter and shorter
  3. Shorting is not only an option, and when it can be done, it is expensive
  4. (Brokerage offerings by most high-street banks are ludicrously backward, expensive and restrictive)

Like in other corners of finance, traditional providers have been caught asleep at the wheel, and new CFD providers (granted, with big teething problems and a big conflict of interest) caught them off-guard… But when Mathias reaches the broker’s site, he’s offered “negative balance protection” CFDs , so that he won’t lose more than his deposit.

Naturally, Matthias gets spooked – why put your hard earned at risk in something so bad, it needs “negative balance protection”?

What’s wrong with OTC CFDs?

Here’s the issue:

  1. Some (not all) providers are making a killing by enticing people to leverage OTC CFDs bets, and vulnerable people are losing their shirts as a result
  2. Different customers pay different prices, with different spreads, different commissions and different financing charges for one and the same underlying at the exact same point in time – and apparently this is perfectly fine
  3. Those very same providers set the different prices, with different spreads, different commissions and financing charges by which they bet against retail customers in bets whose liquidity barely reaches the real market where price level, spread and funding rates are set.

In a nutshell: It’s OK that one can engineer a match where one plays against a weaker opponent and gets to call the shots too… as long as one can’t lose more than the initial bet.

The issue is that some CFDs are offered as an OTC instrument, without a proper price finding mechanism with consumer guarantees in place. We have argued about this at length, you can read our broad view on how to fix the issue at root, watch here.

What’s next after Bafin?

If anyone of you knows anyone with the FCA, please ask them NOT to follow in BaFin’s steps:-)

We’ll host a webinar summarising our views on how to fix the CFD sector for good – and we hope you’ll join us!

Meanwhile, feel free to share your views on the subject in the comments section.

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