ESMA – Product Intervention

27 March 2018
The Market Owl

It’s official!

ESMA has intervened and set the new regulatory playing field for traders and providers of Contracts for Differences (CFDs) and FX.

In this post we first outline the new regulation, and then review the consequences for:

  1. Darwinex
  2. DARWIN Investors
  3. DARWIN Providers (aka traders)
    1. Investable
    2. Not (yet) investable
  4. Brokers & Broker-dealers

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ESMA rules

ESMA published its official statement on this link, but here are the measures in a nutshell.

It’s the end of an era

First: bye bye, binary options.

Second: bye bye, wild west CFDs

  1. Leverage limits on the opening of a position by a retail client from 30:1 to 2:1, which vary according to the volatility of the underlying:  
    1. 30:1 for major currency pairs;  
    2. 20:1 for non-major currency pairs, gold and major indices;  
    3. 10:1 for commodities other than gold and non-major equity indices;  
    4. 5:1 for individual equities and other reference values;  
    5. 2:1 for cryptocurrencies;
  2. A margin close out rule on a per account basis. This will standardise the percentage of margin (at 50% of minimum required margin) at which providers are required to close out one or more retail client’s open CFDs;
  3. Negative balance protection on a per account basis. This will provide an overall guaranteed limit on retail client losses;
  4. A restriction on the incentives offered to trade CFDs; and
  5. A standardised risk warning, including the percentage of losses on a CFD provider’s retail investor accounts.

Impact on Darwinex

Let’s first review the items one by one – and then overall.


Our thoughts

Leverage restrictions
  1. Reduces structural risk – we’ll sleep better on lower leverage
  2. No impact on DARWIN investors / traders
  3. Risk to drive some trader business offshore


Margin close-out

Great improvement from previous “per-trade” suggestions – saved a lot of development resources on this one!


Negative Balance Protection  

A red-herring – probability of negative balances on new leverage very limited. Requires regulatory status change for brokers.


Restriction on incentives  

We’ve never provided them!


Standardised Risk Warning  

Oh well…


Overall, we had argued that forcing CFDs on Exchange would fix CFDs once and for all… but this hasn’t happened yet.

Meanwhile, 2 takeaways for Darwinex:

  1. Competition no longer imposes leverage levels harmful to both us and customers
  2. We’re upgrading our matched principal to a full-scope broker-dealer permission

We have argued that a conflict free, agency only model is the most transparent way to align incentives with customers. ESMA preferred to “invent” negative balance protection instead… so we’re upgrading our regulatory permission to a full-scope broker-dealer.

We’re doing this because it’s technically impossible to offer negative balance protection and not take market risk… but: rest assured that Darwinex will leverage its new license to disrupt brokerage further! More on that when the time comes 🙂

ESMA intervention for DARWIN investors

This one’s quick 🙂

In a nutshell: no impact

  1. The new target leverage levels that ESMA has now finalised are above the maximum leverage thresholds that the risk manager would tolerate
  2. Leverage limits apply at a DARWIN portfolio (not DARWIN individual) level – this adds extra breathing room

So, what about traders?

ESMA intervention for traders

We expect the European CFD market to

  1. Shrink: somewhat in the short-term: less gambling advertising budgets will flow into CFDs, and will go elsewhere (online gambling, crypto, offshore, etc.)
  2. Mature: bucket-shops will finally go away, and with them the regulatory stigma that’s hurt the entire sector.

Overall we remain bullish on retail trading: financial markets remain the highest payout game out there. With tighter controls, the general public (and regulators) will realise that the problem was not CFDs, but wild-west CFDs.

Volumes will eventually come back, stronger – just like when other jurisdictions (Singapore, Japan, etc.) restricted leverage.

Investable traders

For good traders, ESMA tilts the balance:

  1. Away from borrowing debt capital from brokers,
  2. Towards investor equity capital (unlimited, healthy leverage)

Which is another of saying: broker leverage is limited, but with a high capacity, high quality DARWIN, investor leverage is infinite, in addition to risk-free.

We have a vested interest in saying this, but hey, DARWINs are now more appealing than ever. We look forward to more investable managers leveraging the DARWIN Exchange to tap into investor capital – it’s a win-win for them and their investors!

(Future) Investable traders

… are arguably the biggest beneficiaries.

Lower leverage offers:

  1. Longer learning curves: newbies won’t fritter their accounts away into leverage. This will buy them more time to learn how markets work… and work-out winning strategies that are worthy of investor capital
  2. Lower advertisement budgets: b-book profitability will dramatically fall. This, together with bans on bonuses and advertising, will reduce the amount of ignorant innocents who approach markets with the wrong mind-set

Brokers & Broker-dealers

As discussed above, there will just be broker-dealers going forward.

Darwinex will formally graduate from broker to full-blown broker-dealer, and continue to drive trader evolution in just the same way as for the last 6 years.

Let us wholeheartedly thank all of those who’ve helped us grow from small start-up to consolidated player in the industry since then. Thanks to your trust, there’s meanwhile 45 employees delivering technology, customer service and education to traders worldwide.

ESMA or no ESMA; the future belongs to the independent trader movement, and we’re grateful to act as your humble servants!

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