This post explains why negative balance protection is a regulatory faux pas that damages precisely the customers it ought to protect
The European Securities and Markets Authority recently updated on its ongoing review of CFDs and other speculative products.
ESMA weighs several measures for CFDs:
- Leverage limits on the opening of a position between 30:1 and 5:1, whose limit will vary according to the volatility of the underlying asset;
- A margin close-out rule;
- Negative balance protection to provide a guaranteed limit on client losses;
- A restriction on benefits incentivising trading and
- A standardised risk warning
We’ve explained our take on all the above in this webinar.
The rest of this post lays out why Negative Balance Protection is a bad idea.
Our take on #3: negative balance protection
We replied when BaFin first “invented” negative balance protection. ESMA seems to follow suit, thus making this a PanEuropean, as opposed to “just” a German mess.
This post lays out our (upgraded) take on ESMA’s #3: Negative Balance Protection, tackling:
- What is negative balance?
- How it affects traders
- How it affects providers
- What is negative balance Protection?
- How it incentivise traders and providers
What is negative balance?
First things first. What is it?
Definition of Negative Balance
Negative balance is the ugly side of leverage / borrowing. Negative balance results from sudden adverse market shifts, whereby the market value of a customers’ assets, shrinks below the market value of his borrowing, before a stop-loss or a close-out trade unwinds the losing trade. As a result of this adverse shocks, customers find themselves:
- Losing 100% of account equity, PLUS
- Owing any shortfall between assets and liabilities before the position was stopped out.
Negative Balance? What Negative balance?
The knowledgeable trader knows there are 2 ways to trade CFDs, namely via:
- CFD brokers: whereby traders end-up holding a position against “the market” (=anyone BUT the broker)
- CFD dealers: whereby the dealer takes the other side of the traders positions (=makes the “market”)
As we explain below, negative balance is an economic impossibility for dealer – it only applies when brokers route positions to a 3rd party.
CFD-dealer negative balance
Customer and CFD provider enter the following DEAL:
- The customer:
- Puts down collateral
- Picks an asset & a pay-out pattern (aka, leverage)
- Enters the trade on one side of the spread
- The Dealer:
… takes the other side of the trade
As long as movements in the underlying haven’t forced either side out of the bet, the customer´s choices are:
- Close the position and pocket the pay-out (positive or negative), after paying the spread
- Roll the position, compensating the dealer for the cost of capital tied up in the other side of the bet overnight (aka paying swaps),
- If the market wipes out customer equity, the dealer keeps customer margin (= the customer´s losses). T
That’s it! As you’ll gather, negative balance is just not possible – we’re talking about a simple bet where one side’s loss was the other side’s win.
A CFD dealer claiming negative balance is as moral as a winner re-defining the pay-out of a settled bet.
Negative balance for a CFD-broker
Note that the below set-up applies to OTC brokerage, not necessarily on exchange brokerage where we would merely act as an agent instead of a matched-principal)
A CFD broker brokers a 2-leg sequence whereby customers end-up owning an asset / betting against the market (e.g. anyone BUT the broker):
- A client leg, whereby the matched-principal broker “bets” against the customer on one side of the spread (just like a dealer),
- The market leg, whereby the broker:
- Auctions your bet to get you the best market offer and
- “Bets” on your behalf against the market,
This has 3 core benefits:
- The broker is always on your side,
- You get a competitive, market validated price, not the dealer price,
- In the case of broker insolvency, the broker’s counterparties honour your bets against them,
The broker may fund your position, for you to lever up your purchase/bet against the market.
Alas, this introduces a disadvantage vs. betting against a dealer since, in a negative balance event, you:
- Really owe the negative balance to your broker, because
- The market will claim it from him
E.g. in the event of a market earth-quake, theres´s real broken dishes on the brokerage side. The question is:
- How high is the bill?
- Who should pay for it?
Impact of negative balance
Negative balance is a bit like tsunamis:
- Extremely rare in liquid markets when prices move continuously. This is because stop-losses unwind customer positions before the margin is exhausted
- Potentially deadly: whilst infrequent, its severity can be high when large market dislocations meet highly levered customers.
To give you an indication of impact, the repercussions of negative balance in each of the recent market events (SNB Flash Crash, GBP Flash Crash, etc.) was a loss amounting to between 1 and 2 weeks of revenue.
More importantly, Darwinex chose not to claim damages from customers, because any potential recoveries were outweighed by:
- The reputational damage incurred by prosecuting debt from a customer who already lost 100% of their account
- The legal costs involved in recovering small debts from multiple customers
The fact that we chose NOT to prosecute them -this does not mean that we won’t do it in the future though-, doesn’t make it a good idea to include this provision in our terms and conditions, as ESMA would have it…
What is negative balance Protection?
Negative Balance Protection (NBP) is a regulatory invention whereby CFD providers waive customer debts in a negative balance event.
As you’ve seen above, whether or not there’s negative balance depends on the type of provider:
- If you bet against a CFD-dealer, you don’t need negative balance protection, because you won’t have negative balance, as you won’t be trading in the market, but instead referencing your bet to it
- If you borrowed to finance your purchase / market bet, YOU ought to settle your debt
Now, according to ESMA; it shouldn’t be you but your broker who pays your broken dishes, which leaves your broker with 4 choices:
- Stop providing leverage, and/or
- Raise capital to insure itself, and/or
- Raise commissions to build up capital, and/or
- Stop providing CFD brokerage services
All the while CFD-dealers think: THANK YOU, ESMA.
- Not only does your regulatory review let us keep customer losses (CFD in broker jargon stands for Cash for Dealers)
- Furthermore, it pushes CFD brokers out of the market…
As a proof of gratefulness, little wonder DEALERS provide customers with negative balance protection, FOR FREE.
Moral Hazard – cross subsidy
Unfortunately, this is an incredibly naive solution.
- If there is a debt, and the trader is off the hook
- Surely someone has to pay for it,
As we shall see, if there is a debt, it can only come out:
- Directly out of the customers’ pocket,
- Out of the provider’s pocket – which is another way of saying, indirectly out of the customers’ pocket
Conclusion: A solution chasing a problem
The biggest problem with NBP is designed to solve a non-issue:
- The problem is that CFD traders are losing a very significant portion of their deposits,
- The problem, 99.99% of the time is overwhelmingly NOT CFD traders losing more than their deposit
That leaves the 0.01% market event, in which negative balance protection introduces a dangerous subsidy whereby:
- The higher the leverage, the bigger the degree to which traders free-ride provider balance sheet,
- If the impact becomes high enough, high leverage end up becoming a counterparty risk to low leverage traders
But wait, it gets worse.
Tackling the wrong issue to compound the real one
Not only does NBP NOT solve a NON-issue, it does so at the cost of making an already bad situation even worse, by incentivising:
- Rational CFD traders to trade more, not less leverage to make the most of a free implied option.
- Brokers (as opposed to dealers) to NOT provide CFD trading, if NBP is imposed on them
- Broker-dealers (who selectively internalize flow), to internalise more, not less flow.
(Think of it in insurance terms: imagine the regulator forcing insurers to provide free flood insurance to home-builders building on beachfronts!!
Of course this would default the insurers… at the expense of users who did NOT build their house on the beachfront!)
All of the above make matters worse, not better for customers.
In a nutshell: ESMA; please scrap it. Align incentives instead.