Last week saw a potentially momentous move by a European regulator – the Belgian market authority banned the distribution of some OTC derivatives to retail counterparties. The move is likely not to stay isolated. ESMA, the pan-european regulator has recently issued yet another warning. The regulatory radar has firmly focused on the sector – with trends in the US pointing in a similar direction.
In effect, Belgian’s move might be a first in a movement to gradually ban OTC trading of binary options, spot forex contracts and CFDs (Contracts for differences). We have received a lot of customer questions asking how this affects Darwinex. This blog post outlines why we think it was about time that regulators stepped in, and why it validates many of the structural choices we’ve made in servicing the independent trader movement.
Why retail forex OTC is wrong …
An OTC contract allows two counterparties to trade with each other in conditions that both adhere to. It has the potential benefit that anything can be traded, provided both parties agree to it. It can work well between evenly capitalised and knowledgeable parties (e.g. UBS and GS) – although one wonders if even institutions understand the economics behind the clauses they sign.
Offer OTC trading to retail customers (e.g. remove the “equally capitalised and knowledgeable” provision), and OTC means trouble. Take, for instance, a retail broker-dealer, advertising the following bet to any novice retail trader:
- Bet on the “price of the EURUSD” as published (e.g. SET) defined by the dealer
- The retail broker-dealer and the retail trader agree to settle the differences in the price set by the dealer
- The broker-dealer throws in the bonus option of multiplying any movement in the underlying up to 500 times – which can greatly amplify the wins! (and the losses)
We know where this ends: retail investors losing their shirts. Note: the blame doesn’t only lie with the broker-dealer, he didn’t impose the 500:1 leverage choice on the trader – greed and ignorance did. Having said that, there are 2 RED flags in the above set-up:
- A retail-dealer’s business model largely is pocketing the losses greatly compromises its incentives.
- A retail-dealer sets the price of the underlying – e.g. it’s both a player betting its own capital and a referee in the same game.
Not saying that all dealers incentivise their customers to do silly things – but given how profitable the above meat grinder is, is it realistic to expect them to stop customers blow themselves up?
There you go. That’s why the Belgian ban is likely not to be the last we hear on the topic. It only took 10 years, but the good news is:
- Regulators have finally stepped in
- The alternative solution has long existed (we’ve offered it all along!)
- We’ll (Darwinex) stop feeling like fools for doing the right thing and losing out to morally loose competition
… And why retail OTC is obsolete
If you think this problem is new, think again. This has happened every time a new investment opportunity came up.
The solution has long existed. It is to create a “marketplace” – commonly referred to as “Exchange” for financial instruments. Rather than trade bilaterally (pairwise) with bespoke (OTC) conditions with each other, a new central counterparty (CCP) is created, that trades a single standardised contract acting as the middleman that anonymously connects all participants with each other. Read this to understand the difference. This levels the playing field in a way that makes it structurally impossible for anyone party to abuse the market without making itself vulnerable to arbitrage.
There is one situation in which marketplaces don’t work well: with non-standard contracts. Without critical mass in liquidity, it’s too difficult to make a marketplace work, and in that situation market makers are probably better suited than a central counterparty. This is the reason why retail forex trading started OTC: even though no asset is more plain vanilla than spot foreign exchange, 10-15 years ago 1) it wasn’t possible to trade micro-lots in the interbank market, 2) there weren’t as many retail market participants as there are today.
Fast forward to today, and the restrictions are gone. You can trade micro-lots with Goldman Sachs on a marketplace / Exchange. Betfair founded LMAX, the first MiFID compliant multilateral trading facility (MTF) for foreign exchange and CFDs. We have been with LMAX from our very beginning because a) we think it’s the right way and b) we didn’t want to be caught off-guard when regulators (finally) acted.
Why the ban doesn’t affect Darwinex, now or going forward
We have consciously chosen to:
- Align ourselves with traders by
- Operate a matched principal model. We are a pure broker that trades with customers. We gain NOTHING when customers lose.
- Offering a platform allowing traders to legally scale their strategies with investor monies – removing their structural need to over-leverage
- Offer unique technology & tools to
- Inform traders, amongst others, of the risk (Value at Risk) in their strategies
- Protect investors when markets become riskier or traders over-leverage
- Trade on Exchange – by sourcing
- All of our CFD offering from a regulated Multilateral trading facility – e.g. Darwinex CFDs are NOT OTC.
- Part of our FX flow from a regulated Multilateral trading facility – e.g. part of our FX flow is NOT OTC
Furthermore, this is the reason why we’ll soon be offering Futures trading – we’ve simply had it with the stigma condemning even the clean guys in the forex sector.
The only reason we don’t source all our FX flow from LMAX Exchange is that LMAX suffers (and will suffer) from adverse selection until the ban spreads beyond Belgium. Because it doesn’t tolerate last look by LPs, and because it allows any participant (e.g. it doesn’t ban winning traders, regardless of strategies), it has historically been less competitive on raw spread comparisons – LPs offer wider spreads to protect themselves from winning traders, who tend to concentrate with LMAX once they’re banned by retail dealers.
Put it another way: a casino admitting winners offers worse (and worsening!) odds than casinos banning winners. Being as competitive price-wise as possible, together with the need to have a backup provider, is the reason why we partially aggregate liquidity from other parties on an OTC basis. If the regulatory push to trade on Exchange goes Europe (or world) – wide, we will continue servicing customers – this time without the commercial penalty we incur for NOT pocketing their losses.
In other words: rest assured that once this healthy regulatory movement comes full circle, both the independent trader movement and Darwinex will benefit even more from being structurally aligned for profit exchange. Please do not hesitate to highlight points that warrant further clarification – as this post will likely attract long term readership 🙂