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What the New ESMA Regulations Mean for You

What the New ESMA Regulations Mean for You

 

As a trader you are, of course, an independent and intelligent individual, so you will no doubt want to read the proposal for yourself. You can do exactly that right here.

 

The European Securities and Markets Authority (ESMA) is, like any regulatory body, keen to justify its existence. That means that it needs to find new things to point at and regulate. It also means that it often ends up throwing out the baby with the bath water.

 

The European Securities and Markets Authority has the bit between its teeth and when it comes to regulating the way retail traders access the markets it seems like ESMA is determined to put the reins on a sometimes unruly industry.

 

Financial markets do need regulation of course, and there are a number of welcome ideas in this proposal, including restricting the ever-loathed Binary Option.

Binary Options Ban

 

The new ESMA proposals target both Binary Options and CFDs. There aren’t many experienced traders who would disagree with their proposal to prohibit the marketing, distribution or sale of Binary Options to retail traders. As ESMA rightly point out, the mathematics of Binary Options leaves an inherent ‘negative expectation’ for the trader. In other words they have more in common with a casino game like roulette where “the house always wins” than with a true trading product. This is why they are only offered by market making brokers - you are trading against them, and they know that over time they will inevitably come out on top.

 

The proposals to restrict incentivisations to trade will also help to prevent Binary Option firms from suckering unsuspecting newbie traders with unobtainable bonuses that mean their money ends up locked up with no hope of withdrawal.

 

CFDs - NOT the Same as Binary Options!

 

ESMA do recognise that CFDs are not as bad as Binary Options. But that does seem to be their attitude, that they are ‘not as bad’. We would contest that where the Binary Option is a terrible product, CFDs are a fantastic product. The fact that many traders ultimately lose money with CFDs does not make them a bad product, it makes them bad traders.

 

To their credit, the authors of the report recognise that CFDs are a far more nuanced product. As everyone knows, the majority of retail traders lose money, but very few would suggest that there is an inherent bias against the trader that makes it mathematically impossible to make money over time a la Binary Options.

 

We have spoken to enough consistently profitable traders here at Two Blokes Trading to know that trading is a skill. As such, prohibiting retail traders from accessing CFDs would be unjust and as wee bit nanny-stateish .

 

Some of the proposals here are to limit some aspects of CFD marketing, but mostly the proposals are aimed at the peripheral structures around CFDs i.e. leverage, negative balances, margin calls etc.This is more proportionate and measured than an outright ban, for which we are grateful, but we believe they do still go a bit too far.

 

Overdue Positives

 

There are some good things here. For instance, they propose measures that will effectively mean that you can no longer “lose more than your deposit”. The idea that you could end up owing a broker money if there is a large and completely unpredictable move in the market has always seemed slightly unjust.

 

If the broker’s margin requirement was too low because the move was entirely unforeseeable then how can it be fair that they pass that extra loss on to you? And given that it is often market making brokers (who don’t even fully hedge) there may not even actually be a loss for them - they are just after more profit!

 

There are already brokers that offer this ‘negative balance protection’ as a matter of routine - such as our partner broker XTB - but the fact that it will become an industry standard is a positive move.

 

Unforeseen Consequences

 

Despite there being some positives to the proposals there are one or two negatives that we simply can’t get our head around. Primarily we are talking about the proposed restrictions on leverage.

 

One of the great bugbears of regulators when it comes to retail traders has always been the easy access to leverage. The idea that you can trade with some brokers at 500:1 or even 1000:1 leverage has always made them twitchy. This is is justified to some extent - a 0.1% margin requirement is ridiculous!

 

But, the proposals go too far. They are talking about limiting leverage to 30:1 for major currency pairs, all the way down to 5:1 for individual equities. This is a massive change.

 

Limiting leverage to these levels may seem like it will save traders money - if you can only have an exposure that is 5 times the size of your cash then you will lose money at 5% the speed you would if you had 100 times leverage, right?

 

But this argument completely fails to understand retail trader mentality and the way losing traders operate.

 

If you limit the trader’s leverage all you are going to do is slow down the rate at which they lose money. But the majority of losing traders will still blow up their account. Maybe they will lose all their money more slowly, but still lose it all they shall. If you restrict leverage you are going to force that trader to deposit more money in order to gain the same exposure...

 

THIS MEANS THAT THEY WILL END UP LOSING MORE MONEY

 

If you only have access to 5:1 leverage you will need to deposit 20 times as much money in order to gain the same trading exposure as you would if you had 100:1 leverage. And losing traders (i.e. gamblers) want the chance to win big - that is why they trade! Limiting leverage will just require them to make bigger deposits.

 

Even if they lose their money more slowly, if they have to deposit 10 or 20 times as much money then, when they inevitably blow up their entire trading account, they will just lose more money than they otherwise would have done!

 

It staggers me that ESMA have failed to grasp this fundamental truth.

 

The Stats

 

IG Index have put together some statistics. Their figures suggest that where you currently have to put down a margin deposit of $611 to trade one lot of EUR/USD, after the regulations you would need margin of $4073! That is massive.

 

Furthermore, given that many, many retail traders use short positions in equity CFDs in order to hedge their shares portfolios the new 5:1 leverage limit will effectively price them out of their risk management activity - how is that going to help them?

 

As with much of the work of the regulators, their efforts to keep the retail trader safe have unintended consequences. One of these is to make potentially lucrative trading products out of reach for the normal guy and only accessible to the professionals. We don’t believe that it is the job of the regulator to stand in the way of the “little guy’s” freedoms. And worse, in their efforts to protect uninitiated traders from predatory brokers, their leverage limits will almost certainly lead to greater losses because these exact clients will end up depositing more money!

Credit Where Credit is Due

 

There is a lot of good in this ESMA proposal, and Two Blokes Trading certainly welcomes negative balance protection and of course anything that stops the unethical shenanigans of the Binary Options peddlers. But some of the proposals go too far and may have unintended negative consequences.

 

To their credit, ESMA are willing to listen. They have set up a dedicated page for feedback, so if you do wish to make your voice heard then go to this page and leave your thoughts, whatever they may be.

 

CFD trading and Spread Betting are here to stay. Even with these changes, financial markets trading will still represent one of the best ways to achieve financial freedom or top up with a second income. Regardless of the outcome of the ESMA proposals we hope you will continue to listen and learn with us at Two Blokes Trading for a long time to come.

 

Happy trading

 

The Blokes

 

Two Blokes Trading

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