ESMA Regulations – What Will Less Leverage Mean?

Adam Lemon

The European Union has published new regulations applying to retail Forex, CFD, and the few remaining binary options brokerages in its territory. If you have an account with one such brokerage, the regulations will affect you when they come into force during the late spring and summer. This article will outline how the new regulations will impact your bottom line.

Details of the New ESMA Regulations

In March 2018, the European Securities and Markets Authority (ESMA), the financial regulator and supervisor of the European Union, announced new regulations concerning the provision of contracts for differences (CFDs) and binary options to retail investors. It is unclear exactly when the regulations will come into force, but some time in May or June 2018 looks to be the most likely date, and Forex and CFD brokerages located within the European Union (including the United Kingdom, for the time being) will be forced to comply. The regulations will need to be renewed by ESMA every three months to remain in force over the long term.

The regulation concerning binary options is very simple: they may not be sold. In simple terms, this is the end of binary options as a product sold from within the European Union.

The regulations concerning CFDs are more complex but still relatively straightforward. Firstly, there is some confusion as to what exactly is a CFD, with many traders thinking that spot Forex is not considered a CFD and will therefore be exempt from the new regulations. They are wrong: spot Forex is technically defined as a CFD. In fact, every asset you see available for trading at Forex / CFD brokers will most likely be subject to the new regulations.

The new regulations will implement the following changes for retail client accounts (more on who is a “retail client” later).

  • The maximum leverage which can be offered will be 30 to 1. That will apply to major currency pairs such as EUR/USD, GBP/USD, USD/JPY, etc.

  • Other currency pairs, major equity indices, and gold will be subject to a maximum leverage of 20 to 1.

  • Individual equities cannot be offered with leverage greater than 5 to 1.

  • Cryptocurrencies are subject to a maximum leverage of 2 to 1.

  • Brokers will be required to provide negative balance protection, meaning it will be impossible to lose more money than you deposit.

  • Brokers will be required to close a client’s open positions when the account equity reaches 50% of the required minimum margin by all open positions. This “margin call” provision can be tricky to understand, so will be explained in more detail later.

  • Bonuses or any other form of trading incentives may not be offered.

  • Brokers will be required to display a standardized risk warning which will include the percentage of their clients who lose money over a defined period.

Understanding the “Margin Call” Regulation

ESMA RegulationsThe best way to understand the 50% margin call provision is to use an example. Imagine a client opens an account with a Forex broker, depositing €100 in total. The client opens a short trade in EUR/USD, by going short one mini-lot (one tenth of a full lot). One full lot of EUR/USD is worth €10,000, meaning one mini-lot is worth €1,000. To find out the minimum margin required to support that trade, we divide the size of the trade (€1,000) by 30, which comes to €33.33. This is the minimum required margin to maintain the trade. Half of that amount is €16.67. Now assume the trade goes against the client, with the price of EUR/USD rising above the entry price. As soon as the price rises far enough to produce a floating loss of €83.33 (€100 - €16.67), the broker must close the trade out, even if the trade has no stop loss or has not yet reached the stop loss. In theory, this means that a client’s account can never reach zero. Examples involving multiple open trades will be more complex, but will operate according to the same principles.

What Will This Mean for Traders?

The regulations will only apply to “retail clients”, so you might try to apply to be classed as a professional trader. To get a broker to classify you as anything other than a retail client, you will have to show you have financial qualifications, a large amount of liquid assets, plenty of experience trading, and usually that you also trade frequently. Most traders will be unable to qualify, although it is worth noting that one London-based brokerage, IG Group, has stated that their proportion of clients now classified as “professional” has recently increased from 5% to 15% of their total customers.

The major impact these regulations will have on traders is simple – the maximum trade size they can possibly make at brokers regulated in the European Union will shrink. Many will say that the maximum leverage limits still offer far more than any trader could need, and I agree. I am wary of leverage and I hate to see anyone using leverage greater than 3 to 1 for Forex under any conditions, or any leverage at all for stocks and cryptocurrencies. Commodities can also fluctuate wildly in value. Too many people forget that the biggest danger in leverage is not overly large position sizing, it is that a “black swan” event such as the CHF flash crash of 2015 could happen and wipe out your account through huge price slippage. However, there is another factor that is widely forgotten: why assume that a trader’s account at one Forex broker is all the money they have in the world? For example, a trader might have $10,000 in the bank. If they deposit $1,000 at a broker offering maximum leverage of 300 to 1, they can trade up to $300,000. At a leverage limit of 30 to 1, that trader will have to deposit their entire $10,000 fund to trade at the same size. In a real sense, that trader might now have to take on more risk to operate in the same way, because if the broker goes bust, while beforehand they might lose $1,000 now they could lose $10,000! Even without negative balance protection, that broker would still have to come after them to try to get an extra $9,000 which they theoretically risk. Yet we saw after the CHF crash that brokers don’t come after every single client whose losses exceeded their deposit, due to legal costs and reputational issues. This shows that although the stated purpose of the regulation is to protect traders from excessive losses, the story is not as simple as you may think.

Beyond having to deposit more margin, and automatic margin calls, the other major change for traders will be that they will enjoy negative balance protection. This is a positive development which hopefully will make brokerages focus more heavily on the risks they are taking with their business model in the market. At the same time, a possible side effect of the new regulation is the potential increase in average deposits, leading to brokerages being more stable and better capitalized with client funds. Two final notes: brokerages will have to report on their websites the percentages of clients who are losing and making money, although the period over which the statistics must refer to is currently not clear. This will help to shed light on the debate over what percentage of retail traders are profitable, although some brokerages have already released what they claim to be accurate statistics showing that clients with larger account sizes tend to perform better as traders. Additionally, bonuses and promotions will be banned. I welcome this, as not only do they trivialize the serious business of trading, they are almost always a trick offering the illusion of free money whilst preventing traders from withdrawing any profits until a large number of trades are made (read the fine print the next time you see a broker offering a “bonus”).

What If You’re Not Happy Remaining in the EU?

Traders with accounts at affected brokers who cannot obtain professional status classification and feel they really need higher leverage than the ESMA limits outlined above might look for a solution by opening accounts with brokers outside the European Union. The most obvious destination would be Australia or New Zealand, where it will still be possible to find reasonably well-regulated Forex brokerages offering leverage in the range of 400 to 1. A recent development that is not talked about much is the growing difficulty of transferring funds to and from Forex brokerages in less tightly regulated jurisdictions. You might decide to open an account with a brokerage in Vanuatu, but you may find that a bank within the European Union might just refuse to send your money there for a deposit. This means that going far offshore, depending upon where you live, may not be a feasible option. In any case, the new regulations shouldn’t be impossible to live with, and overall there is a compelling case that they are a net benefit to any trader, so why migrate?

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.
Learn more from Adam in his free lessons at FX Academy

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