FCA’s CFD and spread betting consultation

In December 2016, the FCA signalled its intention to consult upon potential rule changes to the way the . While these markets are not used by a very significant proportion of retail clients, the proposed changes are important because they impact upon a couple of the central tenets of both contract law and appropriate regulation.

By way of background, CFDs and spread bets are almost the same product. They vary only slightly in practice. In simple terms, spread betting is undertaken by individuals, since they may legally enter into a gambling contract. Limited companies, trusts etc. cannot enter a gambling contract so they instead would be party to a CFD. Both products essentially give the retail client the ability to speculate upon the direction that a market will move.

Spread betting and spreading regulations

CFDs and spread bets both offer gearing and it is this leverage that concerns the regulator. In making a spreadbet, the retail client only has to make three decisions. Firstly, which market to bet on. Secondly, which way the market will move, and, lastly what stake to speculate with. So, in this context, it is hardly rocket science. Leaving out the choice of market (since it is difficult to regulate for human nature manifesting itself in people wishing to speculate on markets they may be entirely unfamiliar with), the key issues are choosing the stake and direction. Markets can only do three things; move up, down or remain the same. In this regard, flipping a coin should, on average, see you choose a profitable trade 50% of the time. In actual fact, the spread charged by the provider will make this slightly more difficult and reduce your chances of success to something like 49.5%, but for this discussion I will stick with a 50% expectation.

Investing in general, it should be remembered, can be quite tricky. Traditional investing involves (or at least should involve) considerable research before choosing a suitable company share to buy. You then also have to decide how much to invest in those shares. The difference here is that you will only profit when the share increases in value. You do not have the option of shorting the stock and profiting from a price fall. CFDs and spread bets therefore have an advantage to an investor in that they have extra functionality. It is also the fact that spread bets have the added advantage of being outside the scope of tax, both income and capital gains, and do not attract stamp duty.

All in all, spread bets have quite an advantage over traditional “long only” equity investments. So why does the FCA have concerns? Well, firstly, it seems to be because of the losses retail clients seem to have incurred. Given that a random approach, as outlined above, should give an investor a 50% chance of success, why do the FCA see average losses within retail clients at 80%? Such a discrepancy makes strange reading. Such losses seem to indicate that the retail clients seem to make unhealthy choices in deciding upon their “long or short” position. As always, education is a very important factor. All wealth managers will tell you that they only make investments after carefully researching, in detail, the prospects of their chosen investment. Respectable CFD and spread bet providers, who are very much in the majority, offer comprehensive training and education resources of the kind only dreamed of 10 years ago, so this education is there and is growing to counter this weakness.

So, what is at the heart of the FCA’s concern?

It seems that this is the leverage offered to clients by the spread bet provider. The product works by way of gearing. In effect, this means that the client only needs to hold cash on their account that represents a percentage of the real exposure. Typically, to place a spread bet on an equity you would only need to post 10 -20% of the full capital value, with the spread bet provider essentially providing the bulk of the funds. Importantly though, you would also need to ensure you had enough money to cover any running losses. This all seems clear but the FCA have concerns that the clients do not appreciate this and often get closed out early thereby incurring losses. The consultation paper therefore proposes to limit the leverage available to retail clients. This is most concerning.

Given the functionality of spread betting, it is well established within the investment pantheon. It is used extensively by serious investors, specifically for its leverage. The question has to be asked whether a well-educated, experienced, adequately capitalised retail investor, trading with a FCA regulated spread bet counterparty should have an arbitrary maximum leverage level imposed by an external party? This causes grave concerns. If two parties both knowingly accept the contractual arrangement, surely it is not necessary to impose restrictions upon them? Does the concept of contract privity not apply?

Less protection likely, not more, for many investors

It is the case that in these circumstances, if the proposed rules are enacted later in 2017, experienced retail clients may well choose to “elect up” to professional status and avoid these restrictions, just to continue trading with any degree of normality. This however would remove the Financial Services Compensation Scheme protections afforded to retail clients. Is that really what the continued development of regulatory rules is meant to achieve?

For further information please contact Gary Dixon at FCA & regulatory compliance consultants Momentum GRC.