Articles on retail brokerage regulations often discuss how complicated and fraught the space can be. Perhaps it’s a testament to the maturity of the retail FX/CFD industry that this isn’t really the case any longer. In fact, if there is a trend to be observed, it’s that regulators are starting to converge on a common set of rules and requirements. In the following article, we’ll review the current regulatory landscape from the perspective of a newcomer as well as providing context with some history. We’ll also offer some insights that we’ve gleaned over the years as a technology provider in the space. We’ll start by providing a general overview of the different regulatory regimes. To keep things simple, we’ve divided the space into three broad categories (strict, moderate and loose).
Strict Jurisdictions: Japan and the USA
While being two of the biggest markets in the world for online trading, Japan and the USA are also considered two of the hardest for foreign CFD brokers to break into. This is due to a combination of factors, including but not limited to: prohibitive capitalisation requirements that run into the tens of millions of dollars, high operational costs and very strict reporting requirements.
Japan boasts one of the most highly developed retail trading markets in the world. So much so that it has been dubbed the Mrs Watanabe effect, referring to the phenomenon of Japanese retail traders actually affecting the currency markets with their trading volumes. These savvy retail investors were driven to FX trading by record low interest rates in the country’s banking system following decades of unconventional monetary policy by the Bank of Japan (BoJ). The Japanese market boasts a diversity of local brokerages but is dominated by a couple of big players.
As far as the United States goes, it has always been much more of a stock trading nation. The US stock market and its performance is a source of great national pride and one of the most highly prized metrics of economic health in the minds of many Americans. Factor in the US dollar’s reserve currency status and you can see why currencies aren’t a massive concern for most US retail traders.
Contracts for difference are not permitted in the United States. Nevertheless, the country’s sheer size and the affluence of its citizenry have made it a highly desirable market for FX brokers offering access to OTC currency markets. The last decade or so has seen a great consolidation of retail FX brokers. The industry has gone from 52 firms in 2007 to just a handful main players today.
Moderate Jurisdictions: Europe and Australia
Europe is another one of the world’s largest online trading markets, within Europe itself the United Kingdom is the nation with the highest number of active traders. Europe’s CFD brokers fall under the European Securities and Markets Agency (ESMA), which sets the standards and influences the best practices of the national regulatory bodies of individual EU member states.
Australia is a younger player in the retail CFD market. CFDs first appeared in Australia in 2002 when CMC Markets (followed by IG), started developing a presence in the region. By 2016 there were 65 firms offering CFDs in Australia.
Australia’s financial regulator is the Australian Securities and Investment Commission (ASIC). In recent years it has seen an influx of brokers seeking an Australian Financial Services license (AFS) due to tightening regulations in Europe, as well as the opportunity to attract new customers from the APAC region. However, as we will see below, ASIC is taking steps to bring its own regulations in line with those of ESMA, thus closing the door for regulatory arbitrage.
These regulatory regimes are moderate when compared to those of the US and Japan. They feature lower capitalisation requirements dependent on the regulatory categorisation of the broker (under €1 million in the UK and EU, $1 million AUD in the case of Australia), lower operating costs and less stringent reporting requirements.
Within Europe, Cyprus has been a particularly attractive location for CFD brokers due to its competitive corporate tax rates, experienced workforce, as well as the relative ease and cost effectiveness of registering a company and obtaining a license, which can then be passported into the rest of Europe. These strategic advantages have led to it having issued hundreds of licences to retail CFD brokerages. The country’s regulator, the Cyprus Securities and Exchange Commission (CySEC) recently attempted to push back on tightening EU regulations by proposing more flexible leverage limitations that would allow experienced and better capitalised traders to access higher leverage than the 30:1 ESMA cap. It has since abandoned this proposal, which testifies to the fact that regulatory practices are indeed becoming aligned.
Loose Jurisdictions: Bahamas, Belize, British Virgin Islands, Mauritius, Seychelles, Vanuatu
The countries in this last group are regarded as soft regulatory environments with even lower capitalisation limits, much more relaxed reporting requirements and other tax incentives. Add to this low operational costs and ease of setting up banking relationships and you can see why these traditional tax havens are now also very attractive to would-be brokers. They provide the benefits of being licensed by a regulatory authority (e.g. the Securities Commission of the Bahamas (SCB), the International Financial Services Commission (IFSC) in Belize, the British Virgin Islands Financial Services Commission (BVIFSC) in the BVI, or the Vanuatu Financial Services Commission (VFSC) in Vanuatu) without the regulatory impediments of a more stringent jurisdiction, or even the need for a physical presence within the country in some cases.
Many online brokers whose business models depend on practices that are now being phased-out in Europe (aggressive marketing, bonus incentives, high leverage) see these jurisdictions as a viable alternative. In fact, one of the trends we’ve observed has been for new brokers to start out in loose jurisdictions and then move up the ladder, so to speak, to more reputable regulatory environments once their businesses are turning a profit. This option, of course, comes with the downside of having to completely overhaul your business model and reporting infrastructure in order to comply with the regulatory practices in the stricter jurisdictions.
Regulatory trends to be aware of
With most CFD brokers opting out of the US and Japanese markets, the moderate jurisdictions have gained prominence in the last decade or so. As we have already mentioned in the introduction, these jurisdictions are currently in the process of adopting a common set of requirements that discourage regulatory arbitrage and move to protect investors from some of the former excesses of the industry (500:1 leverage, free money bonuses, high pressure sales tactics).
Recent documents from Australian regulators have revealed that they are now considering the implementation of CFD restrictions which would bring them closely in line with the restrictions implemented by ESMA in Europe in 2019.
ASIC’s own Product Intervention: OTC binary options and CFDs consultation paper, outlines a strikingly similar proposal to that of ESMA. As you can see below, the only expected difference is that ASIC will classify major and minor FX pairs under the same 20:1 leverage limit, which also applies to gold, as well as combining major and minor indices into the same 10:1 maximum leverage ratio category.
Other common strands between ESMA and the proposed ASIC restrictions include outright banning of binary options trading for retail investors, negative balance protection for all clients and the prevention of margin on client positions from falling below 50%. Similarly, ASIC have also proposed the ban trading inducements such as bonuses and require brokers to clearly display the percentage of losing traders in their marketing materials, both of which ESMA introduced in 2019.
What’s more, the above leverage restrictions are in line with what regulators in other parts of the world are also doing. Japan’s maximum available leverage on CFDs is currently set at 25:1, with a proposal currently being discussed to reduce this to 10:1. Similarly, Singapore and Hong Kong also implement a 20:1 leverage cap and for South Korea it’s currently 10:1.
Technology vs Marketing?
In finance, the relationship between regulators and brokers is often described as a game of cat and mouse. The latter, driven by profit, want to push the boundaries of what’s permitted, always finding novel loopholes to explore. Meanwhile the former, driven by a desire to protect investors, want to slow things down and make them safer for everyone.
As a technology provider, our perspective is somewhat different. Technology is largely agnostic to the regulatory concerns discussed throughout this article. As such it is harnessed by both those attempting to push the boundaries and those wishing to firm them up. When brokers operate fast and loose, before regulators have even been alerted of the need for their presence, technology can be used to further the type of excesses that we have already mentioned above.
Likewise, in a mature market, where an industry is legitimised by regulation and where consumer protections become paramount, technology plays a central role in how brokers optimise their operations under new regimes. It helps them to achieve transparency, while also allowing them to remain flexible to potential changes in both reporting requirements and possible business models.
On the client-facing side, this means low latency platforms and data feeds that provide accurate, to the minute pricing by aggregating rates from multiple liquidity providers into a single executable stream. On the dealing side this involves technologies that allow brokers to simultaneously run multiple business models, profile traders and assign them to the appropriate category based on their risk profile. On the reporting side, this means having the technology in place that allows the above systems to communicate seamlessly with each other, allowing brokers to easily generate reports tailored to the requirements of each regulator they’re working with. Additionally, all of these technologies should be flexible to both changes in the industry (new products, business models) as well as changing reporting requirements on the regulatory side.
This is the phase that we believe the online CFD trading industry is currently entering. Today, what a broker says about their operations via their marketing channels is a lot less important than the technology that they’re actually running. In the past it was enough to focus on converting leads while leaving their technological infrastructure as an afterthought. We believe the days of that approach are numbered, particularly in the moderate jurisdictions outlined above, which are a substantial part of the overall market.
If the trends in the stricter regulatory jurisdictions are anything to go by, a highly regulated market radically increases the cost of compliance while simultaneously decreasing the possibility of easy revenues from unregulated activities. This necessarily leads to consolidation into fewer big players.
In such an environment the fittest firms are those that can drastically optimise the efficiency of their business models and reporting infrastructures, while harmonizing both with the requirements of their regulators and liquidity providers.
In other words, it’s the technology behind the trading platforms, the market data infrastructures, the risk-management, connectivity, reporting and customer data architectures that will give tomorrow’s brokers a vital edge in an ever more competitive market.