IOSCO proposes measures to protect Retail Investors
27 February 2018, Bachir El Nakib (CAMS) Senior Consultant Compliance Alert LLC
The International Organization of Securities Commissions (IOSCO) is consulting [consulting] CR01/2018 dated February 2018 “Report on Retail OTC Leveraged Products”
on potential policy measures aimed at protecting retail investors in over-the-counter (OTC) leveraged products such as contracts-for-difference (CFDs) and binary options.
IOSCO's proposals follow recent moves by a number of regulators, including the European Securities and Markets Authority (ESMA), to strengthen protections for retail customers of such products.
Categories of products covered
The following categories of OTC leveraged products are covered by IOSCO's proposals:
- Rolling-spot forex contracts — these are described by IOSCO as contracts where the pay-out is based on the fluctuation of foreign exchange rates and the initial maturity of two business days is automatically extended (by one business day at a time) if the contract is still open by the end of trading on the second business day.
- CFDs — these are described as contracts where the pay-out is based on the fluctuation of any of a variety of underlying financial rates and prices and which stay open until closed by one of the parties.
- Binary options — IOSCO describes these as contracts where the pay-out, based on any of a variety of underlying financial rates and prices, depends entirely on the outcome of a yes/no proposition (typically whether the price of the underlying will raise or fall below a specified level), and is either zero or a fixed amount or a specified percentage of the price (amount invested) of the option.
The proposals relate to the offer and sale by intermediaries of such products to retail investors. IOSCO notes that typically such products are offered through online platforms and are sold without investment advice being provided.
In a report on retail OTC leveraged products, published in December 2016, IOSCO highlighted supervisory concerns and challenges presented by the sector. The report detailed potential risks to investors as well as examples of misconduct by licensed firms.
IOSCO notes that a significant proportion of firms offer services on a cross-border basis.
Among the risks of OTC leveraged products identified by IOSCO are:
- Distribution risks — the number of market intermediaries offering such products has increased in a number of IOSCO member jurisdictions and there is evidence that a wider market is being targeted. Concerns relating to this trend include that firms may adopt aggressive marketing methods to attract new customers, that they might adopt a business model that relied on churning a high volume of inexperienced customers, and that firms might use incentives such as bonuses to attract customers which put them at risk of suffering higher losses than they might otherwise have assumed.
- Risks resulting from certain product features —there is evidence of an increase in the level of leverage being offered by firms in recent years. Among the concerns this gives rise to are that high levels of leverage expose clients to a high probability and high value losses which could exceed their deposited funds.
- Conflicts of interest —there are concerns about the inherent conflict of interest that arises from the fact that firms offering such products sometimes act as the counterparty to the client's trade. Potential conflicts arising from the lack of transparency in the pricing of such products is also flagged.
- Unlicensed entities — there is evidence of an increase in the number of unlicensed firms offering such products illegally.
Proposed policy measures
IOSCO sets out nine measures, some of which have already been adopted by member jurisdictions, which it suggests member jurisdictions might consider when determining their approach to address the various risks posed by such products. It provides examples of the application of the measures in member jurisdictions who have already taken action as well as guidance on applying each measure.
- Measure 1: Requirement for firms offering OTC leverage products to retail investors to be licensed. It is acknowledged that this measure, which seeks to ensure that firms are subject to regulatory oversight regardless of where their client is located, already exists in most member jurisdictions. IOSCO notes that in order to help provide a consistent level of investor protection, jurisdictions would need to characterise OTC leveraged products as financial instruments.
- Measure 2: Requirement for firms to incorporate a prescribed minimum margin requirement for retail investors. Under this measure, market intermediaries would be required to apply minimum margin requirements when transacting in CFDs or rolling spot forex contracts. It might be considered applying the measure so that it requires a certain level of margin to be maintained to support a position over the course of a trade.
- Measure 3: Negative balance protection. In order to protect retail clients from excessive losses, this measure would require intermediaries to limit clients' loses in CFDs and rolling spot forex contracts to their deposited funds or their funds invested for each trade.
- Measure 4: Prescribed disclosures setting out the total costs of the product. Under this measure, market intermediaries would have to provide a standardised disclosure before a product was sold clearly setting out the total costs and charges that will be applied by intermediaries relating to the product.
- Measure 5: Disclosure of investor profit and loss ratios. In order to ensure that firms offering such products adequately describe the levels of risk, this measure would require market intermediaries to disclose to clients the percentage of client accounts that made a net profit or loss during an identified period of trading activity. It is noted that in applying such a measure it might be necessary for the regulatory body to provide specific instructions to firms on calculating the profit-loss ratio.
- Measure 6: Adoption of a fair pricing methodology and use of externally verifiable price sources. Under this measure, market intermediaries would be required to demonstrate a clear pricing methodology and use independent and externally verifiable price sources and liquidity providers as the basis for their prices.
- Measure 7: Enhanced disclosures about order execution quality. In order to increase transparency around order execution, this measure would require market intermediaries to provide clear and effective disclosures to clients about how their orders are executed.
- Measure 8: A ban or restrictions on certain forms of marketing and sales techniques for such products. Under this measure, restrictions would be placed on certain forms of marketing or sales techniques such as unsolicited promotions or cold calling.
- Measure 9: A ban or restriction on the sale and/or distribution of such products by intermediaries. Where the other suggested measures might be insufficient in mitigating the investor protection risks arising, it is suggested that a ban or restriction on the sale or distribution of such products to retail investors be considered. This measure might be considered particularly relevant to binary options since, according to IOSCO, their product features might mean that some of the suggested measures would have little or no impact in addressing the risks posed.
The deadline for submitting comments on the measures suggested by IOSCO is March 27, 2018.
The proposals form one part of three complementary workstreams being undertaken by IOSCO aimed at addressing investor protection concerns. The other two concern developing a toolkit of investor education material with guidance and developing a toolkit of enforcement approaches and practices to address and mitigate the risks posed by unlicensed firms.