Topic Consumer protection General Administrative Act regarding CFDs
Announcement of the General Administrative Act of the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) pursuant to section 4b (1) of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG) regarding contracts for differences ("CFDs") under section 41 (3) and (4) of the German Administrative Procedure Act (Verwaltungsverfahrensgesetz – VwVfG) in conjunction with section 17 (2) of the German Act Establishing the Federal Financial Supervisory Authority (Finanzdienstleistungsaufsichtsgesetz – FinDAG) as well as announcement under section 4b (4) of the WpHG
Dear Sir or Madam,
BaFin issues the following
General Administrative Act:
- I order the limitation of the marketing, distribution and sale of financial contracts for difference ("CFDs") within the meaning of section 2 (2) no. 3 of the WpHG. The marketing, distribution and sale of CFDs to retail clients within the meaning of section 31a (3) of the WpHG shall be prohibited insofar as they may give rise to an additional payments obligation. This limitation is to be implemented by 10 August 2017.
- The General Administrative Act shall be deemed announced on the day following the public announcement.
- I reserve the right to revoke this General Administrative Act at any time.
I. CFD fundamentals
Financial contracts for difference are arrangements between two parties who speculate on the price performance of a certain underlying asset. CFDs are used for short-term speculation and are offered over the counter. They are leveraged contracts characterised by a high risk of loss for the investor. In the case of the CFDs affected by this measure, the client's risk of loss is not limited to a particular margin payment but instead may encompass the entirety of the client's assets. If the client's loss exceeds the balance on their account for the purpose of CFD trading, they must pay for the loss from their other assets (additional payments obligation). The CFD providers who are the retail investor’s contractual partner take on the risk inherent in the CFD into their books and so act as a market maker, or hedge against that risk by transferring it to other market players.
CFDs were developed in the 1990s in investment banking in order to bypass stamp duty to be paid in the United Kingdom when trading in shares at the London Stock Exchange. They enable retail investors to use a relatively small margin (deposit) to speculate on the performance of currency pairs, shares, indices, commodities, bonds and other underlying assets without having to invest in the underlying asset directly. In a CFD transaction, no underlying assets are therefore ever purchased or traded by the investor. By opening a share CFD position, the retail client never participates directly in financing a company through the capital market.
In CFDs, the contractual partners agree to settle the difference between the price of an underlying asset at two different points in time (t and t+n). The result of the speculation is calculated as the difference between the opening and closing price of the underlying asset. For example, if an investor speculates on the price of a share going up, a CFD provider, who acts as the contractual party in this CFD and does not hedge against market risk, speculates on the price of the share going down. When the price of the underlying asset changes, the corresponding price gains or losses are mirrored by the CFD. If the difference is positive, the retail investor is paid the difference amount by the CFD provider; if, however, the difference is negative, it is the investor who must pay the difference to the CFD provider.
The retail investor opens a CFD position in order to speculate on the performance of the price of Share A. The CFD position is 4,000 Shares A at EUR 10 each, totalling EUR 40,000. The CFD provider offers the retail investor a leverage of 20. This means that the margin required for the entire position is EUR 2,000 (or 5% of the entire position). The effects of the changes in value of the underlying asset on the profit/loss from the CFD are as follows:
Effects of the changes in value of the underlying asset on the profit/loss from the CFD
The price of the underlying asset when opening the CFD position (opening price) and when closing the CFD position (closing price) determines the amount of the difference due. The opening and closing of a CFD position is based on prices determined by the CFD provider. The customer thus speculates on the development of prices that are determined and set by the CFD provider. These prices may generally mirror the available market prices such as stock market prices or underlying asset prices available on reference markets. However, CFD providers have scope for discretion in determining the price difference that is contractually due and may therefore set the relevant price at their own discretion in compliance with the opening clauses agreed with the retail investor, e.g. in the event of particularly high volatility of the underlying asset or in the case of market turbulence.
In addition, a phenomenon called "price gap" frequently occurs when the price is determined. A price gap occurs when the price of the underlying asset as determined by the CFD provider for the retail investor abruptly "jumps" to a different level. Such price jumps may follow the publication of economic data or significant economic events that lead to major price fluctuation of the underlying asset. If a price gap occurs when the price of the underlying asset develops in a way that is unfavourable to the retail investor, they may not always have the opportunity to close their open CFD position between the two price levels in order to minimise their losses. Instead, they are only able to close their CFD position at the next price as determined by the provider. This price, though, may differ significantly from the previous one.
The key characteristic of CFDs is their leverage. If a retail investor opens a CFD position, they do not need to have enough balance on their trading account with the CFD provider to equal the current price of the underlying asset of the CFD position. Rather, CFD providers only require the retail investor to put down a small fraction of the price of the underlying asset on their trading account (what is known as a "margin"). The investor can thus speculate with a larger amount (mathematical value of the corresponding position in underlyings) than they have actually put down as margin. The mathematical value of the corresponding position in underlyings can even exceed the value of the investor's total existing assets. Such an arrangement enables the investor to participate in the price changes of the underlying asset (both upwards and downwards) to a disproportionate extent. For every open CFD position, the retail investor must put down a margin that is calculated as a percentage of the price of the underlying asset. If the margin on an underlying asset is 1%, the retail investor can open a CFD position whose underlying asset may be worth 100 times more than the margin. The margin amount is determined in detail for every underlying asset by the CFD provider. Since the value of the underlying asset varies depending on its price performance, the amount to be maintained as margin on the CFD account does not remain constant but instead fluctuates in line with the price performance of the underlying asset. If, as a result of the price performance of the underlying asset, the amount paid into the trading account is utilised in full by the amount to be maintained as margin, the investor can deposit more money on their trading account; otherwise, the CFD position will be forcibly closed by the provider.
The investor therefore does not have to have the entire contract amount on their CFD account when opening a CFD position. Instead, the CFD provider accepts the investor putting down only a fraction of this amount. In this way, the retail investor's willingness to speculate is purposefully encouraged.
The amount of the margin held for the CFD position in a certain underlying asset plays a key role in determining how high the leverage is with which the retail investor can participate in the price developments of the underlying asset. The lower the margin that the retail investor has on their CFD account as compared with the value of the underlying asset, the higher the leverage. The smaller the fraction of the underlying asset held as margin, the higher impact both positive and negative price changes of the underlying asset of the CFD have as compared with the retail investor's margin.
If the price of the underlying asset of a CFD shows significant fluctuation within short periods of time (high volatility) and if the CFD provider requires a minimum margin for that underlying asset that is similar to the fluctuation range of the underlying asset, the retail investor has the opportunity to quickly multiply the margin. The drawback of leverage, however, is that there is a corresponding risk of the retail investor's losses reaching levels many times the amount of the margin. If, for instance, the price moves significantly in a direction that is unfavourable to the retail investor, the difference between the opening and closing price they have to pay may be many times the amount they have as margin on their account.
If the margin held on the client's CFD trading account is insufficient to pay for the losses incurred, the client must pay for the losses using their other assets (additional payments obligation).
It must be noted that the leverage produces a particular scaling impact in connection with the potential extent of the additional payments obligation. This is because the leverage increases the potential loss in proportion to the margin put down. In certain cases, this loss can exceed the margin held on the client's trading account. The higher the CFD's leverage, the higher the potential loss and the higher the probability that the margin held on the client's trading account will not be sufficient to pay for the losses incurred, which means that the client will be obliged to make additional payments.
In principle, CFDs have no length limit. However, this only applies as long as the retail investor fulfils the minimum margin requirements set by the individual CFD provider. If the retail investor's balance (margin plus freely capital on the CFD account) is no longer sufficient to fulfil the margin requirements set by the CFD provider, the latter will issue a margin call. Depending on the provider, such margin calls may reach different escalation steps and involve, for instance, notifying the retail investor when a certain threshold has been exceeded (e.g. loss of 80% of balance). If the retail investor's balance is no longer sufficient to fulfil the CFD provider's margin requirements, the CFD position is automatically closed. However, such forced closing does not guarantee that the retail investor's losses will be limited to their balance with the CFD provider. Instead, abrupt price fluctuations of the underlying asset or the price gaps result in the retail investor's losses amounting to multiples of their initial margin payment. These must then be paid for using the investor's other assets.
A CFD position is typically closed by clients on the same day that it is opened. If CFD positions are kept open overnight, however, the retail investor is usually charged an overnight fee. The short-term character of trading also manifests itself in the design of the CFD providers' trading platforms. These platforms typically include a whole range of visual signals, the intention of which is to indicate the relevant price developments to the client. These indicators are intended to support the clients when estimating price developments. The flashing price information and visual effects indicating possible price developments could encourage the retail investor to open CFD positions.
Based on the observations made by BaFin in the course of its supervisory duties, CFD providers target almost exclusively retail clients within the meaning of section 31a (3) of the WpHG. A typical CFD client is a retail investor. According to a market survey conducted on behalf of the CFD association CFD Verband e.V. by the Research Center for Financial Services, there were around 127,137 CFD client accounts in 2015.2) The number is approximately representative of the number of clients affected.
BaFin's observations and studies carried out by European supervisory authorities3) show that the average amount of time spent as a client of a CFD provider is rather short. In that time, as observed by BaFin and other European supervisory authorities, the majority of retail investors lose the money they have invested. These prudential observations have also been confirmed by various studies conducted by European supervisory authorities.
The Central Bank of Ireland in its study published on 23 November 2015 concluded that around 75% of all active CFD clients lose their money.4) In the study, the Central Bank of Ireland states that these CFD clients (39,000 retail clients, 5,000 of whom are domiciled in Ireland) suffered an average loss of EUR 6,900 in the years 2013 and 2014.
The French securities supervisory authority Autorité des marchés financiers (AMF) in its study entitled "Study of investment performance of individuals trading in CFDs and forex in France" of 13 October 2014 concluded that 89% of all active CFD clients lose their money.5) In the study, the AMF found that these CFD clients (14,799 clients) suffered a loss between 2009 and 2013, losing on average EUR 10,887 (median of EUR 1,843; aggregated losses of all clients total EUR 161,115,493).
The aggregated client losses feed into the CFD providers' profits. This includes CFD providers who take on the risks inherent in the CFD (e.g. market risk) onto their books and so participate in both the advantages and disadvantages of the CFD trades with retail investors. These CFD providers carry out proprietary trading within the meaning of section 2 (3) sentence 1 no. 2 (c) of the WpHG and are called market makers or liquidity providers. The only possible exception might be the rare cases where the CFD provider executes a hedging transaction for each client order, just as in a direct market access business model that has actually been implemented.
Another group accounting for the above-mentioned aggregate sum is the CFD providers who act as intermediaries between these market makers/liquidity providers and retail investors. Such CFD providers typically provide principal broking services within the meaning of section 2 (3) sentence 1 no. 1 of the WpHG as they enter into CFDs with a market maker/liquidity provider that is prepared to carry the risks resulting from the CFD in their own name for the account of their clients. These providers make their profit from the fees charged to the clients for order execution, either determined as a fixed fee or calculated as a percentage markup. These costs also increase the threshold beyond which a retail investor may make a profit from their initial investment (break-even point).
In their investor warning issued as early as 28 February 20136), the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) warned that purchasing CFDs may result in losses significantly exceeding initial investment. On 25 July 2016, ESMA published another warning on CFDs and other speculative products.7) In it, ESMA again warned against major risks resulting from CFD's leverage, for example. ESMA pointed out that the providers in their advertising often presented an unbalanced picture of the opportunities and risks of these products. Moreover, ESMA remarked that the commercial interests of providers of CFDs and the other above-mentioned products often conflicted with the interests of the investors. According to ESMA, these conflicts of interest were particularly apparent in business models of the providers whose profits directly correlate with the investors' losses.
In international comparison, the following trend has been found regarding the treatment of leveraged products with a structure similar to CFDs:
In the US, similarly to Europe, CFDs are not traded on the stock exchange. However, in the US, over-the-counter CFD trading is prohibited for retail clients unless the investor has a minimum investment capital of USD 10 million or USD 5 million solely for hedging purposes in CFD trading.
For other products which are economically similar to a CFD with a currency pair as the underlying asset (e.g. leveraged forex products), a leverage limit of 50 applies. On behalf of the Commodity Futures Trading Commission (CFTC), the National Futures Association (NFA) has additionally limited the permissible leverage for forex products with particularly volatile underlying assets to 20.8)
In addition to ESMA's warning, the following member states of the European Union and European Economic Area have so far taken measures to counter the risks posed by CFDs: Poland, France, Belgium, the United Kingdom and Malta.
In Poland, a ban on the execution of client orders regarding margin-based financial instruments, including CFDs, was issued on 5 December 2014.9) The ban applies as soon as the margin put down by the client falls below the threshold of 1% of the nominal value of the financial instrument. This measure de facto means a ban on the sale and purchase of CFDs with a leverage exceeding 100.
On 9 January 2017, both the direct and indirect advertising of speculative and risky financial instruments to retail clients by way of electronic advertising was prohibited in France at the initiative of the AMF.10) The advertising ban covers not only binary options and forward foreign exchange contracts but also extends to CFDs and applies to these financial instruments if their risk of loss is incalculable at the time of subscription or if they may establish an additional payments obligation. The Belgian Financial Services and Markets Authority (FSMA) follows a similar approach. On 8 August 2016, it announced that a regulation on limiting the sale of CFDs was coming into force. This regulation prohibits the distribution of CFDs which are not included in trading on the regulated market or multilateral trading facilities.11)
On 3 April 2017, the Malta Financial Services Authority (MFSA) published details on a measure to limit leverage to 50 in the case of CFDs and rolling spot forex contracts for retail clients.12) In the MFSA's view, the measure takes account of the supervisors' observation that some CFD providers predominantly offer the highest possible leverage to retail investors, which poses significant risks to the investors concerned.
On 6 December 2016, the UK's Financial Conduct Authority (FCA) published a consultation paper which contains a package of measures with regard to CFDs.13) Amongst other things, the package provides for standardised risk warnings and mandatory disclosures of investors' profits and losses, a leverage limit of 25 for inexperienced retail clients and a leverage limit of 50 for all other retail clients. The measures are intended to enter into force before the summer of 2017.
II. Consultation on the product intervention measure
On 8 December 2016, BaFin published the draft General Administrative Act and gave participants the opportunity to comment on the matter by 20 January 2017 pursuant to section 28 (1) of the VwVfG. In total, BaFin received 30 responses during the formal consultation procedure. The submissions came from CFD providers, citizens, lawyers and stakeholders. Overall, it was found that there is a wide range of opinions on the matter. Of the 30 petitioners (participants, stakeholders and other third parties), 11 were in favour of the measure, 17 were against it and 2 merely had enquiries. Of the 11 CFD providers as well as 1 providers' association which participated in the consultation procedure, 4 were in favour of the measure while the other 8 were against it.
The petitioners were essentially of the view that BaFin itself did not or did not adequately investigate the facts of the matter in its role as an administrative authority. Instead, it was claimed that BaFin referred only to articles from business media as well as studies conducted abroad. The figures used to demonstrate that 75% to 89% of all CFD clients suffered total losses, for example, derived solely from studies carried out in Ireland or France. The only example cited with regard to the additional payments obligation – the decoupling of the Swiss franc from the euro by the Swiss National Bank – was, according to the petitioners, an exceptional circumstance brought about by an intervention not related to the market itself which should not be cited as a reason for a far-reaching intervention in basic rights, in retail clients' economic freedom of action and CFD providers' freedom to choose their own occupation. BaFin's findings in relation to the average amount of time spent as a client of a CFD provider in Germany as well as in relation to the relevant investor profile were also attacked. The petitioners claim that BaFin, in its legal assessment, based its arguments on retail investors as a whole, without considering the qualifications, ability or experience of the individual clients. They assert that the investor types would vary, however, from inexperienced investors right up to very experienced ones who have been investing in different kinds of investments for many years. The measure would also cover quasi-institutional investors such as foundations, for which treatment as a professional investor was not an option for a number of reasons. According to the petitioners, experienced investors would be able to understand concepts like leveraged trading and additional payments obligations.
Some petitioners contended that the principle of leverage is used not only in CFDs but also in futures, forwards, options, warrants, leverage certificates, leveraged ETFs and margin-based shares trading.
The petitioners asserted that the additional payments obligation for retail clients was consciously accepted by the legislators. With the amendment to the German Stock Exchange Act (Börsengesetznovelle) of 1989, the legislators opened trading in certain financial instruments to retail investors and were aware that such investors would be exposed to the risk of possible additional payments obligations in the context of futures and options.
According to the petitioners, it would be totally unusual for an investor to invest only in one single CFD position. In the vast majority of cases, investor behaviour is usually characterised by simultaneous investment in different (and sometimes offsetting) CFDs. This spreading of risks means that the de facto leverage for the investor's total assets is very significantly reduced.
With regard to the CFD providers' discretion when setting prices, some petitioners essentially contended that such scope for discretion is not unusual and is not unique to CFDs. They claimed that this scope for discretion is afforded to providers of all financial instruments. Where the underlying asset is especially volatile or in the event of market turbulence, it is not possible to set the price in any other way. They also alleged that price gaps are a phenomenon that is not unique to CFDs but rather one which occurs with all financial products. According to the petitioners, it is possible for clients to check if the provider is exercising their discretion properly when setting prices. Many clients would have access to prices and information in real-time via publicly accessible sources or via trading accounts with competing providers. The reasonableness of discretionary decisions taken can also be reviewed by courts, it was claimed. One petitioner contended that client orders are adequately protected by best execution requirements, which regulated providers subject to the provisions of the Markets in Financial Instruments Directive (MiFID) are obliged to adhere to.
According to the petitioner, limitation of the risk of loss is possible through guaranteed stop-loss orders (GSLOs), which function like a regular stop-loss order except that, with GSLOs, the closing of trades at the specified price is guaranteed irrespective of market volatility or gapping.
The petitioners went on to say that considerable investor protection concerns essentially exist solely owing to the existence of unlicensed CFD providers active on the German market as well as owing to misleading advertising promises by these unregulated providers or by CFD providers regulated by supervisory authorities in jurisdictions with lower regulatory standards compared to those maintained by BaFin.
Some petitioners claimed that the planned measure is disproportionate and is a misuse of discretion; in particular, they contended that the measure is unnecessary. They suggested a wide range of more moderate measures. The less drastic measures proposed by the petitioners consisted essentially of: warnings by BaFin, an intensification of efforts to advise clients with regard to risk (for example using the key information documents to be introduced under the Regulation on key information documents for packaged retail and insurance-based investment products (PRIIPs Regulation)), limiting leverage, the option of allowing investors to limit the additional payments obligation themselves, a potential self-commitment on the part of the CFD providers, a restriction solely on active distribution and marketing, prohibition of bonus incentives for the initial CFD transactions or the opening of CFD accounts, detailed rules for dealing with conflicts of interest and unfair business practices as well as a mandatory disclosure of general figures relating to profits and losses for CFD transactions.
According to the petitioners, another more moderate measure would be the prohibition of distribution and sale of CFDs with an additional payments obligation to retail investors whose CFD account balance falls below a certain minimum amount. A further more moderate measure would be the prohibition of distribution and sale solely to "inexperienced" retail investors. The petitioners claimed that it is only these "inexperienced" retail investors who need special protection. One petitioner was of the view that the threshold for categorisation as a professional client, i.e. minimum assets of EUR 500,000 in cash deposits and financial instruments, was too high.
The petitioners also claimed that the measure could give rise to the risk that bad practices would develop within the industry and CFD providers with low compliance standards would recategorise retail clients as professional investors even if these clients do not meet the relevant requirements.
In addition, some petitioners believed the measure was disproportionate in the narrower sense. They claimed that it was fundamentally dubious to prohibit consumers from investing in certain products in order to protect them from themselves and their own potential investment decisions. Any informed retail investor who consciously chooses a product with indeterminable risk of loss would not need to be protected by the state from the consequences of their own decision. According to the petitioners, the number of clients who choose products without an additional payments obligation is very low. If the majority of clients decide of their own free will to invest in a product with an additional payments obligation, it cannot be in the interest of the majority to be forced to have to accept a different type of account with greater restrictions and higher costs.
In addition, some petitioners claimed that the planned restrictions would lead to a de facto discontinuation of most CFD products available at the moment, as there is no demand on the market for such "tame" CFDs.
In addition, the petitioners contended that the measure would create a risk for investors owing to an increased risk of insolvency for the providers if the risk of negative balances is transferred to these providers. Doing away with the additional payments obligation would lead to a concentration of risks at the broker instead of spreading the risks among those investors responsible for the negative balances.
Some petitioners forecast that investors would take on greater risks as they would not have to bear all losses. Doing away with the additional payments obligation would lead to reduced perception of risk. Many investors who previously had no interest in CFDs would now try their luck.
Some of the petitioners also commented on the implementation period of three months, saying that it was too short. Adaptation of the business models to the planned prohibition would take far longer than this, they claimed. Owing to the considerable encroachment on the freedom to choose an occupation, a longer implementation period would be necessary, especially for CFD providers which solely offer CFDs with an additional payments obligation.
Some petitioners argued for a "grandfathering clause" for existing accounts. They argued that the additional payments obligation should remain in place for existing clients if they so wish.
Furthermore, the petitioners pointed out the (potentially) higher costs for investors. They claimed that the increasing costs as a result of the abolished additional payments obligation would encourage responsible-minded clients to open their accounts with "disreputable" brokers abroad.
Some petitioners stressed that BaFin's measure would result in the agency trading model (also known as the non-dealing desk, execution model14)) no longer being offered. This is because in order to financially compensate for the risk, for example through hedging transactions, the agency trading model would retain only a very low margin set in advance which may not be sufficient to cover the risk. In the dealing desk model15) on the other hand, the CFD provider can opt not to cover their own risk, which means that additional trading profits are possible. In particular in a market which is going against the investor, the petitioners asserted that the CFD provider could generate additional profits by doing without hedging. Those brokers which act as market makers would see their profits rise. As long as they could offer small accounts and high leverage in combination, they would be prepared to disregard the risk of an additional payments obligation.
B. Legal assessment
The General Administrative Act is based on section 4b (1) no. 1 (a) and (2) of the WpHG. Pursuant to its provisions, BaFin may limit the marketing, distribution and sale of specific financial instruments where there is evidence to suggest that a financial instrument, activity or practice gives rise to significant investor protection concerns, the investor protection concerns can be remedied by limiting the distribution or sale and the measure is adequate considering the risks and level of expertise of the investors in question or market participants and the likely ramifications of the measure for investors or market participants.
In this case, these conditions are met.
I. Requirements for the above-mentioned legal competence
1. Financial instruments
The subject of this General Administrative Act is contracts for difference (CFDs) within the meaning of section 2 (2) no. 3 of the WpHG. According to Article 4(2) of the Markets in Financial Instruments Directive (MiFID) and MiFID Annex 1 Section C point 9 and the provisions transposing these MiFID provisions into German law, i.e. section 1 (11) sentence 3 no. 3 of the German Banking Act (Kreditwesengesetz – KWG) and section 2 (2) no. 3 in conjunction with subsection 2b of the WpHG, CFDs are deemed financial instruments. German legislators treat CFDs as a subgroup of derivatives.
2. Significant investor protection concerns regarding CFDs with an additional payments obligation
The marketing, distribution and sale of CFDs with additional payments obligation to retail clients raise significant concerns with regard to investor protection within the meaning of section 4b (2) no. 1a of the WpHG. The significant investor protection concerns result from the characteristics inherent to CFDs as products. Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012 ("MiFIR")16) will introduce a directly applicable product intervention right in the member states. The Regulation has already entered into force but is not yet applicable.17) The authorisation for product intervention was introduced early at the national level in the German Retail Investor Protection Act (Kleinanlegerschutzgesetz).18) The legal basis for authorisation in section 4b of the WpHG is thus based on the wording of the European Regulation. On 19 December 2014, ESMA published Technical Advice19) on the conditions for a product intervention measure. These criteria have since found expression in Commission Delegated Regulation (EU) 2017/567 of 18 May 2016.20) It provides that the existence of significant investor protection concerns must be assessed using criteria including the following:
- complexity of the calculation of the financial instrument's price development;
- nature and scope of the risks inherent in the financial instrument;
- lack of transparency of the financial instrument's price development;
- unforeseeable risk for the retail investor;
- extent of potential negative consequences, in particular with due consideration of the number of clients, investors or market participants involved.
In this context special consideration is to be given to the question whether a leverage effect inherent in the product or relating to financing is characteristic of the financial instrument and whether the value of its underlying may no longer be available or determined in a reliable manner in the short term. Moreover, the type of client targeted by the financial instrument's marketing or sale is to be taken into account. Specifically, it should be taken into consideration whether a typical client is a retail investor and what sort of qualifications, skills and experience such client typically has.
In the case of CFDs there are significant investor protection concerns as the purchase of CFDs that may give rise to an additional payments obligation results in unforeseeable risks of loss arising for the investor. The risk of loss encompasses not only the margin that the retail client has put down, but also their other assets. If the difference to be settled by the retail client exceeds their initial margin payment, the resulting difference amount must be paid using the retail client's other assets. It is an uncontested fact in the CFD sector that the extent of the retail client's possible additional payments obligation when purchasing a standard CFD may not be calculated ex-ante.
2.1. Complexity of performance calculation
The significant investor protection concerns in the case of CFDs with an additional payments obligation result first and foremost from the complexity of calculation of their performance. In the case of CFDs, leverage quickly results in losing control over market developments and makes it all but impossible for an average retail investor to anticipate the likelihood of losses and, consequently, the chances of success.
To avoid losses from an opened high-leverage CFD position, the retail investor must be able to reliably assess the price fluctuation range of the selected underlying asset and project the price moves of the underlying within that price fluctuation range (multiplied by the applied leverage) on the margin they have put down. Unlike in the case of direct investment in underlying assets such as shares, bonds, currency pairs or commodity futures, in these cases the retail investor is exposed to an exponentiated market risk; controlling such risk requires the kind of expertise and trading experience mostly possessed only by professional clients.
The margin held by the retail investor on their CFD account amounts to just a fraction of the value of the corresponding underlying asset of the CFD when high leverage is applied. The higher the leverage, the smaller the fraction of the underlying asset's value to be put down and the smaller the part of the underlying's price fluctuation range covered by the retail client's margin. Because the client only has to put down a fraction of the contract value as a margin in relation to the concluded contract, there is a danger that they are not aware of the extent of the risks of loss they are entering into. In this respect, it is not clear to the client what amount of money is actually at risk.
The effects of the leverage described above are all the more problematic because they are not limited to the margin put down by the client for trading purposes. Instead, the leverage can constitute a risk of loss associated with an additional payments obligation, the extent of which is incalculable for the retail client. Within the CFD sector, it is undisputed that the extent of the possible additional payments obligation cannot be determined at the outset in the case of these leveraged financial instruments.
This became particularly apparent on 15 January 2015 after the decision of the Swiss National Bank (SNB) to decouple the Swiss franc from the euro. On that day, some retail investors suffered losses a thousand times higher than the original amount invested. In one instance, an investor lost EUR 280,000 after a margin payment of around EUR 2,800.21) In this case, too, a high leverage was applied (1:400) in order to speculate on the exchange rate fluctuations of the aforementioned currency pair. This shows that the purchase of a CFD which establishes an additional payments obligation can drive a retail investor to financial ruin.
Even the CFD providers themselves often describe their clients' risk of loss as indeterminable. One CFD provider even explains on its website that, in the case of CFDs, the maximum loss cannot be determined at the outset. It may far exceed the client's initial margin payment and does not have any upper limit. The client's risk of loss is therefore not limited to their initial margin payment but instead may extend to cover the entirety of their other assets. According to this particular CFD provider, forced closure of CFD positions in the event of an insufficient credit balance in the CFD account is undertaken solely in the provider's interest and the client cannot infer any rights from the possibility of such a forced closure. Another CFD provider explains on its website that the loss associated with a trade, even within a short period of time, may be considerably higher than the deposit and may even exceed it, with there being no upper limit on the potential loss. It goes on to say that this is a feature of leveraged instruments. According to this CFD provider, during market fluctuations leverage means that the client can share in the losses of the underlying to a disproportionate extent. If the client applies a leverage of 10, the effects of market fluctuations are ten times greater than if the client had traded without leverage or had invested directly in the underlying. Accordingly, the greater the leverage the greater the risk. The CFD provider goes on to say that the effect of price movements on the client's trades depends on the size of their position in the respective CFD, on the leverage of their trade as well as on the size of their margin rates rather than on their account balance when they enter into the position. Small price fluctuations could therefore have a major impact on the client's trades and on their account if they execute large trades on margin.
This has been confirmed by European supervisory authorities in their studies on retail clients' profit and loss ratios conducted in recent years. The study published by the Central Bank of Ireland on 23 December 2015 showed that around 75 % of all active CFD clients lose their money.22) The study conducted by the French securities supervisory authority AMF found that 89% of all active CFD clients lose their money.23) Statistics on profits and losses from CFDs compiled but not published by the industry itself in October 2016 show that 62.7% of CFD clients in the German market suffer losses24). The losses suffered by retail clients and the above-mentioned studies show that the average retail investor is unable to adequately assess the impacts of high CFD leverage. Retail clients using the services of CFD providers are advised of the unforeseeable risks of loss of CFDs. However, the efforts to explain the risks to retail investors have so far done nothing to change the loss-making of this client group. This is due to the fact that a retail investor with average expertise lacks the trading experience necessary to realistically assess the likelihood of loss inherent in this financial instrument. Instead, the relevant risk advice is seen by the retail investors as a purely hypothetical scenario. The typical retail client lacks the experience required to realistically assess the likelihood of losses materialising and their extent.
The assertion made by some petitioners during the consultation procedure that the principle of leverage is applied not only to CFDs but also to futures, forwards, options, warrants, leverage certificates, leveraged ETFs or margin-based shares trading also does not stand in the way of the measure. This is because, unlike the CFDs covered by this measure, warrants, leverage certificates, and leveraged ETFs do not include any additional payments obligation. In addition, futures, forwards, options and margin-based shares trading are not as widespread as CFDs in the retail investor segment.
It was also claimed during the consultation procedure that the investment behaviour of retail clients is usually characterised by the fact that investments are made simultaneously in different (and sometimes offsetting) CFDs. As a result of the spreading of risks achieved through this, leverage is claimed to be significantly reduced. However, such professional risk management and diversification strategies presuppose knowledge and above all trading experience, which at best only professional clients possess. Holding several arbitrary CFDs does not necessarily lead to effective diversification of a portfolio.
2.2. Speculation (more or less) on credit
In economic terms, a CFD provider allows retail investors to speculate on credit by way of leverage. This results from the fact that, for each CFD position, the investor only has to put down a fraction of the contract value as a margin on their CFD trading account. The investor is therefore exposed to the financial consequences of the speculation with an investment amount, of which they actually only have to put up a small percentage themselves. This is made clear using the example cited under A. I. : the underlying position, the risks of which the investor is exposed to there, is worth EUR 40,000. The amount which must be held available by the investor, however, is only EUR 2,000. Although this was viewed differently by some petitioners, in economic terms it is as if the investor had acquired the CFD position to the amount exceeding the margin on credit. In the field of financial theory, a credit-financed investment strategy is considered particularly risky. If a retail investor speculates with money which does not belong to them, speculative losses will affect them particularly hard. A credit-financed speculation, where a retail investor only has to provide a fraction of the actual speculative value, is often even associated with existential risks for the investor concerned.
Legislators, too, consider credit-financed speculation to carry a particularly high potential for risk. This is shown for example by the special reporting obligation for asset managers of credit-financed portfolios established in section 31 (8) of the WpHG in conjunction with section 8 (6) of the German Investment Services Conduct of Business and Organisation Regulation (Wertpapierdienstleistungs-Verhaltens- und Organisationsverordnung – WpDVVerOV). If an investment services enterprise enters into a transaction which includes an uncovered position in a transaction with contingent liabilities, it must also inform the retail client about the uncovered (or not fully covered) losses arising from contingent liabilities. In addition, under section 2 (3a) no. 2 of the WpHG the legislators categorise the granting of credits or loans to others as an ancillary investment service requiring supervision provided such credits or loans are granted for the carrying out of investment services in which the enterprise granting the credits or loans is itself involved.
This makes it clear that legislators view credit-financed speculation practised by retail clients as an exceptional phenomenon which necessitates the creation of special provisions to protect retail clients. These assessments made by the legislators justify protecting the, in this respect, economically equivalent CFD investor from those losses which exceed the amount paid into their CFD trading account and which therefore encroach on the investor's other assets.
2.3. Lack of transparency in the calculation of underlyings where there are price gaps
In the case of financial contracts for difference, the CFD provider is often a counterparty to the retail client. In its role as a market maker or liquidity provider, the CFD provider has extensive discretionary powers when it comes to setting prices once markets become turbulent. Whether or not the CFD provider exercises its discretion soundly and in line with the market cannot be assessed by the retail investor. The retail client does not have any information at their disposal which allows them to assess if the price quoted by the provider is in line with market conditions or not.
The effects of a price set at a level which is not in the best interests of the retail investor is exponentiated by the respective leverage applied. If the CFD provider makes a misestimation of one euro when setting the binding price for an underlying, the leverage applied exponentiates the effects of this bad decision on the retail investor's capital many times over.
In all CFD transactions, a CFD provider acts as counterparty to the client in the chain of execution, which means that the client's losses correspond to the CFD provider's profits. This constitutes a major conflict of interest for the CFD provider in question. The only exception to this might be the rare cases where the CFD provider executes a hedging transaction for each client order, just as in a direct market access business model that has actually been implemented. This conflict of interest becomes particularly evident if, during turbulent times on the market, the CFD provider exercises discretion when setting the price of the underlying, which is binding for determining the respective difference owed. Even though such scope for discretion also exists in some instances for other financial instruments, in the case of CFDs the leverage exponentiates the effects of the misexercise of discretion on the client's risk of loss in a manner which is also a cause for significant investor protection concern.
A slight deviation on the part of the CFD provider when setting the binding price for an underlying can, through the leverage applied, exponentiate the effects of such a bad decision on the retail investor's capital.
Contrary to the view of some petitioners, investors can also not be told to reclaim by legal procedure the amounts they originally lost owing to a price set at a level which was not in the best interests of the retail investor. Only a small minority of retail investors will decide in the event of such bad decisions to initiate court proceedings while having to bear the burden of proof and the cost of the proceedings, especially since retail investors will already not have any information at their disposal which would allow them to check whether or not the prices quoted are in line with market conditions.
2.4. No limitation on the risk of loss through the margin call procedure
The extent of the retail client's risk of loss cannot be limited by the process known as margin call.
Price fluctuations of the underlying may be so significant within the shortest intervals that the CFD provider will no longer have time for a margin call to the retail investor and the CFD position will have to be forcibly closed on an ad hoc basis. During unforeseen turbulence on the market, it is not possible to (fully) liquidate the CFD position opened by the client in the event of unfavourable price performance, because the market maker which is the client's counterparty is not obliged to continually provide price quotations. Unlike the operators of multilateral trading facilities or systematic internalisers, the CFD providers which act as market makers are not subject to the obligation to publish binding quotes during regular trading hours for the underlyings of the products they offer. The closing of an existing CFD position in order to limit losses can therefore be suspended or significantly delayed to the client's disadvantage – which is exactly what happened on 15 January 2015 during the CHF/EUR crash.
If the retail client avails themselves of the investment services of a CFD provider which provides principal broking services and executes client orders with other CFD providers (market makers or liquidity providers of a liquidity pool), there may be a risk for the retail investor (even if price quotations are continually provided) that the aforementioned liquidity providers will not make available the trading volume required by the client. In such instances, an open CFD position could be only partially closed. In the event of extreme price fluctuations, this can lead to a situation where the client's losses can amount to multiples of the capital invested despite a forced closing of the CFD position by the CFD provider.
2.5. No limitation of the risk of loss by stop-loss orders
Furthermore, the level of the retail investor's risk of loss cannot be limited by stop-loss orders.
If the retail investor places a stop-loss order with the CFD provider to limit their losses, the CFD provider is only obliged to execute this order at the "next available" price of the underlying. Significant losses may also be incurred by the retail client upon execution of the stop-loss order. This is because execution at the "next available" price means that the price used to calculate the difference owed by the retail client may differ significantly from the price set by the retail investor as the threshold which triggers the closing of the position. Here, too, the price of the underlying may fluctuate so much within the shortest periods of time that the "next available" price can catapult the difference to be paid by the retail investor to multiples of the capital they originally invested.
Finally, it must be pointed out that both ESMA and the EBA warned retail clients in their investor warning of 28 February 2013 that, in the case of leveraged trades, retail investors' losses may significantly exceed their original investment.
2.6. No limitation of the risk of loss by guaranteed stop-loss orders
A small number of CFD providers also offer a guaranteed stop-loss order, which functions like a regular stop-loss order except that closure of positions at the indicated price is guaranteed irrespective of market volatility or gapping.
The extent of the retail investor's risk of loss cannot be limited in all instances through the use of guaranteed stop-loss orders. An effective limitation of the risk of loss could only be achieved if guaranteed stop-loss orders would be actually mandatory for all positions held by the investor. If they remain only optional for investors, inexperienced investors in particular could be prevented from using a guaranteed stop-loss order owing to a lack of knowledge on their part of the risks or owing to additional costs. In addition, in individual cases the specific conditions offered by the provider may include exceptions, e.g. for unusual market conditions or interventions in the market from outside, and thereby further reduce the protective effect. A guaranteed stop-loss order is also placed by the investor for a particular limit. This limit may be set too high or too low, which means that a guaranteed stop-loss order does not offer any effective limitation of the risks for the investor. Overall, a guaranteed stop-loss order does not offer the same protection as an elimination of the additional payments obligation for all CFD accounts held by retail investors.
2.7. Large number of retail investors affected
Furthermore, the significant concerns outlined above affect a large number of retail clients. According to a market study conducted on behalf of the CFD association CFD Verband e.V. by the Research Center for Financial Services, there were around 127,137 CFD client accounts in 2015.25) The number of retail clients affected is roughly the same.
3. Determining the facts
Contrary to the claims made by some petitioners during the consultation procedure, the facts relevant to the issue were adequately investigated by me pursuant to section 24 of the VwVfG. The significant investor protection concerns described above result in the present case from product features inherent to CFDs. It is an uncontested fact in the CFD sector that the extent of the retail client's possible additional payments obligation when purchasing a standard CFD may not be calculated ex-ante. In light of the nature of section 4b of the WpHG as an enabling provision to avert risks in advance, the damages which have already been proven to have been suffered by investors, either of a certain amount or with a particular frequency, do not constitute a precondition for issuing a product intervention measure.
4. Proportionality assessment
4.1. Suitability within the meaning of section 4b (2) no. 2 of the WpHG
The intended restriction is suitable for taking account of the aforementioned significant investor protection concerns that exist:
The elimination from CFDs of the additional payments obligation is a suitable way of countering retail investors' incalculable risk of loss. As a result, the complexity of calculating potential losses is significantly reduced. Although losses on the part of the retail client are not completely eliminated as a result, they are limited to the capital originally paid in by the client. This will enable the retail client to better manage their risks of loss.
In this respect, speculation (more or less) on credit is then no longer possible in any event, as the amount speculated would exceed the capital paid into the trading account. Losses are thus limited to the capital provided by the client for speculative purposes and do not encroach on the client's other assets.
Neither the price gaps themselves described earlier nor the right to exercise discretion granted to providers in relation to setting prices in this context nor any failure of the stop-loss mechanisms can then still lead to incalculable losses on the part of the retail clients.
In this respect, the intended measure counters all significant investor protection concerns brought forward.
The legislators themselves also believe that protection against additional payments obligations is basically a suitable investor protection measure. Therefore, with the aim of protecting investors from margin calls26), in section 5b of the German Capital Investment Act (Vermögensanlagengesetz – VermAnlG), they have provided that capital investments with an obligation to make additional payments shall not be permissible for public offer or distribution in Germany. Contrary to the submission made by some petitioners during the consultation procedure, it is therefore by no means the will of the legislators that the additional payments obligation be accepted for all conceivable constellations and financial instruments.
4.2. Proportionality of the measure within the meaning of section 4b (2) no. 3 of the WpHG
The measure is also proportionate considering the risks identified, the level of expertise of the investors or market participants concerned and the likely consequences of the measure for said investors and market participants. In this case, interests are to be weighed up by way of an overall assessment of all relevant concerns. It must be borne in mind here that the legislators afford particular importance to the protection of collective consumer interests. In this case, the public interest in protecting the collective interests of consumers outweighs retail investors' individual interest in trading with CFDs which have an additional payments obligation as well as the economic interest of the CFD providers concerned in achieving unlimited turnover from marketing, distributing and selling CFDs.
4.2.1. Level of expertise of the investors concerned
Based on the observations made by BaFin in the course of its supervisory duties, CFD providers target almost exclusively retail clients within the meaning of section 31a (3) of the WpHG. A typical CFD client is a retail investor. As outlined under I. 2.1. above, the performance calculation which needs to be mastered by the clients for CFDs is complex and is not in keeping with the level of expertise typically possessed by the investors concerned. Prudential observations, which have been confirmed by various studies conducted by European supervisory authorities27), show that the average length of time spent as a client of a CFD provider is rather short, which means that clients normally cannot acquire any extensive product knowledge over the economic life of the products.
4.2.2. Effects of the restriction on retail investors
The effects of the restriction on retail investors are proportionate.
The restriction pertains to the marketing, distribution and sale of CFDs to retail investors where the CFDs establish an obligation on the part of the retail investor to make additional payments. CFDs without an additional payments obligation, on the other hand, may continue to be marketed, distributed and sold to retail investors. Access to CFDs for retail clients within the meaning of section 31a (3) of the WpHG is therefore not blocked completely. Even before the entry into force of this measure, a range of CFD providers stated that they had offered trading accounts without an additional payments obligation on the German market and they continue to do so. Retail clients can therefore benefit from the product's cash-flow advantages without having to accept unforeseeable risks of loss arising from the additional payments obligation. It cannot be ruled out that the measure will lead to modifications in CFD accounts, since CFD providers will more than likely hedge themselves against the market risk taken on equal to the amount of the additional payments obligation. In some cases, this may lead not only to a limitation in the choice of underlyings available but also to a higher minimum balance requirement on the CFD account, a leverage limit or somewhat higher product costs. In this sense, the restriction could at least have indirect consequences for retail investors. However, CFD trading accounts without an additional payments obligation already offered on the market indicate that the product will remain available to retail clients and that their freedom to make investment decisions is not significantly limited by the measure. A product intervention measure does, nevertheless, necessarily lead to a certain restriction of investment possibilities. However, this is the legislators' intent. The aim of section 4b of the WpHG is to give BaFin the option to intervene where there are significant investor protection concerns.
Overall, the interest of retail investors in using CFDs with an additional payments obligation comes behind the public interest in limiting the risks associated with this particular financial instrument.
Furthermore, this General Administrative Act does not pertain to the marketing, distribution and sale of CFDs to professional clients. In the case of these clients, it can be assumed that they have the necessary knowledge and experience to be able to adequately judge the risks associated with those CFDs which are the subject of the restriction discussed above. In addition, these clients are better able to bear the financial risks associated with the purchase of CFDs with an additional payments obligation. This category includes, in particular, those retail clients who may be categorised as professional clients upon request pursuant to section 31a (7) of the WpHG.
4.2.3. Effects of the restriction on other market participants
The anticipated effects of the restriction on other market participants are also proportionate.
This General Administrative Act pertains to an isolated market segment. It can be ruled out with high probability that the General Administrative Act will have any effect on the financial sector as a whole. There is little interdependence between the CFD market and other capital markets, and the effects on stock exchange trading are minimal.
The General Administrative Act provides for a restriction on the marketing and sale of CFDs to retail clients where these financial instruments establish an obligation on the part of the retail client to make additional payments. In this sense, the General Administrative act does not constitute a complete product ban.
In particular – and contrary to the submissions made by some petitioners during the consultation procedure – the measure will not lead to a de facto discontinuation of most CFD products on the market owing to lack of demand. Recent market studies of the industry, presented during the consultation procedure, show that 55.1% of investors interested but not active in CFD trading may be motivated to switch from an account without an additional payments obligation to CFD trading. In addition, a large number of CFD providers already offer their clients accounts without an additional payments obligation. This, too, points to an existing demand for such a product.
Furthermore, by granting a reasonable implementation period the General Administrative Act takes account of any processes of adaptation in the CFD sector. These processes of adaptation affect in particular those CFD providers which provide principal broking services by executing client orders (CFD opening and closing orders) via market makers or liquidity providers. In such cases, client orders are executed through the conclusion of a further CFD with the CFD provider acting as market maker or liquidity provider. This new CFD mirrors exactly the CFD concluded with the client. The role of the CFD providers offering principal broking services is limited in this respect to that of an intermediary between the retail client and the market maker or liquidity provider which enjoys the financial gains and suffers the financial losses resulting from the contracts for difference. In relation to market makers or liquidity providers, CFD providers which execute client orders within the context of principal broking services constitute a special category of professional clients (so-called eligible counterparties within the meaning of section 31a (4) of the WpHG). CFD transactions with eligible counterparties remain unaffected by this General Administrative Act, which means that a market maker may continue to sell CFDs to professional clients without any restrictions. In the case of CFD providers acting as intermediaries, the restriction on the marketing, distribution and sale of CFDs with an additional payments obligation can, in this respect, lead to the following situation: on the one hand, they will no longer be allowed to call for additional payments from their clients while, on the other hand, when concluding transactions for the account of the client they may themselves be obliged to make additional unlimited payments to market makers or liquidity providers. This will force the CFD providers concerned to seek market makers and liquidity providers which will be prepared to forgo the intermediaries' additional payments obligation. However, other strategies aimed at making the shift in risk allocation from retail clients to CFD providers through elimination of the additional payments obligation manageable for CFD providers are also fundamentally possible. It would, for example, be possible for providers to in future only allow speculation on certain less volatile underlyings, to introduce a leverage limit, to introduce a certain minimum capital requirement on the investor account as a prerequisite for trading or to demand somewhat higher trading fees in order to be able to conclude hedging transactions. The implementability of such strategies is otherwise confirmed by submissions made during the consultation procedure as well as by CFD accounts without an additional payments obligation offered on the market by providers which execute client orders in the context of principal broking services. Contrary to the submission made by some petitioners during the consultation procedure, the measure would therefore not necessarily result in a situation where the business model of CFD providers which provide principal broking services could no longer survive on the market. Fundamentally, however, it is the responsibility of the CFD provider to adapt its business model so that its risk is economically bearable. The necessary adaptations to the business model described above will not result in CFD providers being burdened inappropriately. Overall, the public interest in limiting the risks of this financial instrument outweighs the interests of the CFD providers in an unaltered continuation of their business models.
The adaptations to the CFD providers' business models and the resulting consequences for these providers are proportionate. In this case, the process of adaptation is taken account of by the period allowed for implementation of the General Administrative Act, which can be found in said Act. During this period, the CFD providers will be able to adapt their business models to the fact that, in future, CFDs may only be marketed to retail investors where the CFDs do not establish an obligation on the part of the investor to make additional payments. In particular, it will be possible during this time for the CFD providers to adapt their IT systems. Precisely those CFD providers which offer principal broking services will be enabled, where necessary, to adapt the cooperation agreements they have already concluded with undertakings acting as market makers or liquidity providers to ensure compliance with the provisions of the General Administrative Act. Owing to the necessary weighing up of the providers' interests with the public interest in collective consumer protection, a longer implementation period is not appropriate. Even before the measure came into effect, a number of CFD providers redesigned their business models within a few weeks and now offer accounts without an additional payments obligation. A permanent grandfathering clause for CFD accounts held by existing clients, however, would run contrary to the purpose of the measure. Some petitioners argued for an exemption from the measure for trading accounts opened before the measure entered into force. BaFin is of the view, however, that existing clients should also be protected by the measure when they conclude new transactions after the implementation period has expired.
II. Exercising of discretion
For the purpose of the aforementioned measure, I have exercised the discretion granted to me under section 4b (1) sentence 1 of the WpHG. The measure is proportionate in the wider sense, as it is suitable, necessary and appropriate.
1. Suitability of the restriction
The restriction on the marketing, distribution and sale of CFDs with an additional payments obligation is suitable in order to achieve the legitimate aim pursued with this measure. The purpose of section 4b of the WpHG is to protect the collective interests of investors. With the restriction, the considerable investor protection concerns which arise from the product features inherent to CFDs and which could result in unforeseeable risks of loss for retail clients, in particular owing to the additional payments obligation, are countered. The prohibition on the marketing, distribution and sale of CFDs with an additional payments obligation to retail clients leads to a limitation of these risks. Losses on the part of the retail client are thereby limited to the capital originally paid in by the client. Through this restriction, the investor can be aware at all times what percentage of their total assets they would like to expose to the risk. The restriction is thus suitable for the purpose of achieving its objective.
2. Necessity of the restriction
The restriction is also necessary. There is no other more moderate measure which would be equally suitable in dispelling the significant investor protection concerns that exist in relation to CFDs with an additional payments obligation.
Even though an intensification of efforts on the part of CFD providers to advise retail clients in relation to the risks associated with CFDs could, in principle, be considered as a more moderate measure, this would not be equally suitable for achieving the intended aim. In particular, it would not change anything in terms of the risk arising from the obligation on the part of the retail client to make additional payments. The same applies to the suggestion made by one petitioner during the consultation procedure regarding mandatory disclosure of general figures relating to profits and losses for CFD transactions in order to warn inexperienced retail investors. Over the past three years, BaFin has consistently worked on an intensification of efforts to advise retail investors in relation to the risks associated with such products. In particular, it enforced a requirement that CFD providers have clearly visible risk warnings on their websites. BaFin pays particular attention towards ensuring that, if the CFD providers highlight any advantages associated with CFDs, they also point out to their clients or potential clients the incalculable nature of the risks of loss associated with CFDs. However, because of their lack of requisite trading experience, retail clients view these risk warnings as purely theoretical scenarios. Intensification of efforts to explain the risks to retail clients as well as the publication of studies conducted by European supervisory authorities on retail clients' profit and loss ratios did not turn out to be equally effective measures and were not in this respect able to protect retail investors from suffering huge losses. A typical retail investor lacks the necessary experience to realistically assess the likelihood of a loss scenario materialising.
The PRIIPs Regulation28) mentioned by some petitioners is not intended to apply until 201829) and, on its own, cannot therefore be an obstacle to the measure. In addition, it is not comprehensible why the provisions of the PRIIPs Regulation would be an obstacle to the restriction on the additional payments obligation for CFDs introduced with this measure. The provisions regarding the key information document merely constitute a minimum standard for transparency and do not stand in the way of regulatory measures for individual cases.
Contrary to the view expressed by some petitioners during the consultation procedure, a warning issued by BaFin would not be a more moderate yet equally effective measure for dispelling the significant investor protection concerns that exist in this case. Instead, supervisory authorities have observed that the investor warning from ESMA and the EBA dated 28 February 2013 did not have any significant effect on the trading behaviour of retail investors in CFDs, nor on the loss ratio of such investors. This becomes clear when one considers the losses suffered by retail investors following the decoupling of the Swiss franc from the euro on 15 January 2015. The GBP flash crash of 7 October 2016 also led to losses by retail clients despite the preceding warning notice issued by ESMA on 25 July 2016.
The suggestion made by some petitioners during the consultation procedure to limit the measure to accounts where a certain minimum balance is not maintained would fundamentally be conceivable. However, it would not be equally suitable, since investors with a higher account balance are also fundamentally deserving of protection. Legislators have already made an unambiguous assessment of the matter by providing for a classification into professional clients under section 31a (1) of the WpHG and retail clients under section 31a (3) of the WpHG. This classification makes it clear that legislators are proceeding on the basis that retail clients as a whole deserve special protection. The planned measure pursues the same goal by explicitly excluding professional clients. A retail client may be categorised as a professional client if they possess the experience, knowledge and expertise to make an investment decision and if they are capable of adequately assessing the risks involved (section 31a (7) of the WpHG). Legislators have also determined when this may be possible by way of three criteria listed in section 31a (7) sentence 3 of the WpHG, of which at least two must be satisfied. Legislators have already considered the client's cash deposits and financial instruments by way of the threshold described in section 31a (7) sentence 3 no. 2 of the WpHG. If this criterion, i.e. that of the client's cash deposits, and one further criterion, for example that relating to the average trading volume pursuant to section 31a (7) sentence 3 no. 1 of the WpHG, are satisfied, the retail client may be categorised as a professional client.
The suggestion made by some petitioners during the consultation procedure to limit the measure exclusively to less experienced retail investors can fundamentally be considered a more moderate measure. However, it would not be equally effective in achieving the aim pursued. Investors who already have some trading experience must also be protected from the unforeseeable risks of loss resulting from the additional payments obligation. Events of extreme volatility, such as the "Swiss franc shock" mentioned earlier, may only occur infrequently and may therefore lie outside the retail client's realm of experience. Legislators have already considered client's experience in criteria 1 and 3 of section 31a (7) sentence 3 of the WpHG. If these criteria relating to experience are satisfied, categorisation as a professional client is possible. There is therefore no reason to ignore this legal assessment and introduce a further subdivision of the retail client category. Contrary to the submissions made by some petitioners during the consultation procedure, the threshold for categorisation as a professional client is also not too high, since only two of the criteria set out in section 31a (7) sentence 3 of the WpHG have to be satisfied in each case. It would thus be possible in particular for a retail client with cash deposits and financial instruments below the threshold set out in section 31a (7) sentence 3 no. 2 of the WpHG to be categorised as a professional client based on their experience alone.
To date, there is also not any self-commitment on the part of the industry itself which extensively covers the market and which would address the significant investor protection concerns that exist and which could justify deferring the measure.
Neither does the leverage limit proposed during the consultation procedure entail an adequate limitation of risks inherent to CFDs as products for retail investors, in particular in the event of sudden high volatility. Where there is a higher degree of volatility and where a larger margin payment has been made, the additional payments obligation can involve unforeseeable risks of loss for the investor even if the leverage is limited. Moreover, leverage that is limited by the regulatory authorities would also interfere in CFD providers' freedom to choose an occupation and restrict retail clients in their investment options. The fact that a majority of brokers are already offering accounts without an additional payments obligation but with a high leverage of 500 even before any product intervention measure by BaFin clearly shows that such a product offer is in principle economically possible for CFD providers and is also in demand by clients. According to market studies of the industry presented during the consultation procedure and cited above, 55.1% of investors interested but not active in CFD trading stated that the availability of an account without an additional payments obligation could encourage them to begin CFD trading. Through the limitation on the additional payments obligation, leverage essentially remains a sought after product feature for providers and clients alike.
Contrary to the submission made by some petitioners during the consultation procedure, a restriction solely on active distribution and marketing does not constitute an equally effective measure. CFDs are primarily advertised and sold across national borders online. A prohibition on active distribution and marketing would extend only to advertising efforts aimed at the German market. It could, however be very difficult to differentiate between an advertisement aimed at the German market and an advertising campaign aimed, for instance, at the Austrian market. Thus, providers would continue to be able to disseminate demo accounts, promotional videos, testimonies, etc. online in German. Overall, in the case of a financial instrument like this distributed across national borders, a prohibition solely on advertising and distribution would likely only have a very limited protective effect for investors if sale of the product to retail clients were to remain permissible.
One petitioner suggested during the consultation procedure that clear and detailed rules be laid down for undertakings on dealing with conflicts of interest and unfair business practices. However, this proposal would not be equally effective in dispelling the significant investor protection concerns which arise from the unforeseeable risks of loss that exist for retail investors. Such an approach – should there be any legal basis for its authorisation at all – could at best dispel only certain aspects of the concerns outlined under I. 2. above. In particular, it would change nothing in relation to the product features inherent to CFDs.
The legal requirements for orientation to the client's "best possible" interests pursuant to section 33a of the WpHG (known as "best execution") or better enforcement of these interests by BaFin also do not contradict the necessity of the measure. The requirement of best execution is intended in particular to guarantee that competition between marketplaces results in price improvements for the end-investor. By contrast, in the case of CFDs there is usually only one execution venue available, as the CFD provider itself frequently acts as counterparty to the investor. However, even CFD providers which act solely as intermediaries often only have one market maker or liquidity provider at their disposal. Therefore, in the case of this financial instrument the requirement of best execution does not achieve a protective effect comparable with that of this measure.
Contrary to the submission made by one petitioner, a limitation on the additional payments obligation to be set by the investor themselves would not be equally effective. It can be assumed that providers will provide for certain restrictions and potential additional costs for accounts without an additional payments obligation in order to limit the additional market risk they have taken on. The investor would therefore receive an incentive to not apply the limitation on the additional payments obligation. This would mean that inexperienced investors in particular would continue to be exposed to unforeseeable risks.
Raising potential CFD clients' product-specific level of knowledge, through the use of educational tools, for example, does not constitute a more moderate measure in this case. Such tools (webinars, for instance) have been used intensively heretofore by CFD providers in order to attract primarily clients with little knowledge or experience of capital markets to CFD trading. However, tools like these cannot replace the trading experience which is absolutely necessary for CFD trading. The same applies to the use of demo accounts, where the client trades using a virtual account balance. Such virtual trading experience cannot turn a retail investor into an experienced investor, as the losses suffered in this context are of a completely different quality to actual losses suffered. However, even if one were to presume that such virtual trading experience would be enough to substitute practical trading experience, the investor would have to gain enough experience to meet the requirements set out in section 31a (7) of the WpHG in order to realistically assess the risks of unlimited CFDs and to effectively manage these. In such a case, they would have to be categorised as professional clients, which would mean that the marketing of relevant CFDs to those affected would no longer fall under the scope of this General Administrative Act.
3. Proportionality of the General Administrative Act in the narrower sense (appropriateness)
The restriction is also proportionate in the narrower sense of the word. In this case, the different legally protected rights are to be weighed up by way of an overview of all relevant concerns.
Legislators afford great importance to the protection of the collective interests of consumers. Within its legal mandate, BaFin is obliged pursuant to section 4 (1a) of the FinDAG to protect the collective interests of consumers. This legal mandate is to be viewed in light of the economic significance of collective consumer protection. By participating in the capital market, the typical retail investor is primarily pursuing the aim of capital accumulation. This is fundamentally a process of saving or investment. The capital required for this typically comes from the retail investor's other income.
The CFD providers, too, see themselves as part of the capital market and market their investment services and products as speculative investment opportunities and not as an opportunity to participate in a chance-based lottery, for example. Even though the retail investor is reminded by way of multiple warnings from the CFD providers that their investment should be understood as risk capital, at the same time, based on their connection to stock exchange prices and reference markets, the CFDs are marketed as an opportunity to participate in developments on the capital market over the long term. For the average retail investor, CFDs are a speculative investment and not a wager whose likelihood of success depends on chance and whose potential for loss is incalculable.
At the same time, it must be borne in mind that each retail investor must decide for themselves, with due consideration of their personal life circumstances and financial situation, whether or not CFDs are a suitable investment for them. In this respect, the purchase of a CFD constitutes an exercise in private autonomy. The General Administrative Act limits this autonomy, as it restricts the retail investor's options, at least indirectly. However, this restriction is proportionate, since the effects of the General Administrative Act on the retail investor remain limited.
Furthermore, it must be considered that retail investors are not completely barred from trading in CFDs with an additional payments obligation. A retail client can request to be categorised as a professional client and, following the granting of this status, receive access to unlimited CFDs. A retail client may be categorised as a professional client if they possess the experience, knowledge and expertise to make an investment decision and if they are capable of adequately assessing the risks involved (section 31a (7) sentence 2 of the WpHG). It is the legislators' intent that a change in categorisation will be considered if at least two of the criteria mentioned in section 31a (7) sentence 3 nos. 1 to 3 are satisfied. Thus, the retail client can be recategorised as a professional client if they satisfy the criterion on trading volume pursuant to section 31a (7) sentence 3 no. 1 of the WpHG as well as the criterion on cash deposits pursuant to section 31a (7) sentence 3 no. 2 of the WpHG. However, the client can also be recategorised as a professional client solely on the basis of their professional experience pursuant to section 31a (7) sentence 3 no. 3 of the WpHG along with their having reached a certain trading volume pursuant to section 31a (7) sentence 3 no. 3 of the WpHG, even if they do not have cash deposits and financial instruments worth in excess of EUR 500,000. This breakdown is appropriate, since it can be assumed that such an investor, based on their experience, knowledge and expertise, is able to adequately assess and bear the unforeseeable financial risks that are attached to a CFD.
Appropriate classification into the legally prescribed client categories forms part of the rules of conduct contained within Part 6 of the WpHG. Compliance with these rules of conduct, and thereby also the recategorisation as a professional client by the CFD provider pursuant to section 31 (7) of the WpHG is subject to monitoring by BaFin pursuant to sections 4 and 35 et seq. of the WpHG, for example within the scope of the annual examination pursuant to section 36 of the WpHG.
The interest in protecting the collective interests of consumers ultimately outweighs the interest of CFD providers in continuing to pursue their commercial interests without any restrictions. Product providers whose business models are based on the sale of products which may at any time drive the retail investor to financial ruin cannot expect that a weighing up of their economic interests and those of the investors will result in an outcome favourable to them.
In all other respects, I refer to the considerations cited in the context of proportionality under I. 4. above.
III. Appropriateness of the implementation period
The implementation period envisaged in item 1 of the General Administrative Act is appropriate. With due consideration of a potentially necessary adaptation of the business models of CFD providers to the restriction which is the subject of this General Administrative Act, it is reasonable to expect that the CFD providers fulfil the obligation within three months of the General Administrative Act being disclosed. After weighing up the interests of the providers and those relating to investor protection, a short implementation period has to be set. Already upon publication of the notice of hearing but before the measure came into effect, some providers adapted their business models within a few weeks and have since been offering accounts without an additional payments obligation. However, the establishment of a transitional period is necessary in this case for reasons of proportionality (cf. the explanations provided under I.4.2.3.). Neither does the aforementioned implementation period run contrary to the purpose of the measure. Instead, the aim of the measure is to give CFD providers the opportunity to adapt their business models to the intended restriction.
IV. Grounds for reservation of revocation
I reserve the right to revoke this General Administrative Act in particular in order to be able to prevent this product intervention measure from contradicting any future uniform regulation of CFDs at the European level. In addition, reservation of revocation should allow any changes in the market situation to be responded to.
Pursuant to section 17 (2) sentence 1 of the FinDAG, the General Administrative Act shall be publicly announced.
Pursuant to section 4b (6) of the WpHG, objections to and appeals against the measures under subsection (1) shall have no postponing effect.
I would also like to point out that, pursuant to section 39 (2) no. 2b of the WpHG, an administrative offence is deemed to be committed by any party who, wilfully or negligently, fails to comply with an enforceable order under section 4b (1) of the WpHG.
Instruction on available remedies
Objections to this General Administrative Act can be submitted to BaFin in Bonn or Frankfurt am Main within one month of its publication.
1) Simplified example, not considering any potential transaction costs.
3) ESMA "Q&A Relating to the provision of CFDs and other speculative products to retail investors under MiFID" of 12 July 2016, page 18.
14) In this execution model, the best possible bid and offer price of another CFD provider (either plus a surcharge or for commission) is selected.
15) Here, the CFD provider itself sets the bid or offer price at which they are prepared to sell to or buy from a client. The CFD provider acts as market maker.
16) Official Journal of the European Union (OJ EU), L 173, 12 June 2014, p. 84.
17) The Regulation will apply in all Member States from 3 January 2018.
18) Legislative intent of the draft German Retail Investor Protection Act, Bundestag printed paper, 18/3994, p. 53.
19) Final Report, ESMA's Technical Advice to the Commission on MiFID II and MiFIR (ref. no.: 2014/1569), p. 190 et seq., available under: www.esma.europa.eu
20) Commission Delegated Regulation (EU) 2017/567 of 18 May 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions (OJ EU, L 87, 31 March 2017, p. 90 et seq.)
24) Also quoted by the Managing Director of the CDF association in Germany in the article "Ein Hebel, der in den Ruin führen kann" (Leverage that can lead to ruin) published in the Handelsblatt newspaper on 25 April 2017 – page 40).
26) Bundestag printed paper 18/3994, p. 43.
27) ESMA "Q&A Relating to the provision of CFDs and other speculative products to retail investors under MiFID" of 12 July 2016, page 18.
28) Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 November 2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs)
29) Regulation (EU) 2016/2340 of the European Parliament and of the Council of 14 December 2016 amending Regulation (EU) No 1286/2014 on key information documents for packaged retail and insurance-based investment products as regards the date of its application
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