On March 27th, European Securities and Markets Authority (ESMA) published its long-awaited verdict on the conduct of brokers in the industry. It fulfilled all the fears in the retail brokerage industry and will be fatal for some and force others to merge. Sadly the excesses of a few, have impacted the industry. Unregulated brokers that have plagued the forex and CFDs trading industry along with criminal binary options brokerage industry have prompted a severe response by the EU-wide industry watchdog.
Briefly, they have set the maximum leverage for trading. It has been cut to 1:30 for FX, 1:20 indices and gold, other commodities are at 1:10 and shares are at 1:5. Brokers will be required to provide a negative balance protection (stop protection) and display clearly on their marketing message what is the percentage of their clients that lose money. We all know almost all retail customers lose money. Of course, knowing you have zero realistic chance of winning the lottery does not stop people buying tickets but at least they do not have the odds pushed into their face at the convenience store.
The Impact of ESMA Directive on Market Makers
Many retail brokers act as principals and their flow is a major source of income. The so-called market makers will be hit hard by the ESMA changes. These brokers are typically reliant on (often aggressive) marketing, trading incentives and most crucially, their clients losing money. Higher leverage always means a shorter life-span (or client burn rate as it is called in the industry) for a retail trader’s account. Brokers have been offering high leverage to clients in order to lure them into the narrative that it is easy to make a lot of money with a relatively small deposit – 1:500 is not uncommon. The reality in the financial markets is that between 80 and 95 percent of retail clients are losing their deposits quickly, say the ESMA.
A seesaw between fear and greed in the brain’s chemistry is one of the most perilous enemies of a trader but good for brokerage. Trading the market is catering to these emotions and short bursts of dopamine when a trader is winning are driving his desire to trade more. Some heavy social media users are experiencing precisely the same pattern that lures them into continue consuming that phone screen on the train. Following and automatically copying the trades of very active traders is a new popular phenomenon.
The levels of leverage which the ESMA is mandating will put a halt on the excitement levels. Suddenly a trader has to deposit $5000 to open a position sizeable enough to get into the trading action. When previously $500 was all that was needed to open an account and change your life. Brokers will need the change their acquisition and retention strategy altogether to stay on top of their game when attracting clients. They will be forced to look for better healed, less greedy and better-educated clients. Better educated clients will be longer lasting clients. A retained client is like a new client. New clients are expensive to acquire. Better to spend money keeping the clients alive. Better educated and longer lasting clients are less likely to seek the solace of the regulators if they are disappointed by their trading performance. There are tough times ahead for the market maker brokers.
There is another model for retail brokerage: Straight-Through Processing (STP). These firms are not relying in any way on the losses of their clients as the money in those accounts is flowing into the market. Their revenue relies on commissions. The more trades a trader makes within his/her lifespan, the more commissions the brokerage is getting. These brokers are keen on their clients not losing money because they will stop generating commissions the moment they lose their balance. Such brokers are typically more inclined to provide their clients with added value tools – such as charting packages, education courses and genuine research that can drive a mediocre trader closer to success. The ESMA’s new regulations are going to have an impact on such companies in two major ways.
Broker volumes will register a decline, and initially, it will be a big drop. Gearing restrictions have had a mixed impact on other markets elsewhere. In Japan, the official maximum leverage of 1:25 has not impacted the industry in the long run as local brokers are posting the highest trading volumes in the world.
Capital requirements is another issue. All brokers are now mandated to provide negative balance protection and the FCA was one of the first regulators that realised that having firms with a capital requirement of a couple of hundred grand was no longer adequate. All STP firms are very likely to need to apply for a €730K license and prepare to meet the capital requirements that come with that.
Open an Account with us “90% of Our Customers Lose Money”
Now the brokers have to include in their advertising, not only a bikini-clad lady draped over a brand new Ferrari but also a statement od what percentage of their clients make money. The number will mostly be close to or at nil. ESMA’s announcement will radically change the brokers’ commercial model; they now have an incentive to attract the best possible traders. Suddenly attracting traders is not enough, brokers that want to remain in this industry for the long haul will have to attract the right kind of clients and strive to make their clients better traders all the time. Which traders make money? Who are the >5%? The biggest killer of the retail customer is being undercapitalised and over trading. Few current brokers are currently working in this way, and even fewer have been successful in doing so. Education will no longer be the type which pretends its all as easy as buying when two lines cross each other. Now brokers will want their clients to be demonstrably educated and actually educated in trading skills and trading risk reality.
Even if You Have Nothing to do With the Retail Industry, You Will Notice
When I worked at my alma mata (name begins with B), 15 years ago our FX data was very poor compared to our competitor (name begins with R). People at the firm where we working hard to establish the relationships with the biggest and most important banks in the FX market necessary to get the price feeds. They had a lot of success with this but there was a problem. These banks trade big and often but not continuously. The prices we put out on the terminals we right and good for size but there were gaps from trade and quote to quote. As Global Head of Technical Analysis, I had embarrassing price data in the cross rates and my charts looked horrible. Most importantly our competitors’ chart did not. They someone has a moment of genius. We worked to make relationships with the retail brokers to merge in their price feeds. They trade much smaller in size but they trade continuously and their quotes are narrow. While the trade size maybe $10,000 or £100,000 and not $millions, the feed was now rich with pricing and we had a market bewteen the big trades. Our price feed was now top class. Unfortunately, the retail brokers are about to take a hit. Their updates will be less frequent and they will add less to the fluidity of pricing. Price date will be less full and rich in the near future.
As the final rules are published by the ESMA and as the FCA and the other national regulators start issuing circulars, we get a clearer picture of how the landscape will look. But it is clear, we are in a new marketplace in FX, CFDs and a world without binary options.
by Trevor Neil MSTA MCSI of BETA Group and first published at www.betagroup.co.uk/blog