Retail CFDs are complex, leveraged derivative financial instruments that investment firms commonly offer to retail clients through online trading platforms. To retail customers, CFDs usually mean spread-betting, but they can also include rolling spot foreign exchange products.
For some years, the FCA has had concerns about poor conduct in CFD firms and the associated risks of consumer detriment and has issued a number of publications containing industry guidance. It is clear that the FCA is troubled by the provision of CFDs, which many regard as little different to gambling, but for experienced investors can form a useful part of a trading strategy.
Following a review carried out into a number of CFD providers and distributors, on 10 January this year, the FCA sent a "Dear CEO" letter to all firms operating in the sector, summarising its findings. Overall, the FCA was disappointed with what it found and has asked firms to consider the issues raised in its letter against their conduct in a number of areas:
- Firms should define their target market precisely. However, most firms were unable to offer a satisfactory definition of their target market or to explain how they align the needs of that group to the CFD product offered. In the FCA's view, excessively broad definitions of target markets may lead firms to conclude that CFDs are suitable and/or appropriate for the majority of potential customers, even where this is unlikely to be the case.
- There were a wide range of communication, monitoring and challenge practices by firms, many of which were ineffective and did not meet expectations. For example product providers did not always share with distributors information about product characteristics, the intended target market and whether the information is intended for the end-customer's use. Indeed, the FCA considered that none of the firms reviewed were acting in line with FCA guidance. The FCA considers that poor customer communication is particularly troubling given that it found that the majority (76%) of retail customers who bought CFD products on either an advisory or discretionary basis lost money over the 12 month period under review.
- Most providers had flawed on-boarding due diligence processes when taking on new distributors. Firms did not take steps to understand whether an intermediary has the necessary knowledge and experience to distribute the product and whether the distributor's target market matches that of the product provider.
- All distributors had flawed conflict of interest management arrangements. To the FCA's evident surprise, several firms failed to identify a single instance of a conflict of interest or potential conflict of interest affecting their business.
- Whilst most firms had management information (MI), key performance indicators (KPIs) and monitoring structures in place, there were flaws in those tools which meant firms did not have effective oversight. Firms could not adequately assess whether product distribution was in line with plans and expectations nor identify process or control failures.
- Some firms had good remuneration arrangements in place, but with others there were flaws which meant there was an increased risk of mis-selling. The FCA had particular concerns about firms which paid employees on a 100% variable basis.
- Several distributors had problems with processes and criteria the FCA considers acceptable when categorising clients as elective professionals.
The FCA does not routinely send Dear CEO letters to the firms it regulates. Such letters are reserved for circumstances where it has deep-seated concerns about practices in a particular sector and where the FCA wants to ensure that its concerns are given specific attention in the way that a press release or bulletin does not. Accordingly, all firms in receipt of a Dear CEO letter must take heed of its contents and should conduct a detailed gap analysis of practices in their firm as against the relevant handbook rules and guidance referred to in the Dear CEO letter and elsewhere.
The FCA has already confirmed that one firm in the sector has been referred to FCA Enforcement for further investigation. The FCA will conduct further checks on CFD firms in the future to ascertain whether its concerns have been heeded and acted upon. Further enforcement is likely against those firms which have not made sufficient progress, particularly where the FCA is able to identify consumer detriment. For those firms and individuals who do end up in enforcement the existence of a prior Dear CEO letter amounts to an aggravating factor which will increase any fine or other sanction imposed.
Given the FCA's enforcement priority of taking action against senior individuals where appropriate, any enforcement investigation is likely to also involve senior management. Whilst the addressees of the Dear CEO letter and other senior managers will rely on their compliance teams to undertake a detailed review of the letter and firm practices, the FCA will expect senior management to take responsibility for the firm's compliance, which means senior management must provide effective guidance and challenge to their compliance staff.
The FCA is particularly concerned about the distribution of CFD products on an advisory or discretionary basis. Customers of such products might expect to make money on trading, given it is undertaken on the advice or direction of so-called experts, but as the FCA found, in fact most customers lose money. Several firms have told the FCA that they intend to stop providing CFDs to firms that distribute products on an advisory or discretionary basis. It is likely that such decisions were made in the context of significant pressure from supervisors at the FCA.
Other firms providing their CFD products to firms distributing on an advisory or discretionary basis will have difficult decisions to make. It is clear that the FCA is troubled by this sub-sector and further enforcement is likely. Those firms who continue to operate in the advisory or discretionary sector will have to demonstrate very high levels of compliance. The possibility that the FCA might seek to regulate this sub-sector out of existence cannot be discounted.
In parallel with work undertaken by the FCA, on 18 January 2018, The European Securities and Markets Authority (ESMA) launched a consultation on the use of product intervention powers to address the risks to investor protection surrounding the provision of CFDs to retail clients. ESMA proposes to place restrictions on the marketing, distribution and sale to retail clients of CFDs.
The FCA's domestic policy work on permanent product intervention measures applicable to the CFD sector is also ongoing and any permanent FCA policy measures would take into account any prospective ESMA measures.
[A version of this article first appeared in Compliance Monitor]