On 23 March 2018, the European Securities and Markets Authority (ESMA) agreed to take measures on the provision of contracts for differences (CFDs) and binary options to retail investors in the European Union (EU). The main thrust of these measures is to prohibit the marketing, distribution, and sales of both CFDs and Binary Options to retail investors. Moreover, further restrictions add strong protections and limitations for retail investors in CFDs.
The ESMA has taken these measures out of persistent concern on behalf of retail investors. The most significant of these concerns in relation to CFDs and Binary Options is their complexity and opacity. The ESMA felt that there were strong concerns about the risks that retail investors were taking when investing in CFDs and Binary Options.
The National Competent Authorities analysed CFD trading and trading on Binary Options across different EU jurisdictions. Their analyses show that 74-89% of retail accounts in CFDs lose money on their investments. Average losses per client can range from €1,600 to €29,000. Likewise, the NCA’s analyses for Binary Options found consistent losses on retail clients’ accounts.
Steven Maijoor, the chairman of the ESMA’s Board of supervisors, observed that ““The agreed measures ESMA is announcing today will guarantee greater investor protection across the EU by ensuring a common minimum level of protection for retail investors. The new measures on CFDs will for the first time ensure that investors cannot lose more money than they put in, restrict the use of leverage and incentives, and provide a risk warning for investors. For binary options, the prohibition we are announcing is needed to protect investors due to the products’ characteristics. The combination of the promise of high returns, easy-to-trade digital platforms, in an environment of historical low interest rates has created an offer that appeals to retail investors. However, the inherent complexity of the products and their excessive leverage – in the case of CFDs – has resulted in significant losses for retail investors. A pan-EU approach is required given the cross-border nature of these products, and ESMA’s intervention is the most appropriate and efficient tool to address this major investor protection issue”.
A Contract for Difference (CFD) is a popular form of derivative trading. An investor in CFDs does not invest in the underlying asset. It is instead a tradable instrument made in a futures contract that mirrors the movement of the asset underlying it. It is a contract between the client and the broker. Gains and losses are settled in cash, offering the investor an easy way of investing without actually holding the asset itself.
A Binary Option provides access to stocks, indices, commodities and foreign exchange. The most common Binary Option is a "high-low" option, which is also called a fixed-return option. This is because the option has an expiry date and time and also what is called a strike price. If a trader correctly predicts the market's direction, and the price at the time of expiry is on the correct side of the strike price, the trader is paid a fixed return regardless of how much the instrument moved. A trader whose prediction on the market's direction is incorrect loses his investment. There are other types of Binary Options but the basic principle remains the same. Major advantages of Binary Options include accurate knowledge of risk and reward. Major disadvantages include disparity between expected return and risk of loss.