The UK's spread betters are in purgatory at the moment. The Financial Conduct Authority (FCA) has proposed a range of restrictions on companies selling contracts for difference (CFD) to retail clients. The most hard-hitting of the proposals is to limit the amount of leverage these customers can trade with to 50 times the value they have deposited in their account. As such, the investment case for the CFD sector has become a whole lot more uncertain and, unsurprisingly, the three main UK-listed providers -
In its most recent review of the CFD sector, the FCA found shortcomings in the way in which providers assessed the appropriateness of clients to trade, as well as the anti-money-laundering checks being carried out. What's more, the regulator found that more than 80 per cent of clients lost money on these products, with the average result per client being a loss of £2,200.
The FCA is not the only European regulator to crack down on the CFD sector. In August, French stock market regulator AMF announced plans to ban the advertising of binary bets, as well as CFDs and currency products with leverage greater than 5:1, by any electronic means such as email and website banners. Meanwhile, the German regulator has proposed the marketing, distribution and sales of CFDs to retail clients may only be carried out if they are not at risk of losing more than the amount deposited in their account.
Days before the FCA's announcement, the Cyprus Securities and Exchange Commission also put out a circular clarifying rules on the way CFDs are marketed to customers. This stated that providers must avoid offering bonuses to incentivise retail clients to trade in complex instruments such as CFDs and binary options.
The FCA found shortcomings in the way in which providers assessed the appropriateness of clients to trade, as well as the anti-money-laundering checks being carried out.
The focus of the review is on the appropriateness of CFDs, as complex financial products, to be marketed to mass retail clients. Plus500, CMC Markets and IG Group all say they carry out rigorous checks to assess a client's appropriateness for a trading account.
A spokesperson for IG Group said that before the group allows a prospective client to open an account, it carries out an appropriateness check to determine whether its products are suitable for them; assessing their trading experience and history, field of employment and education. "We actively question applicants and must be satisfied that clients have the necessary knowledge or experience to understand the risks involved. To further assess whether our products could produce poor outcomes, we ask clients for details of their income and savings, both at account opening and in rolling reviews."
CMC has also said it focuses on higher-value experienced clients who understand the markets and products they are trading. Ongoing client education about markets, products and associated risks is part of this, the company said.
Plus500 said it has undertaken significant work on enhancing and adjusting its regulatory compliance in line with new requirements that were published by regulators in the various markets in which the group operates.
Watch out for leverage
If the FCA has its way, a leverage cap of 50:1 will be applied to CFDs sold to retail clients. However, a lower limit of 25:1 will be set for inexperienced retail clients - deemed to be those with less than 12 months of active trading experience in CFDs or other margined products during the past three years. Inexperienced clients will have to deposit a greater amount of capital in order to trade in more illiquid markets.
All the big three CFD providers currently offer products that would breach the limit for even experienced retail investors. For instance, the deposited margin required for more liquid major indices and FX pairs is usually lower than for illiquid small-cap equities. IG Group has set entry point margin rates at 0.5 per cent on major FX pairs and major indices, equivalent to 200:1 leverage. However, the equivalent entry point for individual equities is 5 per cent, equivalent to 20:1 leverage for a small number of major equities and 25 per cent for most FTSE 250 stocks. The margin required also reduces when a position gets larger.
All the big three CFD providers currently offer products that would breach the limit for even experienced retail investors
Plus500 and CMC Markets allow clients to trade in some instruments with greater leverage than this. Retail investors can trade in major indices via Plus500's platform with leverage of 300:1. However, for more vanilla options a 20 per cent margin deposit is required. Meanwhile, CMC Markets offers trading in some major currencies and indices with a margin requirement of 0.2 per cent, equivalent to leverage of 500:1.
The concern for some providers is that limiting the leverage for FCA-regulated providers could prompt clients without sufficient capital to meet the new requirements to trade with externally licensed companies. A spokesperson for the FCA confirmed that providers with a Markets in Financial Instruments Directive (Mifid) services passport would still be able to sell CFDs to UK clients. However, it would prohibit financial promotions for companies that "do not adopt a similar conduct of business standards".
Avoiding the churn
Providers with a higher number of recurring clients could be more insulated against the changes, since a greater proportion of its client base will fall under the category of 'experienced investor' as defined by the FCA. Around half of IG Group's trading revenue was generated by clients that have been trading with the group for three years or more at the end of November 2016. This was down from 55 per cent at the same time in the previous year, although much of this was due to a spike in new users around the time of the referendum and US election. Revenue is also skewed towards a small number of high-value clients, with generally around half of trading revenue attributable to the most active 2 per cent of clients in that period.
CMC Markets also has a relatively stable client base. Continuous traders accounted for around 37,000 of its 48,000 active clients during the six months to September 2016. Meanwhile, new clients numbered 10,000. However, Plus500 has a higher customer churn rate. Active customers - defined as those that have made a real money trade during the period - were just shy of 156,000 last year, but 104,432 of these were new customers. In contrast to IG Group, management says no one client contributes any more than 0.4 per cent of its revenue.
Plus500, CMC and IG Group are becoming more geographically diverse, but the UK still remains an important market. What's more, there is a global trend towards increasing regulation of CFDs. All three CFD providers have suffered analyst downgrades, anticipating an impact on profitability in the UK. For now, that deters us from upgrading any of these companies, despite the fall in the value of the shares.
IG Group's revenue is skewed towards a smaller number of long-term, high-value clients. A high concentration of revenue among a minority of clients can have its drawbacks if some of these clients were to leave. However, it could mean that the company is less affected by regulatory efforts to clamp down on lower-value retail clients being offered higher leverage. However, even trading at an undemanding 11 times forward earnings, the air of uncertainty around the impact of lower leverage limits keeps us from buying in.
Plus500 has done a lot of work in upgrading its compliance systems since it was forced to temporarily freeze UK customer accounts to ensure its compliance with anti-money-laundering regulations. However, the higher turnover of clients means it is at greater risk of losing clients if it loses its competitive edge by being forced to increase margin requirements in the UK.
More sophisticated clients, often drawn from those working in financial markets, represent a different cohort in our view. We do not think that such clients, more prevalent at established operators such as IG Group and CMC Markets, were the prime target of the FCA proposals. Client attrition runs at much lower levels at these operators than some of the new entrants, such as Plus500, where average revenue per client is also much lower. Indeed, if tightening European regulation slows the rate at which new clients are attracted to the industry, then a high attrition rate could quickly see the number of active clients drop at a faster rate than they can be replaced by new ones. We see a couple of potential mitigating factors for the established operators. First, higher-value clients could elect for a 'professional' designation, subject to meeting certain FCA tests. This would remove them from the FCA proposals, which only cover 'retail' clients and, given that around 90 per cent of revenue in any given period comes from the highest 10 per cent of clients, could provide a meaningful cushion. Second, the final report due in Spring may allow an element of 'grandfathering' such that the rules apply only to new clients signed up from a certain future date. Given the precipitous falls in the share prices of all operators, we think the market has priced in a harsh view on the final outcome. Therefore, accepting that forecasts will still be heavily influenced by the final FCA outcome, we see some speculative value in CMC Markets at current levels, even though we view IG Group as the highest quality operator (we upgraded from 'sell' to 'hold' after the shares fell below 500p) and would want to see consistently lower attrition at Plus500 to be more confident in its ability to address a post-tightening slowdown in new client sign-ups for the industry as a whole.
Paul McGinnis is an analyst at Shore Capital
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