There’s nothing like uncertainty to throw a spanner in the works for regulated companies. The Financial Conduct Authority’s (FCA) intention to tighten restrictions on the sale and marketing of spread-betting products to the retail market caught both providers and investors off-guard, sending shares in the three major UK-listed specialists down by as much as a third.
Yet as the governance mist has lifted – with the European Securities and Markets Authority (ESMA) adopting the final set of rules in June – so too have the valuations of stocks in the sector’s major players. Shares in IG Group (IGG) and CMC Markets (CMCX) have recovered by around a third during the past 12 months, while Plus500 (PLUS) stock has more than doubled. That’s left shares in IG and Plus500 trading at a slight premium to their three-year historical averages, and the more-recently-listed CMC higher than its two-year historical average, according to Bloomberg consensus forecasts. But with the addressable market shrinking, have lower revenue expectations been priced in adequately? And which are the companies best placed to thrive in a stricter regulatory environment?
The new rules – which are set to be implemented next month – include lowering leverage limits on the opening position by a client to between 30:1 and 2:1 depending on the volatility of the underlying instrument. At the top end of the leverage boundaries are major currency pairs, while cryptocurrencies are, unsurprisingly, considered the riskiest. Other restrictions include mandatory negative balance protection on client accounts and a 'margin closeout rule', whereby the provider must close one or more contracts for difference (CFDs) if the balance of the account falls below 50 per cent of the 'margin requirement' – loosely defined as the minimum required deposit in an underlying instrument. A ban on the sale of binary options is already in force.
The decision to clamp down on leverage limits is a blow to revenue potential, as many retail investors lack the funds to meet these margin requirements. Taking advantage of this leverage was also a clear motivator for investors to trade with CFDs, according to a survey by financial services industry research company Investment Trends. Currently, many providers offer leverage limits on some instruments of up to several hundred times the amount deposited in client accounts. For instance, Plus500 allows traders to leverage up as much as 300 times for trading indices. With that in mind, it’s unsurprising that the industry has lobbied in response to these initial proposals; IG Group set up a website where clients could protest the plans, which gained around 14,600 responses.
However, analysts at Numis reckon that while retail clients are likely to trade smaller amounts, many will be already close to minimum trade sizes, and not have the scope to trade less. What’s more, the potential profit on a trade could be much smaller and fail to justify the effort of stopping trading altogether or reducing the size of the trade.
Damage control
Given the restrictions only apply to retail investors, providers have started to actively encourage their private clients to apply for 'professional' trading status. Under FCA rules, investors can qualify for 'elective' professional status if two out of three criteria are met: the client has carried out significantly-sized transactions of an average frequency of 10 per quarter over the previous four quarters; the size of their portfolio – including cash deposits and financial instruments – exceeds €0.5m (£0.45m); and the client has worked in a professional position within the financial sector for at least a year at any time in their career.
The first of those criteria might be easy for retail clients to meet, but the latter two less so. Of the 18,650 applications for professional status last year, 77 per cent were rejected. At CMC, 71 per cent were unsuccessful. By the end of June, IG’s combined UK and EU revenue generated by professional clients accounted for just over 40 per cent of the total top line, a figure management expects to rise to 50 per cent. CMC expects more than 40 per cent of UK and EU revenue to come via professional traders. Plus500 estimated that around 12 per cent of its UK and EU client base may be eligible, and typically generates three-quarters of its revenues from the region.
Some providers have also applied for licences in other jurisdictions, which enables EU and UK customers to open accounts outside their domicile. IG Group chief executive Peter Hetherington says it's "inevitable" that providers will need to diversify their product ranges too. This year the group also plans to launch a European derivatives exchange, which will not be affected by the ESMA regulation.
Clients who convert to professional status are expected to help to offset some of the sales dent once the reforms are introduced, but the impact will still be sizeable. IG Group estimated the revenue impact at 10 per cent next year, assuming no further benefits from mitigating actions taken by management, which will result in a drop in group sales on 2018. However, it expects to return to growth after 2019. That decline will also impact on the group's historically generous dividend which, after being raised by a third for the year to May 2018, will be kept flat at 43.2p a share until earnings recover. Meanwhile, CMC Markets estimates the potential cost of the reforms will be higher, expecting a fall of between 10 and 15 per cent in CFD revenue next year. By contrast, Plus500 has raised its trading expectations for the full year, on the back of high levels of customer sign-ups during the first quarter. However, management admitted group performance could be impacted by the rate at which clients request – and are accepted – as professional investors.
