- ESMA is rolling out significant changes for forex trading in the European Union.
- What are the regulations? How will they impact trading? How can I prepare?
- This article aims to answer all these questions and more.
What it is all about and what we think about it
What are the regulations in general?
The new regulations impose limits on leverage for various assets (30:1 is the top tier), ban binary options and bonuses, require transparency and negative balance protection measures from brokers and more. More details are below.
What do we think about these significant changes?
Francesc Riverola, the Founder and President of FXStreet, says that while some brokers fear a drop in profitability in European accounts, this regulation may be a step forward in making forex an asset class and points to the Japanese forex industry which has successfully weathered leverage restrictions.
“The new regulations will help distinguish between three types of brokers: the big brands offering multi-market financial instruments, the forex brokers that are experts in marketing and conversion, and the offshore ones,” says Riverola. “The ESMA rules will help brokers focus on their audiences and traders pick the right broker for them. So far, it was sometimes not too easy to see a clear distinction between the three types.”
What is ESMA?
The European Securities Markets Authority is known for its involvement in the debt crisis, but it is taking on a supranational role in regulating markets. So far, regulation has varied between various jurisdictions within the European Union (all EU countries, not only the euro-zone), with Cyprus attracting many brokers. These guidelines also apply to the UK until it leaves the EU.
Who are the winners of these new regulations?
Prudent brokers are likely to be winners: those that play it safe and do not market themselves aggressively are now shielded from the more shady ones. Also, traders will get more transparency about the losses that a brokers’ clients suffer, enabling a better choice.
Who are the losers of these new regulations?
Brokers that have marketed aggressively with bonuses and excessive leverage will either adapt or leave the scene. Traders that like turbo-charging their leverage will also need to adjust or find new jurisdictions.
So, let’s begin with the numbers.
Leverage limits
Leverage is one of the key characteristics of forex trading as part of the cost structure. The first thing that stands out in the ESMA regulations is this topic.
I trade EUR/USD and sometimes GBP/USD. Will the new rules have an impact?
Probably not. The limit for major currency pairs is 30:1, which is quite broad and suitable for most traders. Japan has a limit of 25:1 and the market is thriving. If you trade EUR/USD, GBP/USD, USD/JPY and other majors pairs for some time, you probably do not need higher levels of leverage. In any case, remember not to risk more than 2% of your account at any given point.
I prefer the smaller, nimbler currency pairs and occasionally trade gold and indices. Where do I stand?
The limit for non-major forex pairs, gold, and major stock indices is 20:1. Similar to major currency pairs, most traders will not need 20 times the amount they have to trade. The limit is lower as movements are sharper in assets such as crosses, the S&P, and the DAX.
I trade oil, and I am an expert in stocks in my home country. What should I know?
The limits to leverage rise with volatility: oil prices move more rapidly, and the new leverage limit is 10:1. For those trading the black gold and other non-gold commodities, this leverage is already more of an impediment but not surprising given the volatility. The same applies for non-major indices: liquidity is lower in the Slovenian or Malaysian stock exchange than in the French or Japanese ones.
I am an expert on the Apple stock and like the volatility on Facebook. What are the new limits?
Once again, things get tighter as volatility rises: only 5:1. Most traders with brokers likely prefer currencies in any case, and high leverage ratios are probably not suitable for stocks that rise and fall in a rapid manner and with several percentage points.
I do not believe in fiat currencies and trade only cryptocurrencies. What is the leverage limit?
The highest level of volatility receives the lowest level of permitted leverage. Many of those that are into crypto cannot really be called traders: they Hold On for Dear Life (or HODL): buy and never sell. For those that do trade and follow the likes of Bitcoin, Ethereum, Ripple, and others, all know that movements may be wild.
More: ESMA and the Tale of the 5 Leverages
Trader protections
Can I lose more money than I deposited?
The negative balances that traders were supposed to cover after the infamous “SNBomb” are now prohibited. In January 2015, the Swiss National Bank suddenly removed the floor under the EUR/CHF, and the cross collapsed. Not only were long positions erased, but in some cases, retail traders were expected to cover the deep and leveraged losses. No more. Brokers will now be required to provide negative balance protection. Besides, they are obliged to close out margin positions each time an account passes 50% of the minimum required margin.
More: Margin Call: a guaranteed limited risk
Will I know how my fellow traders fared?
Another novelty comes from transparency. The new regulation forces brokers to display the percentage of clients that lose money. This is similar to a rule introduced by the CFTC in the US several years ago. The rate of losses reflects on the brokers’ execution of trades, the level of education and more. It joins the factors in choosing a forex broker.
The bans
Can I still hedge my trades with binary options?
No, as binary options are now banned. While some traders used this instrument to take the other side of a trade and hedge, many used it for pure speculation. Some of the binary options operations were run by not-so-clean organizations, and they were defined by ESMA as products that have a structurally expected negative return. The binary options industry was on the decline for some time, and the ESMA ruling is their death knell.
The broker promised a bonus. Will I get it?
If the bonus was promised under the previous regime, the forex broker needs to honor the pledge. However, bonuses and other incentives are now prohibited. They were seen as an indecent way to woo traders. The ads promising a considerable reward will soon disappear from the European scene.
Conclusion
While regulation can have unintended consequences and can sometimes be contradictory, the new ESMA regulations will undoubtedly have a significant impact on the foreign exchange industry. Traders and brokers will all have to adapt, but after the initial pains, the industry has a chance to grow and become stronger.
What do you think? Contact us.