Compliance Alert: CONSULTATION PAPER ON THE REGULATION OF RETAIL OVER THE COUNTER LEVERAGED PRODUCTS
On 16th November 2020, the Dubai Financial Services Authority (DFSA), the Financial Services Regulator in Dubai International Financial Centre (DIFC), issued a Consultation Paper on the regulation of retail over the counter (OTC) leveraged products.
The Paper proposes to provide an increased level of protection to retail clients who trade in highly leveraged OTC derivative products. This is particularly important because such products are inherently risky, complex and retail clients may not easily understand the risks associated with them.
Please note that the deadline for providing comments on this proposal expires on 16 January 2021.
What is meant by retail OTC leveraged products?
According to the International Organisation of Securities Commission (IOSCO), the international body that brings together the world’s securities regulators, retail OTC leveraged products are off-exchange products used by retail investors to speculate on the short team price movement in a given underlying asset. Such products include:
- Rolling spot FX contracts – contracts where the pay-out is based on the fluctuation of foreign exchange rates;
- Contracts for difference (CFD) – contracts where the pay-out is based on the fluctuation of underlying financial rates and prices; and
- Binary options – contracts where the pay-out, based on any of a variety of underlying financial rates and prices, depends entirely on the outcome of a yes/no proposition.
These products are most commonly sold via an online trading platform without the provision of investment advice where a leverage mechanism is used. Leverage alters the investor’s financial exposure to the underlying asset. It allows the investor to enter into trades by only posting a small proportion of the total notional investment to support the trading position. This is highly risky.
Why are such regulations required?
In 2017, the DFSA raised several concerns with Authorized Firms offering and selling high leveraged OTC products to retail clients. Such concerns include but are not limited to the below:
- Retail clients losing money off the back of entering into CFD trades;
- Where clients entered into high leverage trades, a high percentage of clients lost more than their initial investment;
- Lacked transparency with associated fees and costs;
- Confusing and unclear price methodology.
As a result of the above concerns, the DFSA issued a ‘Dear SEO letter’ outlining the guidance and recommendations for Authorized Firms that offer or sell high leverage OCT products to retail clients.
The IOSCO has also published a toolkit, which details recommendations that can be adopted by regulators to address some of the issues noted above.
The DFSA also found that other major jurisdictions including the EU, UK and Australia were introducing detailed conduct standards for regulating the trading of highly leveraged products in the retail market.
These jurisdictions found that retail investors faced a risk high loss where Firms offered increased leverage. It was also found that the increased competition between new and existing Firms brokering high leveraged products was not treating customers fairly and adopting best practice.
This, in turn, encouraged the DFSA to become more aligned with these major jurisdictions by adopting international best practice when regulating retail OTC leveraged products also known as Restrictive Speculative Investments (RSIs)
Definition of the RSI proposals
The DFSA proposes to refer to the high leverage OTC products collectively as Restricted Speculative Investments. More specifically, the definition will list and define the various OTC products that fall within the definition of RSIs including CFDs, rolling spot forex trades and other binary options.
Application of the RSI proposals
The DFSA proposes for Authorized Firms that carry out the following regulated activities to be caught by the new regulations, Firms:
- Dealing in investment as principal (including dealings on a matched principal basis);
- Dealing in investment as an agent;
- Advising on financial products;
- Arranging deals in investments;
- Acting as a representative office; and
- Conducting financial promotions.
As you can see, the proposed regulations cover a broad spectrum of market participants. This is to ensure that retail clients are not put into RSI contracts where they are not subject to adequate protection.
What is the Appropriateness Assessment?
Under the current appropriateness assessment (COBS rule 3.4.2 (1), Authorized Firms that recommend a product or execute a trade on a discretionary basis are required to conduct a suitability assessment to ensure that a product meets a client’s needs, objectives and their financial situation. However, this rule does not typically extend to offering to trade in RSI to retail clients mainly because these instruments are offered on an execution only basis as opposed to on a discretionary basis or where a recommendation has been made.
Both the EU and the UK have an Appropriateness Test for Firms to follow before retail clients are put into RSI trades. The IOSCO’s toolbox also recommends that Firms should apply such a test when offering and marketing RSI products.
In light of the above, the Consultation Papers proposes that Authorized Firms in the DFSA undertake an appropriateness test to:
- ensure clients have the necessary skills and expertise relating to RSIs; and
- Have the ability to absorb significant losses particularly due to leverage trades.
Guidance will be provided for Firms regarding the factors that should be considered how Firms can demonstrate that they have conducted such due diligence on retail clients.
Proposed risk warnings
Due to the inherent risks associated with trading RSIs, the DFSA proposes that Firms must issue retail clients with stand-alone risk warnings prior to entering into any agreement. The risk warnings should detail the following:
- The complex nature of the products;
- The high percentage of losing money due to high leverage trades;
- Disclosure of general performance in terms of profit and loss; and
- The person should before entering into an agreement to trade the RSI, carefully consider whether the retail client understands the features and the risk profile of RSI offered and how they work.
The DFSA proposes to provide further guidance of the intricacies of the above.
What are the proposals for fee disclosures?
Currently, as part of the key information provided to a retail client when entering into an agreement, a Firm must disclose fees, costs and other charges.
The DFSA propose making a mandatory requirement for Firms offering RSI to provide retail clients with the following information:
- Any commission charged;
- The amount of any markup prices a Firm receives from an external source;
- Financing charges, including daily and overnight financing charges;
- The amount of any mark up when calculating financing charges; and
- Costs and charges to be applied if the client is seeking to sell or exit early.
It is important to highlight that if there are any material changes to a Firm’s fees then the DFSA proposes for Firms to issue new disclosure information to retail clients pertaining to the new fees, costs and any charges.
Minimum margin requirements
The Consultation Paper proposes introducing minimum margin requirements that will reduce the amount of leverage a Firm is able to offer retail clients for a given amount of exposure. Please refer to the table below for the proposed requirements:
Margin close-out requirements
A margin close-out is when a trading account runs low on funds, which occurs because of a losing trade.
In order to protect retail clients with additional protections, the DFSA proposes to introduce the following margin close-out requirements for regulated Firms:
- The firm must close out any of the client’s open positions in the client’s RSI trading account when the client’s net equity for that position falls below 50% of the margin required to maintain that open position; and
- Do so as soon as practicable, and on the best possible terms for the client.
What are the proposals around Negative Balance Protection?
In line with other major jurisdictions, the DFSA proposes introducing a negative balance protection requirement so that a retail client’s liability for losses resulting from trading in RSIs are limited to the client’s funds in the trading account.
Are there any restrictions when using credit to fund a trading account?
Some brokers allow the retail client to fund their trading account using credit cards. However, it is the DFSA’s position that Firms should not encourage clients to take positions with money they do not actually have. As such, the DFSA is proposing a requirement that will ensure that Firms will take reasonable steps to ensure that client does not use credit cards to open trade positions in RSIs.
Are there any restrictions relating to the type of RSI?
The DFSA has proposed that RSI’s should only be offered to retail clients in the following instances:
- Where the RSI has a transparent pricing mechanism available to determine the price movement of the underlying reference, by reference to which the profit or loss of each party to the contract is determined; or
- The Authorized Firm provides a two-way pricing mechanism that allows the retail client to trade-in at the quoted prices during the currency of the RSI contract.
Are Firms permitted to accept referrals from unregulated persons?
No, under the proposed regulations Authorized Firms are prohibited from accepting clients from unregulated sources.
Restrictions relating to the distributing and marketing of RSI
Authorized Firms including Firms dealing as agent, advising on, or arranging deals on RSIs are permitted to distribute and market material relating to RSIs, if the DFSA are reasonably satisfied that those RSI’s are regulated under the DFSA’s regime.
Is there a prohibition against the offer of incentives?
Yes, the DFSA proposes to prohibit the offer of inducements to retail clients by Authorized Firms who:
- The deal, advise, or arrange deals in RSIs; or
- undertake marketing activities as a Representative Office relating to RSIs.
This is consistent with other jurisdictions.
Prudential Categorization for dealing in RSI
Under the current regime, Firms that act as a counter-party to its client in an RSI contract are dealing in investment as a principle. Such Firms fall either fall under Prudential Category 2 (if they are acting as agent) or Prudential Category 3A if they are dealing on a matching principle basis (brokers who undertake matching transactions to fulfil their client’s orders).
However, the DFSA are of the opinion that Firms trading in back-to-back positions entered into with a parent company or another group member do not fulfil the requirements relating to matched principle dealing. This is because the transaction is not entered into to fulfil client orders.
The DFSA has asked for the public to comment on whether and to which extent Authorized Firms are using the matched principle for trading in RSI and if so, how their activities fit within the parameters of dealing on a matched principal basis.
Other Proposals include the requirements for Firms to:
- Maintain adequate record-keeping relating to their compliance with the applicable RSI requirements;
- Provide a 6-month transition period to Authorized Firms in relation to existing clients to enable them to meet the proposed requirements, from the date of the implementation of the proposal; and
- Provide risk warnings on marketing and other communications that are clear, concise, prominent and relate to risks associated with trading in such products.
It is evident that the DFSA’s proposed regulations for retail OTC leveraged products provide a high level of protection for retail investors trading RSIs by mitigating the said risks associated with the offering, selling and marketing of RSI products. The proposals are in line with international best practice and set out clear requirements for Authorized Firms (that are caught by the proposed regulations) to adhere to.
Partner & Head – Regulatory & Compliance Services
Senior Manager – Regulatory & Compliance Services
  https://www.iosco.org/library/pubdocs/pdf/IOSCOPD613.pdf
  https://www.iosco.org/library/pubdocs/pdf/IOSCOPD613.pdf
  https://www.iosco.org/library/pubdocs/pdf/IOSCOPD613.pdf