ESMA regulations for Forex and CFD – lower financial leverage

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The European Securities and Markets Authority (ESMA) has formally announced the date of ESMA regulations coming into force. ESMA’s new rules for Forex market and CFDs (Contract for Difference) will come into force on the 1st of August 2018. What does this mean for European Forex traders?

In the theory of the pan-European regulator – greater protection for investors in the Forex and CFD markets. In practice, ESMA’s regulations on Forex and CFD markets lower the Forex leverage to 1:30, and on CFDs on indices even to 1:20! Does this mean that European Forex traders will no longer have the opportunity to trade with high Forex leverage? Luckily not – Forex and CFD brokers from Australia come with the relief.

Are the new ESMA regulations beneficial for Forex investors?

ESMA CFDFrom the perspective of a Forex and CFD trader, the significance of the five restrictive measures taken by ESMA can be divided into minor or unimportant, doubtful and extremely unfavorable ones.

ESMA restrictions on limiting the provision of incentives to trade Forex (bonuses) and on harmonising risk warnings for CFDs should be considered as minor and of low relevance. Why did we consider these points to be of small importance?

In our opinion, a conscious Forex investor and CFD trader cannot be tempted to certain Forex broker just by the bonus or promotional offer, but compares the offers of different Forex and CFD brokers and selects the one that best suits his expectations and needs.

What is more, many national regulators, such as the Polish Financial Supervision Authority or the Cypriot CySec, had already introduced these restrictions on local markets many months ago, which is why ESMA’s regulations will not change anything there. The same applies to the risk warning, which all brokers operating in the EU are obliged to provide.

Stop Out

Undoubted benefits from the perspective of Forex and CFD investors are the unified Stop-Out mechanism – a process of automatic closing of positions when the margin level drops to 50%, and a mandatory protection against negative balances for each account.

Let’s start with the Stop-Out mechanism, which has been used by virtually all brokers available on the market for years. Some of the brokers had a Stop-Out level at 20% or 30% of margin level, which meant that the investor was able to survive greater price fluctuations without exposing himself to the risk of automatic liquidation of his market positions.

With a Stop-Out value set by ESMA at 50% of margin level, positions will be liquidated sooner than with a Stop-Out of 20% or 30%. Why did ESMA arbitrarily set this level at 50%? Was this process preceded by consultations with the investor community or in-depth research confirming the validity of such assumptions?

Negative balance protection

Let us move on to another point in the ESMA regulations, namely the mechanism for protection against negative balances. At first glance, this mechanism can be considered an excellent tool, thanks to which the investor will not lose more money than he invested with the Forex broker.

Forex traders who remember the events on the Swiss franc market on January 15, 2015 know perfectly what can happen to the margin and the equity on their trading account when orders are executed with huge slippages or are not executed at all. The occurrence of such a situation – high market volatility along with low market liquidity – may lead to a negative balance on the trading account, which the mechanism of negative balance protection introduced by ESMA regulations is to protect the Forex trader from.

Why, then, is this a questionable advantage? Because there is no ‘free lunch’ on the market. Brokers and other financial institutions operating within the Forex and CFD markets have the status of eligible counterparties and, unlike retail and professional clients, their legal protection is incomparably lower.

In relation to this, can we imagine that our broker in an agreement with an investment bank in New York or London has a clause in the contract which says ‘I cannot lose more than I have deposited with you’? We cannot imagine that!

Black Swan Event

ESMA Forex leverage

If the market had experienced extraordinary volatility, comparable to that of the unlucky January 15, 2015, when the Swiss franc to Europe peg was lifted, what would have happened to the orders that our broker processed to his liquidity provider?

Certainly, they would be executed with huge slippage, on which our broker would lose plenty of cash. Our account balance would probably have fallen to zero, while a broker would have had a debt to pay off to his liquidity provider. Would the broker be able to withstand such a shock with regards to its capital? And what if there were many more Forex traders – clients to this particular Forex broker like us? Or maybe in such situations it is not worth for the broker to ‘take the risk’ of transferring orders to its liquidity providers, but rather keep the trades ‘in-house’ by being the counterparty of the trade in broker’s B-book?

This directly leads to a Market Maker model, which by definition is trading against the clients and earning on clients’ losses. So will ESMA regulations eliminate from the Forex market real ECN brokers and only MM brokers (Market Makers) will remain on the Forex market?

Is lower Forex leverage beneficial for Forex traders?

We have left the issue of ESMA’s cap on the maximum leverage on Forex and CFDs as the last point of the discussion as it requires a thorough debate and indication of all upsides and downsides of this restriction. To start with, what are the limitations of the leverage as of August 1, 2018? Maximum leverage levels are:

  • 30:1 for major currency pairs;
  • 20:1 for non-major currency pairs, gold and major indices;
  • 10:1 for commodities other than gold and non-major equity indices;
  • 5:1 for individual equities and other reference values;
  • 2:1 for cryptocurrencies;

ESMA’s regulations probably followed the logic that the lower the leverage, the lower the risk of capital loss for the investor. Why, then, do we consider lowering the leverage on Forex and CFDs to be an extremely negative phenomenon?

Because in our opinion no one, except the trader, should interfere in the trading process carried out by him! If my strategy requires a leverage of 1:100, should I stop trading in the face of a reduction of Forex leverage? Shall I change my trading strategy or shall I choose IC Markets or IFM Trade – Australian brokers that offer leverage up to 1:500?

Only a trader, who struggles every day on the market and risks his own capital should have the right to make such a decision – which leverage I am trading Forex with.

ESMA regulations - Forex leverage ESMA

Does a higher level of leverage automatically pose a higher risk? No. Just like a 400 BHP car does not pose any immediate risk for the driver. It is not the leverage that decides how big positions we trade, just as it is not the car that decides how fast we drive. These are solely trader’s and driver’s decisions, respectively.

It’s true that a higher Forex leverage allows you to operate larger volumes, but does it force you to do so? Whether the potential of Forex leverage will be fully used, or it will just remain available but not fully used, is determined by many factors including the trading strategy of the trader, the degree of knowledge and experience of the investor.

Forex trading leverage

Moreover, the higher the leverage on trader’s Forex trading account, the lower the required margin. With a leverage of 1:500, a 1.0 lot position on EURUSD requires a deposit of only 200 EUR. Opening the same position with a leverage of 1:30 will require from trader to hold margin of 3333.33 EUR.

The risk taken by the Forex trader in both cases is exactly the same, as it is market exposure – total volume of all open market positions – that tells how big the risk is, not the level of Forex leverage on the trading account. The question remains then, what is the purpose of keeping as much as 3333.33 EUR deposit with a Forex broker if the same market position can be traded with only 200 EUR margin?

Forex leverage vs Stop-out

Moreover, the level of Forex leverage influences how Stop-Out mechanism functions on our trading account. Let’s present it on a practical example in which we assume that a trader trades with the following values: equity of 5,000 EUR, the position of 1.0 lot and the Stop-Out mechanism is set at 50% of margin level.

With the leverage level of 1:500, the margin for such a position is only 200 EUR. Question – when will the position be automatically liquidated by the Stop-Out? The answer is simple – when the equity on the account falls by 4900 EUR to 100 EUR, i.e. half of the margin needed to collateralize the position (50% x 200 EUR). How does it look in the second case, where the Forex leverage is 1:30?

Since the margin will equal to as much as 3333.33 EUR, the Stop-Out mechanism will activate itself when a loss on the account reaches 1666.67 EUR (50% x 3333.33 EUR). Theoretically, the loss is lower in the example with lower leverage, amounting to 1666.67 EUR compared to 4900 EUR in the first example. But is it the correct approach?

Let’s not forget that the size of a potential profit or loss is determined by the size of the position, thus the size of one pip and these values are identical in both examples! If we were to assume – for easier calculation – that the size of one pip would be 10 EUR, the loss of 1666.67 EUR would need a market move of 167 pips against our position while in order to lose as much as 4900 EUR EURUSD market would have to move as many as 490 pips against us!

In other words, the Stop-Out mechanism in the first example with a leverage of 1:500 would activate itself if EURUSD moved 490 pips against our position, whereas with a leverage of 1:30, our position would be automatically closed by the Stop-Out with a move of 167 pips against our EURUSD position. What does it mean? Greater leverage gives us a bigger ‘buffer’ to exit the market when we can decide for ourselves when to close positions and exit the market – with a loss or profit.

Trading with higher leverage – Australian Forex broker IC Markets or IFM Trade

financial leverage meaning

It is likely that some investors will decide to stay within ESMA’s jurisdiction and try trading Forex and CFDs in an environment of reduced leverage on Forex and CFDs.

Those traders who maximize their rate of return on equity or – their trading strategy requires high Forex leverage within the range of 1:100, 1:200 or even 1:500 should be interested in the offer of two Forex and CFD brokers from Australia – IC Markets and IFM Trade.

Security of funds entrusted by customers of these Forex brokers is guaranteed by the supervision of the Australian Securities and Investments Commission (ASIC), the Australian financial services regulator.

Both IC Markets and IFM Trade offer Forex leverage of up to 1:500 and excellent trading conditions with spreads as low as 0.0 pips. IC Markets and IFM Trade product and services offers are robust, with CFDs on currencies (Forex), stock indices, as well as the most important commodities – gold, silver or crude oil and CFDs on cryptocurrencies – Bitcoin.

The real trading account can be opened from as low as $200 and the minimum trading unit is only 0.01 lot. Since the quality of the services provided by IC Markets and IFM Trade is excellent, it will be difficult to find a comparable offer among brokers registered in the European Union, especially if we take into account no Forex leverage limits in Australia.