ESMA considers MiFID product intervention powers to delay FCA intervention on retail CFDs under CP16/40; but the FCA still finds failings in firms' appropriateness assessments  

The European Securities and Markets Authority (ESMA) and the FCA published statements last week that will be of interest to retail CFD providers. We summarise the announcements below. In summary:

• ESMA is discussing the use of its MiFIR product intervention powers, which could result in material changes to the offering of contracts for difference (CFDs), rolling spot forex and binary options.
• As a result of this, the FCA has delayed publishing its final rules following its consultation on the retail CFD industry (CP16/40), pending the outcome of ESMA's findings.
• Separately, the FCA has found certain firms' appropriateness assessments continue to fail the FCA's expected standards.

1.  ESMA announcement on European retail forex, CFD and spread betting industry

ESMA has announced that it is considering "the possible use" of its product intervention powers under Article 40 of the Markets in Financial Instruments Regulation (MiFIR) - part of the MiFID II reforms - to "address investor protection risks in relation to CFDs, rolling spot forex and binary options." We have summarised ESMA's product intervention powers under MiFIR at the end of this briefing.

ESMA confirms that the measures it is discussing include proposals that take into account a number of measures that have been adopted or publicly consulted on by other European regulators. ESMA says "These measures include leverage limits, guaranteed limits on client losses, and/or restrictions on the marketing and distribution of these products."

Any intervention measures must be approved by the ESMA Board of Supervisors and can only come into effect from 3 January 2018 at the earliest, when MiFIR comes into effect.

Given the different proposals announced by various European regulators, from outright bans to leverage limits, firms will hopefully be able to look forward to (and possibly welcome) a consistent approach across Europe following ESMA's intervention. However, as always with ESMA, there is no knowing which outcome it will plump for. While firms may have a respite until January 2018 (as if there is little else to be getting on with before then!), they should focus on lobbying ESMA and monitoring the possible outcomes of ESMA's discussions. Clearly, sharing a commitment to delivering key aspects of MiFID II (product governance, disclosures and inducements) and PRIIPs KID may also help them fight their corner.

2.  FCA statement on delay to final rule changes proposed under CP16/40

As a result of ESMA's announcement, the FCA has delayed making its final conduct rules for UK firms providing CFDs to retail clients, which it consulted on in CP16/40, pending the outcome of ESMA's findings.

The FCA notes that ESMA is considering measures similar to those the FCA consulted on in CP16/40, as well as measures consulted on by other national competent authorities in Europe.

The FCA's work is not completely on hold, however. It will continue to conduct further policy work in light of consultation feedback and is likely to request additional data from a sample of UK firms over the coming months to inform any future policy decisions and provide a basis on which the FCA can evaluate the impact of any prospective rules.

The FCA may still also publish its final rules in the first half of 2018 if there is a significant delay to the implementation of ESMA's possible measures.

3.  Conclusions from FCA's review of firms' appropriateness assessments

The FCA has also published today its conclusions from its review of appropriateness assessments for sales of CFD products.Following its review, the FCA's key areas of concern remain. This is despite its Dear CEO letter of February 2016 and other subsequent communications to firms. In particular, the FCA's review found that certain firms:

• inadequately assess prospective clients' knowledge

The FCA notes that the assessment of a client's knowledge is separate and additional to an assessment of their experience.

In particular, the FCA's is concerned with questions that ask whether a client has attended a seminar or course about CFDs, or whether they have used a demo account. The FCA says firms should not place undue weight on these factors. Instead, firms should be assessing the client's knowledge of leverage, stop losses and other trading techniques relevant to CFD trading, for example. Firms may want to start using such questions in their take on process.

• take insufficient account of clients' previous transactional experience

The FCA states that certain firms fail "to take adequate account of the nature, volume and/or frequency of prospective clients' previous transactional experience, or the time period over which such transactions had been carried out", which is required by COBS 10.2.2R(2).

• have inadequate risk warnings to clients who fail appropriateness assessments

The FCA states that risk warnings should be designed to interrupt the application process, using clear language and a clear recommendation against proceeding. Clients should not, therefore, be asked to confirm an intention to proceed with a transaction as a next step.

The FCA notes good practice as including the use of "a mandatory 'cooling off' period after the risk warning, and/or requiring the application to submit or respond to a separate communication in which they must acknowledge the risk warning, such that they do not have the option to proceed immediately." This is very similar to the ESMA Q&A.

• fail to turn away clients who fail appropriateness tests

The FCA found, that in most cases, firms did not give meaningful consideration to whether the applicant should still be permitted to proceed having failed the appropriateness assessment. The FCA notes that firms who still permit clients to trade even though they have failed the appropriateness assessment "may be failing to comply with their obligations in relation to customers' best interests under COBS 2.1.1R and Principle 6, as well as acting contrary to our guidance in this regard (COBS 10.3.3G)."

• have poor oversight, weak controls and inadequate management information

The FCA states "It is vital that firms have appropriate, accurate management information and meaningful board level discussions relating to appropriateness assessments." The FCA's review found a lack of evidence of such discussions or of appropriate challenge. The FCA notes that a failure to conduct business with due skill, care and diligence, or failure to take reasonable care to organise affairs responsibly and effectively, may constitute a failure to comply with Principle 2 or 3.

ESMA's product intervention powers under MiFID

Article 40 of MiFIR gives ESMA the power to temporarily prohibit or restrict the marketing, distribution or sale of a financial instrument or type of financial activity. 

This power is conditional on:

• the proposed action addressing a significant investor protection concern, or a threat to the orderly functioning and integrity of financial markets or commodity markets, or a threat to the stability of the whole or part of the EU financial system;
• EU regulatory requirements applicable to the relevant financial instrument or activity do not address the threat; and
• one or more competent authorities have not taken action to address the threat, or actions that have been taken do not adequately address the threat.

It would appear ESMA would intervene on investor protection grounds, satisfying the first condition. ESMA would have to argue that MiFID II does not address its concerns to satisfy the second condition, which it will likely be able to do. However, one might argue that the final condition could pose some problems for ESMA. It is hard to argue that one or more competent authorities have not already taken action to address the threat – outright bans on marketing in France is one example of such action. We suspect ESMA will have to argue that these measures do not adequately address the threat. Either way, it is likely ESMA will find a way to use the powers if it decides it needs to intervene.

Before deciding to exercise its powers, ESMA has to notify national competent authorities. This provides a period whereby competent authorities can raise concerns, in particular in regards to the possible detrimental effect it will have on investors and the efficiency of financial markets (in addition the possible risk of regulatory arbitrage). That said, the decision by ESMA shall prevail over any decision taken by a competent authority.

The decision by ESMA to utilise its power under Article 40 will be published on its website. This notice shall include the details of the prohibition (or restriction) and specify the date/time in which its decision becomes effective. ESMA then has to review the decision at appropriate intervals and at least every three months and, if not reviewed, the decision shall expire.