Product intervention – BaFin restricts CFD trading

For the first time, the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) made use of its product intervention power not individually but for a whole market segment. The marketing, distribution and sale of financial contracts for difference (CFDs) with a subsequent payments obligation (Nachschusspflicht) has been restricted and such contracts may no longer be offered to retail clients in Germany. The upcoming product intervention solely applies to CFDs and not to other structured products.

Providers of CFDs with an additional payments obligation (Nachschusspflicht) have to adjust their business models by 10 August 2017.

BaFin's authorisation for product interventions is based on German legislature implementing the EU regulation 600/2014 on markets in financial instruments (MiFIR) earlier than required.

We summarise BaFin's product intervention relating to CFDs.

Background

In December 2016, BaFin announced its plans to limit CFD trading. BaFin published a draft general administrative act (Allgemeinverfügung) on the matter stating that it has investor protection concerns in relation to CFDs with an additional payments obligation for retail clients.

BaFin expressed concerns that such products would involve an unforeseeable risk of loss for retail clients if the difference to be paid by the retail client exceeds the capital they have invested or held as margin and they are obliged to pay the difference amount from their remaining assets. Therefore, according to BaFin, in the case of CFDs with an additional payments obligation the risk of loss for the investor would be incalculable.

BaFin initiated a hearing and invited participants to comment on the planned restrictions in writing by the end of January 2017. In total, BaFin received 30 responses during the formal consultation procedure. The submissions came from CFD providers, citizens, lawyers and stakeholders. After consultation of the replies received, BaFin issued the general administrative act on 8 May 2017 the (General Administrative Act) as envisaged in the draft.

Content of the product intervention

The product intervention by way of a general administrative act prohibits the marketing, distribution and sale of CFDs to retail clients insofar as they may give rise to additional payments, i.e. if the margin held on the client's CFD trading account is insufficient to pay for the losses incurred, the client must pay for the losses using their other assets (additional payments obligation; Nachschusspflicht).

The limitation is to be implemented by 10 August 2017.

Legal basis of the product intervention

The product intervention is based on section 4b (1) no. 1 (a) and (2) of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG). Pursuant to this provision, BaFin may limit the marketing, distribution and sale of specific financial instruments where there is evidence to suggest that a financial instrument, activity or practice gives rise to significant investor protection concerns, the investor protection concerns can be remedied by limiting the distribution or sale and the measure is adequate considering the risks and level of expertise of the investors in question or market participants and the likely ramifications of the measure for investors or market participants.

In addition, the measure must be proportionate, i.e., it must be suitable, necessary and appropriate.

BaFin's reasoning

BaFin based the General Administrative Act on investor protection concerns and referred to investor warnings issued by the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) stating that purchasing CFDs may result in losses significantly exceeding the initial investment as well as to international trends in the USA and Europe, including France, Malta, Poland and the UK of taking measures with regard to CFDs.

In the light of the concerns pointed out by market participants in the course of the hearing that a ban on the sale of CFDs with an additional payments obligation (Nachschusspflicht) to retail clients would endanger the business models of a large number of CFD providers operating with an Agency-Model rather than a Dealing-Desk-Model, BaFin noted that some providers already offer CFDs without an additional payments obligation (Nachschusspflicht) or have announced that they will offer such products in future due to the planned product intervention.

Based on the criteria which will apply under MiFIR and section 4b (1) no. 1 (a) and (2) WpHG already today for product intervention rights, BaFin assessed the existence of significant investor protection concerns by inter alia the following criteria:

• complexity of the calculation of the financial instrument's price development;
• nature and scope of the risks inherent in the financial instrument;
• lack of transparency of the financial instrument's price development;
• unforeseeable risk for the retail investor;
• extent of potential negative consequences, in particular with due consideration of the number of clients, investors or market participants involved.

BaFin is of the view that in particular the extensive discretionary powers of CFD providers, the unlimited risk of loss for the investors beyond the margin provided, that cannot be prevented reliably by stop-loss orders and the complexity of CFDs in general, gives rise to significant investor protection concerns. A limitation of the intervention to contracts with subsequent payment obligations (Nachschusspflicht) is deemed suitable, necessary and appropriate.

Next steps and consequences

CFD providers have to adapt their business models to the restriction within a three months implementation period. Afterwards, CFDs containing an additional payments obligation (Nachschusspflicht) may not be sold to retail investors in Germany any longer. Violations of the General Administrative Act lead to fines in an amount of up to €500,000.

Application to CFD providers located in EEA member states and third countries

The General Administrative Act applies to all CFD providers selling CFDs to German retail clients. This should include branches (of EEA or third country providers) located in Germany selling CFDs. However, the General Administrative Act is silent on its applicability to providers located in EEA member states selling CFDs on a cross-border basis. However, even if the General Administrative Act is not directly applicable to providers located in another EEA member state it would most likely have a significant positive impact on the civil law position of customers in Germany with the risk of an additional payments obligation (Nachschusspflicht) not being enforceable in particular if the contract qualifies as consumer contract.

Excursus: dismissed product intervention plans regarding CLNs

Last year, BaFin announced its intention to restrict the trading of certificates linked to credit risks (credit linked notes or Bonitätsanleihen, CLN). For reasons of investor protection, BaFin intended to issue a general administrative act prohibiting the marketing, distribution and sale of CLNs to retail clients. In order to avoid a ban, the German financial industry presented a self-commitment including ten principles to improve transparency and investor protection regarding the issuance and distribution of credit linked notes to this client category.

On the basis of this self-commitment, BaFin suspended its planned ban in December 2016. BaFin stated that it will be watching developments very closely over the next six months to see whether the self-commitment provides sufficient protection for retail investors investing in CLNs. Should the protection prove to be insufficient in BaFin's view, it will resume product intervention considerations on this topic. See BaFin dismisses plans for ban of credit linked notes due to industry self-commitment for more detail.