By Gareth Vaughan
The Australian Securities and Investments Commission (ASIC) is clamping down on the peddling of two derivatives products to retail investors and highlighting that Australia's light touch regulation is being exploited by those peddling these products.
ASIC's New Zealand equivalent, the Financial Markets Authority (FMA), is not in a position to follow suit. And NZ's even lighter touch regulation has been exploited, enabling the peddling of these products by NZ-registered entities to overseas investors. Meanwhile Commerce and Consumer Affairs Minister Kris Faafoi says he's not aware of any problems with the sale of such derivatives to retail investors, but notes the Government has recently consulted on introducing product intervention powers like Australia's.
The products at the centre of the ASIC action are binary options and contracts for difference, or CFDs. They are typically offered through online trading platforms. As ASIC puts it, binary options are derivatives that allow clients to make all-or-nothing bets on the occurrence or non-occurrence of a specified event in a defined timeframe such as the price of gold increasing in 30 seconds. CFDs are leveraged derivatives that allow clients to speculate on the change in the value of an underlying asset.
Binary options are a global scourge. Google and Facebook have banned binary options adverts, and in late 2017 Israel's Knesset unanimously passed a law banning the country's binary options industry, which had defrauded millions of victims worldwide of billions of dollars. These so-called Wolves of Tel Aviv even made their presence felt in NZ with local financial services professionals discovering their IDs being used without permission by an Israeli binary options firm.
ASIC is proposing a product intervention order prohibiting the issue and distribution of binary options to retail clients saying they provide "no meaningful investment or economic utility," and "do not offer participation in the growth in value of the underlying asset."
Most retail clients who trade binary options lose money, ASIC adds.
"The inherent structural design flaws are confusing and make them [binary options] unsuitable as an investment or risk management product for retail clients - we find their characteristics are akin to gambling," says ASIC.
'Significant detriment to retail clients'
Of CFDs, ASIC's proposing a product intervention order that imposes five conditions on their issue to retail clients. It says CFDs can serve legitimate trading, investment and hedging purposes, but is concerned that most retail clients lose money trading CFDs, often because of excessive leverage.
The conditions include imposing CFD leverage ratio limits, and implementing a standardised approach to the automatic close out of retail client positions so losses are restricted to about 50% of investment. The proposed leverage ratio limits are 20:1 for currency pairs, 15:1 for equity indices, 10:1 for commodities, and 20:1 for gold.
Additionally ASIC says CFD fees and costs lack transparency, are magnified by leverage and can quickly and significantly deplete a retail client’s investment. Furthermore confusing and unclear pricing methodologies can lead to the sale to retail clients of CFDs that are misaligned with their needs, expectations and understanding.
"We consider that binary options and CFDs have resulted in, and are likely in future to result in, significant detriment to retail clients, primarily financial losses," ASIC says.
FMA can't go as far as ASIC wants to
Here in NZ the FMA in 2017 introduced licensing for firms selling short-duration derivative products, saying these were the source of more than 40% of the complaints it received. At that time FMA CEO Rob Everett said Kiwi retail investors choosing to punt on CFDs and binary options should do so through companies licensed in NZ. The FMA described CFDs and binary options as “very high risk” even for experienced investors, suggesting people take “extreme caution” with them.
The FMA has published information about binary options, including the risks, here, noting; "Binary options may promise to make you money quickly, but like gambling, you could lose all of the money you’ve invested."
However, the FMA does not have the power to go as far as ASIC, with an FMA spokesman telling interest.co.nz the FMA doesn’t have product intervention powers.
"The FMA has already used its call-in powers to require retail issuers of short term derivatives to be licensed, but we don’t have further product intervention powers," the spokesman says.
“The FMA constantly monitors the activity of overseas regulators to identify how trends and risks are being dealt with in other jurisdictions, and ASIC’s work in particular. We have observed increased scrutiny or restrictions on the trade of risky derivatives."
A global problem
In September last year the International Organization of Securities Commissions (IOSCO) issued a report on over the counter, or OTC, retail products such as binary options and CFDs. IOSCO said the complexity and high-risk/high-profit nature of these products makes them "particularly attractive for unlicensed firms to use as tools for defrauding retail investors. As such, unlicensed firms distributing the products via online platforms pose a significant risk to investor protection."
IOSCO set out a toolkit intended to be used by regulators to enhance protections for retail clients, which ASIC has largely followed. ASIC also notes the European Securities and Markets Authority, the UK's Financial Conduct Authority (FCA) and the Canadian Securities Administrators have implemented measures prohibiting or restricting the issue of OTC binary options to retail clients.
ASIC's table 3 below shows further regulatory moves against binary options. Additionally regulators in Singapore, Hong Kong, Japan and South Korea have leverage ratios and other restrictions in place for CFDs, whilst no licence has been issued for the issuing of these products in China. ASIC points out that some regulators are considering interventions relating to crypto-asset CFDs and other derivatives over crypto-assets with the FCA - for example - consulting on a proposal to prohibit the sale of all derivatives over crypto-assets to retail clients. ASIC says it's monitoring these developments.
Regulators' challenge heightened by regulatory arbitrage
To run a financial services business in Australia you must have an Australian financial services (AFS) licence. ASIC oversees the regulation and supervision of AFS licensees. It has identified 65 AFS licensees who issue binary options or CFDs in or from Australia to retail clients, noting at March 31, 99% of binary options and CFD issuers’ clients were retail clients.
ASIC found that most of these clients are not in Australia.
"Surprisingly, as at 31 March 2019, clients based in Australia accounted for just 17% of the approximately one million clients of binary options and CFD issuers identified in our 2019 review. The largest percentage of clients (62%) were based in Asia, one-third of which (21% of total clients) were based in China." (See ASIC diagram below).
ASIC suggests regulatory arbitrage is at work, with overseas entities establishing an Australian subsidiary to take advantage of more lenient regulatory requirements and direct clients to transact through that subsidiary.
"We suspect that our relatively lighter touch regulation of binary options and CFDs has resulted in issuers directing overseas clients to their Australian licensed entities. This could help to explain the significant growth in clients of Australian issuers between the 2017 and 2019 metric reviews, 121% increase to around one million, of which 83% are based overseas. We are working closely with overseas regulators to address illegal activity, regulatory arbitrage and other activity designed to circumvent regulation in other jurisdictions," says ASIC.
One of the trends ASIC and regulators in other countries have discovered is retail clients being reclassified as professional, or wholesale, clients.
"In the 2019 review we asked binary options and CFD issuers to provide us with the number of retail clients that had been reclassified as wholesale clients in the period 1 January 2018 to 31 March 2019. We found that almost 9,200 retail clients had been reclassified as wholesale clients during this period. This is concerning because wholesale clients do not receive the same protection as retail clients. We are also concerned that these clients may not be aware that retail protections no longer apply to them," ASIC says.
"We will continue to closely monitor for ‘regulatory arbitrage’, and other potential avoidance practices by issuers which undermine or attempt to work around the intended purpose of our proposed intervention. If significant consumer detriment persists we will consider further intervention."
New Zealand behind the eight ball & not helped by the FSPR
I asked the FMA how many NZ entities it has licensed to issue binary options and CFDs, and whether it has an estimate of where their clients are, and how many clients there are.
The FMA spokesman says there are currently 25 derivative issuers licenced by the FMA. These licences aren't restricted to particular products, but the FMA requires product disclosure statements to explain the risks associated with each product.
"Eleven of our  licensed issuers are known to provide CFDs. The majority have offices in New Zealand, although they might also be part of overseas-owned groups. Currently, we do not capture how many clients they have but we will start collecting this information in the near future. Binary option trading is less common in NZ, but we know that a select few of our issuers provide these products," the FMA spokesman says.
Unlike in Australia, all entities providing a financial service in NZ don't have to be licensed. However they do have to be registered on the Financial Service Providers Register (FSPR), akin to a phone directory for the financial services sector. Interest.co.nz has documented widespread mis-use and exploitation of the FSPR through numerous articles here. This includes companies registered in NZ but operating overseas free of regulatory oversight and offering derivatives products including CFDs and binary options.
These include Tall Blacks sponsor Security Placements, which appears to target Chinese investors, plus FXBTG Financial which three overseas regulators issued warnings about and has now been removed from the FSPR at the FMA's behest, and ex-Hurricanes rugby team sponsor Fullerton Markets. There's also Starfish Markets Ltd, which has had two stints on the FSPR, remains a registered NZ company with a website promoting CFDs and binary options here and here.
I asked the FMA spokesman to what extent the regulator is concerned that the FSPR could complicate things from a NZ perspective, and whether the FMA has any estimate of how many FSPR registered entities that aren't regulated in NZ may be offering binary options and CFDs overseas.
"Where we become aware of entities who are abusing their registration on the FSPR, making unregulated offers or conducting activities that they are not licensed to provide, we will take action. However, we don’t actively monitor the register so it is difficult to estimate how many entities may be offering binary options and CFDs," the spokesman says.
A recent law change means financial service providers with a place of business in NZ that provide financial services only to overseas persons will no longer be able to register on the FSPR. This comes through reforms to the FSPR via the Financial Services Legislation Amendment Bill, which Parliament passed in April.
“I know that some offshore firms have been registering in New Zealand as financial service providers to give the misleading impression they are subject to regulatory oversight in this country. The changes in the Bill will prevent that from happening," Faafoi said in April.
According to the Ministry of Business, Innovation & Employment, after the relevant law changes come into force in mid-2020, Registrar of Companies and Financial Service Providers Ross van der Schyff "will be able to deregister from the FSPR any registered providers that only have overseas customers, unless the provider is required to be licensed or registered by another Act, or the provider is a reporting entity to which the Anti-Money Laundering and Countering Financing of Terrorism Act applies."
Faafoi's attention not drawn to any problems with over-the-counter derivatives
A spokesman for Faafoi told interest.co.nz that Faafoi hasn't been made aware of particular issues with OTC derivatives such as binary options or CFDs being sold to retail investors.
"However, the Ministry of Business, Innovation and Employment recently consulted on a range of measures to improve the conduct of financial institutions. This range of possible measures included product intervention powers similar to those available in Australia."
"While these measures focus primarily on the conduct of institutions like banks and insurers, the Minister is not aware of issues related to derivatives being sold to retail investors that would suggest they couldn’t also be adequately addressed by existing legislation. The Minister will continue to consider whether further measures, like product intervention powers consulted on recently, may be appropriate," Faafoi's spokesman says.
He points out derivatives offers to retail investors are regulated under the Financial Markets Conduct Act, with the purpose of the Act being to help investors be informed about the risks of particular financial products before investing in a regulated offer. Derivatives issuers who offer derivatives to NZ retail investors must be licensed under the Act.
ASIC's consultation closes on October 1.
*This article is a combination of two stories first published in our email for paying subscribers early on Thursday and Friday morning. See here for more details and how to subscribe.