FCA sets out 'serious concerns' with contracts for difference after year-long review

Out-Law News | 12 Jan 2018 | 2:02 pm | 3 min. read

The UK's Financial Conduct Authority (FCA) has "serious concerns" over the way in which 'contracts for difference' (CFDs) are being promoted and sold to unsophisticated investors, which it has warned have the potential to cause "significant consumer harm".

Three quarters of retail customers who bought CFD products on either an advised or discretionary basis during a year-long review of the sector by the FCA lost money, the regulator said, in a letter to the chief executives of CFD firms (7-page / 100KB PDF) that it published on its website.

The FCA assessed 19 CFD providers and 15 firms that distribute CFDs to retail investors as part of its review. It found examples of ineffective customer communications, weak conflict of interest management arrangements and problems with the way in which firms identified and categorised clients, as well as "significant room for improvement" in firms' remuneration arrangements.

"Given the significant weaknesses we found across our sample, we believe there is a high risk that firms across the sector are not meeting our rules and expectations when providing and distributing CFDs," the FCA said in its letter. "As a result, consumers may be at serious risk of harm from poor practices in this sector."

Several of the firms included in the review have said that they intend to stop distributing the products to retail consumers, or providing the product to those intermediaries that work with retail consumers, the FCA said. It also intends to take "further action" against an unnamed CFD provider whose arrangements were particularly poor.

"It will come as no surprise to many that CFDs continue to be high on the FCA's agenda," said financial regulation expert Michael Ruck of Pinsent Masons, the law firm behind Out-Law.com.

"The letter is a stark warning that behaviours identified by the FCA need to be improved. It is likely to continue to review the conduct of the firms written to and, if behaviours do not begin to meet or exceed the FCA's expectations, then supervisory intervention – for example, imposing a skilled person review, a requirement to undertake certain reviews or actions, or a restriction on a firm's ability to undertake certain forms of business – or enforcement investigation become almost inevitable. The future of CFDs and how they are utilised will be dependent on changes which are made as a result of the FCA's review," he said.

CFDs are complex financial instruments offered by investment firms, often through online platforms, which include the likes of 'spread bet' and rolling spot foreign exchange products. They are a type of derivative which effectively enable investors to bet on the extent to which the value of an underlying asset, such as equity shares or foreign exchange rates, will rise or fall.

Because of the complexity of these products, firms should be able to precisely define their target market, the FCA said in its letter. However, it found that the "majority" of firms in its sample were unable to do so. Instead, firms tended to rely on "broad" investor descriptions such as 'experienced', 'sophisticated' and 'financially literate', "without setting out what these terms actually mean in practice", it said.

"In our view, excessively broad definitions of target markets may lead firms to conclude that CFDs are suitable and/or appropriate for the majority of potential customers, even when this is unlikely to be the case," the FCA said in its letter. "Additionally, if providers share a poorly defined target market definition with their distributors to help their decision-making, then these intermediaries may also reach the same incorrect conclusions about an end-consumer's suitability for this high risk, complex financial product."

None of the providers reviewed by the FCA were passing sufficient information about their products onto distributors, the regulator said. They were also unable to demonstrate that they were acting with "due skill, care and diligence", in line with the FCA Principles. Only one of the providers in the review was able to demonstrate robust due diligence when taking on new distributors, while none of the distributors had effective conflict of interest management arrangements in place.

The FCA was also concerned about the way portfolio managers and advisers were remunerated by the product distributors they were working for after finding examples of employees paid on a commission-only basis. This arrangement "significantly increases the risk of mis-selling since staff may feel pressured to achieve minimum sales targets, regardless of whether this delivers good outcomes for consumers", the FCA said.

CFDs are currently under review by EU regulators, as well as those in the UK. The European Securities and Markets Authority (ESMA) announced last month that it was considering using its new product intervention powers under the recast Markets in Financial Infrastructure Directive (MIFID II) to restrict the marketing, distribution or sale of CFDs to retail clients. It intends to consult on its proposals later this month.