Why Is ESMA Regulating Trading Leverage

Trading

ESMA (European Securities and Markets Authority) has officially announced the dates their new CFD regulations and prohibition of Binary Options will be launched –July 2nd and the deadline toabide by the new regulations is the 1st of August. There has been significant push back and reaction within the CFD industry. Many are calling archaic “nanny-state” arguments claiming these regulations infringe on both brokers and traders’ rights, under the pretense of protecting traders.

If you are unfamiliar with ESMA it is an independent regulatory body that is fully accountable directly to the European Parliament. Its mission is to ensure the stability of the EU’s financial system. Part of their activities also covers assessing risk to EU traders thus the introduction of the new regulations.

To be completely fair the ESMA regulations are a reaction to the majority of traders losing. They claim the percentage of losing brokers isin the area of 85% to 90%. Let’s take a better look at this phenomenon though.

Why do these traders lose and are pulling down an entire industry with them? First a staggering statistic is that many traders, especially younger and lower income ones, approach trading as gambling and not necessarily as investment. If you have ever been on a trading floor, you’ll see professional traders looking at six different screens, all with different information. On top of that slew of information these rooms also feature a half dozen or more large screen televisions playing financial market news on loop.

You can’t expect consistent returns when you approach trading as gambling and not as investment. This of course implies that a large group of traders are not knowledgeable enough to trade. This isn’t extrapolation either – analysts found that traders, counter intuitively, don’t learn about trading – but instead “Trade to learn” which is equivalent of losing on a roulette number repeatedly until you can figure out a pattern.

Most industry experts, trading educators and market analysts recommend that new traders trade on demo until they can produce consistent returns for at least a 3 to 6 months. Some even recommend avoiding going live for an entire year.

This is where leverage comes into play – most mature and experienced traders will avoid using high leverage. Because they are fully aware that leverage may seem to increase the size of your investment, but a small price movement can put them in the red. Novice traders on the other hand, just see the positive scenario and ignore the increased risk as a result of using excessive leverage.

To be fair to these new traders, some brokers want them to act the way they act. As in: consistently lose. This is why they offer, let’s not be coy, obscene amounts of leverage 1:1000 or even double that 1:2000. Not only do they offer mind-boggling, unviable amounts of leverage – they also heavily market it – presenting it as a unique and attractive selling point. A novice trader would see that and think “Wow, does that mean that my $10 would be $10000 when I trade?!” where as an experienced trader would say “Nope.” Because the experienced trader knows that a price movement of 1/1000th of a trade that uses leverage will be decimated.

The ESMA leverage regulations are not all bad. The truth is that the Forex or CFD industry has become densely populated by less than transparent brokers. Some use leverage to take advantage of their clients – targeting novice traders or opportunistic traders that prefer using impulse instead of data. Others change their trading conditions or spreads during high volatility – causing losses and in some cases unexpected losses especially if a new trader isn’t aware these conditions change. Some do both.

This is ultimately the best “side-effect” of the ESMA leverage regulation – predatory brokers, which base their business model on their clients’ losses, will no longer be viable. Although some brokers and many more traders are complaining about the leverage restrictions, ultimately it could stand as a PR recovery for the CFD industry. The once dubious reputation the industry carries should receive a sprucing up, as the brokers that survive will be the ones that have and remain to be as transparent as possible.

Anum

Anum Yoon is the founder and editor of Current on Currency. She loves all things personal finance, which is why you'll find her work all over the PF blogosphere.

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