On 1 December 2022, the FCA highlighted continuing concerns about problem firms in the contract for difference (“CFD”) sector. The regulator’s ‘Dear CEO’ letter contained some familiar observations that should come as no surprise to those operating in this market e.g. use of unauthorised marketing affiliates or social media influencers, poor market abuse controls, and reducing harm from firm failures. All of these issues have been addressed by previous FCA publications or enforcement action. Amongst the familiar issues, the following two statements almost flew under the radar, but they threaten the viability of the most popular operating model in this sector:

“Where the market risk from firms’ customer activity is under-hedged, firms also directly profit from customer losses, further incentivising them to encourage excessive customer trading….”

“We will take action where we see inadequate managing, or exploitation, of COIs.”

What is the B book?

Brokers that use a B book take the opposite side of customer trades instead of hedging every customer trade with another market participant. It is often described as market making because the broker is providing liquidity to the customer and accepting the market risk associated with the trade. In this model, the firm directly profits from customer losses. In contrast, brokers that use an A book model send customer trading orders directly to liquidity providers passing on the market risk. Some firms operate a hybrid model where customers can be a part of either the A book or B book.

The merits of each model to the customer are well debated. They include variable vs fixed spreads, liquidity and the cost of maintaining open positions. The FCA through its comments above, is challenging those operating a B book to ensure that they are adequately managing the inherent conflict of the firm profiting directly from customer losses. But is this possible?

The conflict of interest rules

A firm must take all appropriate steps to identify and to prevent or manage conflicts of interest between the firm and its customers. The conflict of interest between the firm and the customer is inherent in the B book model, it cannot be prevented, but what are firms doing to identify, record and manage the conflict?

*where risks of damage to the interests of a customer cannot be prevented through management arrangements

FCA observations

The regulator offers further insights into potential conflicts of interest for CFD providers:

“Revenue is driven by the size and frequency of customer trading meaning that firms profit when customers are persuaded to trade more frequently and/or in larger volumes than they would otherwise have done. Where the market risk from firms’ customer activity is under-hedged, firms also directly profit from customer losses, further incentivising them to encourage excessive customer trading.”

Why the Consumer Duty represents a challenge for the B book

The FCA conflict of interest rules are designed to ensure that firms do not damage the interests of a customer, whilst the Consumer Duty sets higher standards of consumer protection and requires firms to act to deliver good outcomes for retail customers. The specific areas most relevant to CFD providers are:

The cross-cutting rules state that firms must (i) act in good faith towards retail customers; (ii) avoid foreseeable harm to retail customers; and (iii) enable and support retail customers to pursue their financial objectives. Firms will need to demonstrate robust conflict of interest monitoring and controls to ensure that they are acting in good faith towards retail customers. This becomes more difficult when the firm directly profits from customer losses. How does it ensure that employee bonuses are not linked to encouraging excessive customer trading when volume is a significant driver of revenue?

New rules on price and value are relevant to ensuring the target market for CFDs is appropriate. Approximately 80% of customers lose money when investing in CFDs (FCA, 2022). In some cases brokers profit from losing trades. Accordingly, the FCA expects CFD provides to perform detailed target market assessments. Firms must monitor their activities to ensure that CFDs are not offered to clients falling outside its target market(s).

Enhanced rules on customer service place a greater burden on firms to ensure customers do not put money at risk that they can no longer afford to lose. CFD providers may wish to review the frequency of KYC refreshes to ensure that financial information used to assess appropriateness continues to be accurate and up to date. Where customers fail an appropriateness assessment, what procedures does the firm have to determine whether the customer’s access to the product should be removed?

New rules on communications with clients require firms to consider how they advertise and market products to consumers. The regulator has highlighted several poor practices in this area such as using social media influencers to target unsophisticated investors. Firms will need to demonstrate effective oversight of any third party marketing their services. CFD providers should also ensure that they disclose any conflicts of interest to customers where they are unable to effectively manage the risk to a level where they can be reasonably confident the customer’s interests will not be damaged. If you are running a B book model, how effectively have you explained the model and its risks to your customers?

How can C & G help?

We specialise in providing regulatory advice to financial services firms. Our consultants have a wealth of experience in the brokerage sector and are well placed to assist CFD providers in meeting their regulatory obligations. Contact enquiries@cgregulatorysolutions.com if you need assistance responding to the FCA letter to CFD providers or help with your Consumer Duty Implementation plans.