Clues to Risks in the Market: IOSCO's Suggestions for Retail OTC Leveraged Products

The data IOSCO gathered from its members last year made it clear that individual investors continue to be serious buyers of complex, leveraged OTC products. If there were not a genuine world-wide investor protection problem, IOSCO would hardly have bothered to write extensively on the state and extent of the question, prepared suggestions for national capital markets regulators, and submitted those to public review before endorsing final recommendations.

Although Thomas Murray’s clients are mostly wholesale institutions, the risks observed in the retail OTC space matters to them as well. Wholesale and retail clients share the common market place and feed off one another, affecting one another’s market interest and pricing. Amongst asset managers and owners, there is significant participation in this asset class for the convenience and specificity it brings because of its bespoke nature. But because outstanding OTC market risk positions are less visible in terms of information reported, it blurs both ongoing pricing of underlying assets and related, on-exchange standardized derivative contract positions: when there is less information, there is less certainty about counterparty position risk and how to manage it. To compensate for the greater uncertainty, margin costs are then raised by counterparties and market infrastructures.

The desire to be free of some of the constraints of dealing in standardized exchange-listed and -traded contracts by choosing to trade or invest OTC brings with it other costs, financial and informational.

What IOSCO is putting to the public for review

IOSCO’s focus is on the intermediaries. For the public, this question goes back to December 2016 when IOSCO published a Report on OTC leveraged products advertised and sold by broker-dealers to retail investors. The Report detailed the segment and its practices, and described supervisory concerns and challenges arising in the area. It further set out potential risks to investors and instances of misconduct by licensed firms, as well as growing concerns about activity by unlicensed entities predominantly offering the products online.

What might Thomas Murray suggest?

Thomas Murray understands and supports the value of bespoke OTC instruments when properly deployed, with the risks correctly assessed and assumed before each party concludes a contract.

The IOSCO suggestions reveal poor practice and indeed malpractice – especially because leverage multiplies the effects of market movement. We all like that multiplier on the upside provided the counterparty can be good for the amount when the contract comes due; it is the downside, the other half of the trade, that is so worrisome. As clues to the environment in which all kinds of parties interact, Thomas Murray finds value in highlighting the evolving risks that IOSCO picks up as markets change. They are essential reminders for financial services generally, because with just a bit of tweaking they often apply in contexts other than the particular case examined in this Report.

The nine measures IOSCO puts forward for consideration are:

Measure 1: Requirement for firms offering the relevant products to retail investors to be licensed.

This measure would require market intermediaries to be registered and/or licensed by a relevant regulatory authority when physically based in and operating from that jurisdiction and offering the relevant products to retail investors, regardless of where the end-investor is located. This measure will ensure that firms are subject to regulatory oversight regardless of where their end-customers are located, and that firms meet certain minimum standards when offering their services.

In particular, preventing a carve-out from the licensing requirement based on a client’s location would ensure that all firms operating in the sector:

  • are subject to certain regulatory requirements;
  • can be supervised and inspected; and,
  • can be held to account for their misconduct, including through effective enforcement actions.

Measure 2: Requirement for firms to incorporate a prescribed minimum margin requirement for retail investors.

This measure would require market intermediaries to comply with minimum margin requirements when transacting in CFDs or rolling spot forex contracts, ensuring that they collect from their clients a certain margin amount as collateral before opening a position. The measure can also be applied so that it requires a certain level of margin to be maintained to support a position over the course of the trade.

Setting a minimum margin requirement on CFDs and rolling spot forex contracts reduces the risk of losses to clients trading in these types of products. By limiting the client’s exposure, the measure reduces the likelihood and volume of potential client losses. Limiting the leverage available in the products also helps firms mitigate potential conflicts of interest arising from situations where they act as the counterparty to the client’s trades and where they directly benefit from the client’s losses.

Furthermore, the measure also mitigates the counterparty credit risk that the firms offering the products can present when offering the products to retail customers at excessive levels of leverage.

Measure 3: Negative balance protection

This measure would require market intermediaries to limit retail clients’ losses in CFDs and rolling spot forex contracts to their deposited funds or their funds invested for each trade, thereby preventing firms from recovering any losses that exceed the clients’ deposited funds or funds invested for each trade.

A measure limiting client losses to their deposited funds or funds invested for each trade in CFDs or rolling spot forex contracts provides a high level of protection to clients by guaranteeing a certain floor for the losses clients may be exposed to. It addresses the risk that a significant change in the price of the underlying can subject the client to considerable, in some cases even unlimited losses. It provides a level of certainty to the client of possible investment outcomes when trading in CFDs or rolling spot forex contracts.

Measure 4: Prescribed disclosures setting out the total costs of the product.

This measure would require market intermediaries to provide a standardised disclosure that clearly sets out the total costs and charges levied by intermediaries relating to the product before it is sold to retail clients.

This measure promotes transparency of the information available to clients on the costs and charges of the product. In addition, the measure helps clients compare the different products, helps them to better assess value for money and the impact of costs on the expected performance of the product, and ultimately assists them in making an informed investment decision.

Measure 5: Disclosure of investor profit and loss ratios.

This measure would require market intermediaries to disclose to their clients the percentage of client accounts that made a net profit or loss during a certain period of trading activity. Given that several IOSCO members have found that a majority of clients lose money on these products, this measure provides a simple, firm-specific figure highlighting actual client trading outcomes. It helps to ensure that clients are better informed of the risks associated with the costs built into the product.

While disclosures alone have some limitations in impacting investor behaviour, the measure helps offset the tendency of firms and clients to focus on the potential for profits rather than losses, and supports clients in making an informed decision about whether they wish to proceed with a high-risk product that, statistically, is more likely to result in a loss than a gain.

Measure 6: Adoption of a fair pricing methodology and use of externally verifiable price sources.

This measure would require market intermediaries to be able to demonstrate a clear pricing methodology for the relevant products and to use independent and externally verifiable price sources and liquidity providers to derive their prices.

To increase the transparency in the pricing of the relevant products, IOSCO members may wish to require that firms be able to demonstrate how their prices are constructed and how they apply a spread or a mark-up to the reference prices used. Furthermore, IOSCO members may wish to consider mandating firms to use externally verifiable price sources and liquidity providers to derive their prices as a way of ensuring fair pricing.

Measure 7: Enhanced disclosures about order execution quality.

This measure would require that market intermediaries provide clear and effective disclosures to their clients about how their orders are executed.

Increased transparency around order execution helps clients to better understand and to evaluate the quality of the firm’s execution practices and thus to better assess the quality of the overall service provided to them. In addition, improved information on how the firm prices its products assists clients when monitoring the positions assumed.

Measure 8: A ban or restrictions on certain forms of marketing and sales techniques for the relevant products.

This measure would involve placing restrictions on certain forms of marketing or sales techniques used by market intermediaries offering some or all of these products to retail investors. This measure seeks to ensure that the relevant products to be offered to retail investors are appropriately marketed and/or distributed. It addresses the risk of mis-selling. It is intended to help prevent indiscriminate and inappropriate mass marketing of the products and prevent pressure sales to retail clients.

Measure 9: A ban or restriction on the sale and/or distribution of the relevant products by intermediaries.

This measure would prohibit or restrict the sale and/or distribution of some or all of the relevant products to retail investors by market intermediaries, or require transactions on the relevant products to take place on exchanges.

Banning the sale and/or distribution of any of the relevant products, or requiring such transactions to take place on exchanges, could be used in scenarios where IOSCO members consider that other measures may be insufficient in mitigating the investor protection risks arising from the products. Such measures help ensure that products that pose a significant risk of investor detriment cannot be sold off-exchange and/or distributed to retail clients.

Where the IOSCO Consultation Report goes from here

IOSCO is not suggesting global mandating any or all of these measures for its constituent members. It is suggesting, however, that they adopt the measures that make sense for their jurisdictions. IOSCO’s history of good housekeeping practices for the marketplace are always worth thoughtful review, and these measures are no exception.

Thomas Murray’s clients involved in establishing margin valuations will be particularly interested in seeing what clarity some discipline in this field will provide.


The author, Thomas Krantz, is Senior Advisor, Capital markets, in the firm of Thomas Murray; and served as Secretary General of the World Federation of Exchanges (2000-2012). The views expressed are his own, and not necessarily those of the firm.

Tags: IOSCOOTCRiskderivativescounterpartysecurities market regulationmarket infrastructuresOTC leveraged productsRegulationIOSCO Consultation Report