Regulators get tough on leverage

Last week the Financial Conduct Authority, the UK's financial services regulator, lobbed a bombshell into the world of financial spread betting, setting out proposed limits on the amount of leverage (see below) that punters are allowed to use. While the regulations are primarily designed with contracts for difference in mind, the FCA has confirmed that they intend for them to apply to all similar products, including spread betting, rolling spot foreign exchange and binary bets. The regulator is also imposing restrictions on the type of promotions that spread-betting firms can offer to those who open new accounts.

The FCA is doing this for two main reasons. First, it thinks that these products are being marketed as investment vehicles when it views them as gambling. Second, it believes that many customers don't understand either the underlying products they are trading or the risks involved.

The regulator may be especially concerned about cases when rapid market moves have left traders with huge losses, such as those caused by the surge in the value of the Swiss franc in January 2015 after the Swiss Central Bank scrapped its ceiling for the franc's exchange rate against the euro (client losses from this event led to the collapse of spread-betting firm Alpari). But more broadly, it seems to be worried about the number of clients who end up losing money: it says that its sample of client accounts shows that 82% of people lose money when trading CFDs.

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If the industry has been guilty of deliberately attracting inexperienced traders and encouraging them to take excessive risks, some of the FCA's proposals may be sensible. Standard risk warnings and a ban on cash promotions would do a lot to deter those who don't understand what they are letting themselves in for. Forcing firms to disclose the proportion of accounts that make a loss is also a good idea, in that it could help offset the tendency of spread-betting firms to focus on potential gains rather than losses in their advertising.

However, the maximum leverage ratios that the FCA wants to impose may be too conservative. These would cap the maximum amount that a trader can bet relative to the capital they have (see below). The regulator proposes to limit leverage to a maximum of 50:1 for all customers (with lower limits on some assets) and a maximum of 25:1 for inexperienced traders (clients who have less than 12 months active trading experience defined in a slightly complex way as those have carried out less than 40 trades across four quarters in the past three years).

It also wants firms to close out positions that rack up losses equal to half the initial deposit required. This could, paradoxically, increase the proportion of trades that lose money (although possibly not the amount of money that clients lose in total). However, if there was a sudden gap in the market, firms would be allowed to wait until it was liquid again before closing positions so in a scenario such as the Swiss franc revaluation, customers would still be faced with large bills.

While it makes sense for traders to start out using very limited leverage, there is a danger that tough regulations could push some traders into the arms of shady offshore brokers, who are not covered by the new regulations and offer a lower degree of consumer protection than that provided by UK-regulated firms. However, regardless of the rights and wrongs of the FCA's decision, it's clear that regulators here and elsewhere in the world have trading firms in their sights, say analysts at brokerage Numis, and hence even tougher regulation may well follow in the years ahead.

How leverage works and how to manage it

Leverage involves buying assets with borrowed money in order to boost returns. Say you bought £50 worth of shares. If the price went up to £55, you would make a £5 profit, equating to a 10% return. That's nice, but if you had borrowed an extra £50, enabling you to buy £100 worth of shares, then you would have made a £10 profit, which on an original investment of £50 is a 20% return.

Of course, if the shares had fallen by 10% to £90, then your net equity (the value of the shares minus the money you owe to the firm that lent it to you) would now be only £40 (instead of £45 had you not used leverage). Using leverage can mean you lose more than your initial stake. Let's say that you had combined £50 of your own funds and £150 in borrowed money to enable you to buy £200 worth of shares and the value of the shares had then halved. This means that the value of your shareholding would be worth only £100. Even if you then sold all the shares, you would still owe £50.

When you spread bet on small changes in share movements, you are using leverage. For example, if you bet on the FTSE at £5 per point, you are effectively buying £34,365 worth of shares (6,873 x £5) using money borrowed from your spread-betting provider, who will insist that you put up a small proportion of that against any losses. This is called the margin requirement, and can be low as 0.5% of the face value of the bet (£171.83 in the above example). In other words, the margin requirement is the inverse of the leverage so a 0.5% margin requirement is equal to leverage of 200 times (or 200:1).

There are two key ways to control your potential losses while using leverage. One is to use an appropriate amount. Betting £2.50 per point rather than £5 a point will halve your potential losses. Many novice traders start with far too much leverage, which is a common reason why they lose money. Another is to set a stop-loss, so that if the trade goes against you, it is automatically closed out. In the example above, if you put in a stop-loss at 6,773, the maximum that you should lose would be £500 (£5 (6,873 6,773)).

Of course, this assumes that the stop-loss triggers at the required price. Sometimes the market may jump between prices ("gap"), which means that your trade may be closed at a worse price than your stop-loss specified. To get around this, use a "guaranteed stop-loss", which will be triggered at the specified price even if the market gaps. Spread-betting firms charge a premium for guaranteed stop-losses, but the added security is usually worth it, especially if you know that a market-moving event, like an interest rate decision or referendum result, is about to take place.