All traders need a broker, it is their bridge to the financial markets.
New or inexperienced traders are faced with an array of important decisions when they first start out, the broker they choose is up there as one of the more important ones. In the large majority of cases, not too much thought goes into which broker to use, normally a new trader trades with a broker because that broker found them with a catchy advert. The chances of the new trader happening upon the right broker for them via this process is very slim so the point we want to make to you at the outset is – take responsibility, do your research and find the right broker for you!
In OTC markets regulation is key
Perhaps the main consideration when choosing a broker is how well it is regulated. In our course on How Traders Interact with the Markets, we introduced OTC markets, these are decentralised financial marketplaces. Spread betting, CFD and forex trading are all OTC markets, which means the transaction happens between the trader and their broker, normally there is no other entity involved. The alternative is an exchange-traded centralised market, like for cash shares which are traded via order books on the LSE, NYSE and so on. These centrally run order books mean there is a degree of oversight of the marketplace. In OTC trading there is no central exchange providing this oversight so regulation becomes much more important.
We originally made this video and course for a UK audience, and have expanded out to other jurisdictions as our courses have grown in popularity. Even if you’re not from the UK the points made, and the way to assess brokers are still applicable.
The job of the regulators
Via licencing, brokers are regulated in a certain jurisdiction and can offer their services in other jurisdictions if allowed. In jurisdictions that have well developed regulatory frameworks brokers applying for a licence go through an extensive assessment process where the regulator looks at whether the business has appropriate financial resources, experienced management that know what they’re doing and have a sound business plan. The broker then needs to maintain this, run good systems and controls and report regularly. In short, the regulator is doing some of the due diligence on the broker for the trader.
The regulator’s job is to regulate the brokers, it is not there to tell the citizens of that country where they can trade, that is the individual’s decision. For time immemorial it was assumed the citizens of a particular country would naturally choose to use a broker from that country – then came the internet which allows traders to use brokers from other jurisdictions.
All countries differ in their approach to regulating retail derivatives trading (that is the regulatory term for private traders using margined products like CFDs or spread bets). At one end of the spectrum some countries, the absolute minority we should add, choose the ban these products outright – for example, CFDs are banned in the USA, Brazil and Belgium. At the other end of the spectrum, some countries allow it with no rules! Most countries are trying to strike a balance in between – some countries choose to really restrict how the products are marketed, like France. Others, like the UK and Japan, have restrictions around the amount the leverage allowed.
Assuming the product is allowed, the main areas regulators can seek protection in are:
- Marketing: most developed regulators are seeking to ensure any marketing by brokers is ‘true, fair and not misleading‘. They also seek to ensure the risks are clearly communicated to traders – this is why when viewing an EU based broker’s website you will always see a notice telling you the % of traders that lose money with that broker.
- Capitalisation: given the brokers are the counterparty to a trader’s trades the regulator needs to put in place rules to ensure the broker has enough money, given the risks it takes, to pay up. This needs to be balanced against the need for a competitive brokerage industry that makes a return on its capital. This is called regulatory capital and how its worked out varies from jurisdiction to jurisdiction. FCA brokers tend to be the most advanced in how this is calculated.
- Client money: when trader’s trade using margin they need to deposit funds with the broker – normally when you hand over your money to a business, like for your weekly food shop the money becomes the property of that business. In trading this is not the case, the money put up as margin is still the traders. By asking for a deposit the broker is making sure first that you have it and second that they can access it quickly if it becomes due after a losing trade – that is when it becomes the broker’s money. There is, therefore, the opportunity for the broker to mix this money with their own. In well developed regulatory environments, there are strong and clear rules around client money segregation. In the UK for example, client money needs to be kept in a separate bank account and how it is managed is audited. Be careful here: there are jurisdictions that do not have these rules.
- Fair market pricing and practices: in zero-sum OTC markets it is down to the broker to run the market – if left unregulated there is the incentive for unscrupulous brokers to rig the process to favour themselves. For example, a trader places a trade by clicking on the screen, in that split second between clicking and the trade being received by the broker’s server the price changes in the trader’s favour. What happens? Does the broker reject the trade? What happens if the price moves in the broker’s favour – does it accept the trade? There are lots of scenarios where the broker can tilt the playing field in its favour, good regulation ensures a level OTC playing field.
- Leverage: this has been perhaps the biggest change in European trading over the last few years. Regulators introduced a cap on how much leverage retail traders can trade with, something Japan did about a decade ago. When traders win they want more leverage to amplify the profits, when they lose (which new traders often discount) the leverage amplifies the losses in equal measure.
- Negative balance protection: if markets move against the trader quickly the broker might not be able to margin call them or close out their trades. This might leave the trader owing more money than deposited with the broker – this happens from time to time with flash crashes or big events that shock the market (EURCHF unpegging). Negative balance protection requires the broker to write off anything owed by the trader beyond what they deposited at an account level.
If you want to read more about the regulation in specific countries there is an excellent article written by Finance Magnates that details the broad rules country by country.
The different regulatory approaches to each of these protections, and the ability to enforce them, create a very complex web of disjointed regulatory environments. Overtime some jurisdictions have emerged as the leaders, these are regulators that strike a balance between protecting retail traders and letting trader’s trade in a free market. Let’s look at them.
United Kingdom – FCA
The CFD trading industry (a spread bet is just a CFD in a tax wrapper) in the United Kingdom is arguably the most mature CFD market in the world. As of December 2016, there were 104 firms that have been offering CFDs authorised by the Financial Conduct Authority – the UK regulatory body. The United Kingdom is also one of the largest markets with an estimated 135,000 active traders. Over many years the regulatory environment and the brokers within it have developed a strong offering, this means European traders tend to gravitate towards FCA brokers.
The FCA also ensures that UK-regulated brokerages provide fair market pricing to their customers. Fair market pricing ensures that the price of a CFD on a transaction is in-line with general market expectations, which is an important concept fundamental to a fair and transparent trading market.
The Financial Conduct Authority also makes sure that an FCA-regulated broker maintains enough financial resources to operate properly, that the broker regularly reports on its financial standing, that the management team has sufficient professional experience to run a brokerage firm and that the broker has a sound business plan for current and future operations.
FCA-regulated firms also have to hold all client funds in segregated bank accounts. This ensures that every pound that goes through the broker can be tracked to its final destination. In case of a bankruptcy of the firm, client funds are protected by the Financial Services Compensation Scheme to an amount up to £50,000.
Everything combined ensures that traders who trade with an FCA-regulated broker have peace of mind regarding the safety of their funds while trading with a fully-regulated entity that abides by strict industry and regulatory requirements.
Recent (August 2018) changes to EU rules have resulted in a sizeable contraction in CFD markets in the UK. Brokers are no longer allowed to offer the leverage they deem commercially acceptable, instead, the ESMA rules have capped leverage at 30:1 for major FX markets and 20:1 for index trades. Traders, especially profitable day traders, need leverage and the fairly clunky, one-size-fits-all change in rules have resulted in the more experienced traders demanding leverage to look overseas.
There is nothing stopping a trader seeking leverage setting up an account with a broker outside the EU, the only restriction being brokers outside the EU are not permitted to advertise to consumers inside the EU. But that is hard to enforce and it doesn’t stop traders seeking out brokers. Most large EU brokers offer their services outside the EU and its easy to find your broker’s overseas offering.
As the UK leaves the EU the rules will no doubt evolve, so keep yourself informed.
Australia – ASIC
The main beneficiary of the trader exodus from the EU has been Australia, where there are, at the time of writing, no leverage restrictions and reasonable regulatory safeguards. In Australia, brokers must hold an Australian Financial Services (AFS) Licence, which authorizes them to advise and make a market in derivatives and FX contracts. This is regulated by ASIC.
As of June 2016, there were 65 CFD brokerages and around 37,000 active traders in the Australian market. Unlike in the United Kingdom, brokers that operate under the AFS are not required to provide fair market pricing, but the AFS does provide a general obligation on all AFS-regulated brokers to operate “efficiently, honestly and fairly.”
A lot of Asian traders transact with ASIC brokers. It is in similar time zones and can afford the trader a good level of protection.
Other Regulators
Other important regulatory bodies are:
- The Cyprus Securities and Exchange Commission (CySEC) counts around 181 providers and is an important regulator for brokers that operate in the EU. The costs to maintain a license here are relatively low and due to the EU Passport Rule, brokers that are regulated by CySEC are allowed to offer their products and attract customers from all over the European Union, making CySEC a popular regulator for smaller EU-based brokers.
- In the United States, there are two main regulatory bodies: The Commodity Futures Trade Commission (CFTC) and the National Futures Association (NFA). The US market is quite different from other jurisdictions, as traders don’t have access to CFD trading and brokers have very strict requirements that they must meet in order to offer their services.
Choosing a Jurisdiction
Each trader will have their own requirements, so it is important each trader does their own research around the risks and benefits of a particular jurisdiction or broker.
If the capped leverage is not a concern, and as you’ll see later in the course if you’re new to trading then it shouldn’t be, then EU traders tend to gravitate towards an FCA broker. Outside the EU, and the US, traders either trade with a broker in their own jurisdiction, or if that is less developed, gravitate towards an ASIC regulated broker.
It is an important decision, so don’t click on the first shiny banner advert promising 1000x leverage, take your time and place regulatory protections at the top of the criteria you use to choose your broker.
- All traders need a broker and all margin traders must trade using OTC derivatives.
- A country’s financial services regulator has a big role to play in regulating OTC markets.
- Regulators issue financial service licenses to brokers they then monitor, the regulator is not there to tell individuals who to trade with.
- The main protections enforced by regulators are around: marketing, capitalisation, client money, fair market practices, leverage, and negative balance protection.
- Over time the UK’s FCA and Australia’s ASIC have emerged as the leading jurisdictions for retail derivative brokers to offer their services from.
If you’re happy with everything please click ‘complete’ to move on.
