Posted: 2nd March 2016
On 2 February 2016, the FCA sent a ‘Dear CEO’ letter to providers of contract for difference (CFD) products.
The letter focused specifically on the processes these firms go through with regards to onboarding new clients, and was a direct result of a review it conducted on a sample of ten firms from across the sector who offer these products, incorporating both larger and smaller firms.
The regulator looked at whether these firms’ take-on procedures met the requirements of its Conduct of Business (COBS) and Systems and Controls (SYSC) rules, and in particular, it reviewed:
- When engaging with prospective clients, many firms do not have effective processes that allow them to assess 'appropriateness' for CFD trading
- Initial disclosures to clients
- Anti-money laundering (AML) controls
- Client categorisation
CFDs are complex, derivative products that allow customers to easily access financial markets and speculate on price movements across a range of financial instruments. Spread bets and ‘Rolling Spot’ FX are both examples of a designated type of CFD under the FCA’s Handbook's Glossary of definitions.
There are currently about 100 directly regulated CFD companies in the UK, whilst another 130 have obtained a passport to operate in the UK after registering elsewhere in the European Union.
FCA Director of Supervision, Megan Butler, stated in the letter that the results of the regulator’s review were poor, and demonstrated a “high risk of CFD providers industry-wide” not meeting requirements and failing to do enough to prevent financial crime.
The review found three key issues:
- Many firms do not have effective processes that allow them to assess how appropriateness prospective clients are for CFD trading
- Most risk warnings issued to clients who failed the appropriateness assessments were not adequate
- There were insufficient anti-money laundering (AML) controls in place to manage the increased risks posed by higher risk clients
1. Effective processes
- Many firms gathered insufficient detail regarding the types of service, transactions and designated investments with which the client is familiar
- They did not take into account the nature, volume and frequency of the client’s previous transactional experience, or the time period over which such transactions had been carried out
- They used a scoring system that gave too much weight to a number of other less relevant factors, and less to a client’s relevant knowledge and experience
- They did not assess whether CFDs were appropriate for the client, and instead used tick box exercises to help them self-clarify that they understood the risks of the investment
- They did not assess the client’s level of experience and knowledge
- Many providers had not established a process to assess whether clients who fail the appropriateness assessment, but who still wish to trade in CFDs, should actually be allowed to proceed with CFD transactions
2. Adequate risk warnings
- It was found that risk warnings given to clients were poorly worded and it was not conveyed in a clear and fair way, that the product may not be appropriate for the client
3. AML controls
- Providers were conducting adequate customer due diligence on standard risk clients. However, many were not conducting enhanced due diligence on clients that had been identified as high risk
- Client AML risk assessments did not consider a range of factors and instead focused on jurisdictional risks, limiting their effectiveness
Implications for firms and regulatory next steps
A real regulatory risk has been flagged here by the FCA, with the regulator clearly preparing the path for greater scrutiny in this area.
The FCA will be working with each of the 10 firms in this area individually on the specific failings at those firms. It is also likely that a number of section 166 skilled persons reports (s166) will be commissioned across Lot 5 (Conduct) and Lot 7 (Financial Crime).
For firms that were not a part of the original review, this letter should be seen as the ‘shot across the bows’ that it is intended to be. Going forward, the FCA will expect firms to have rectified these issues, and there will be much more serious consequences for firms found not to have heeded the regulator’s warning here.
Actions for firms
Butler stated in the letter that CFDs can put customers at risk of losing more than their original investment, and firms must assess whether the products are suitable for the client.
Where you are concerned that you are out of step with the regulator’s expectations, you will need to read between the lines of the FCA’s warning:
“You should consider the points we raise in this letter regarding the process that your firm follows when taking on new clients. If, when reviewing your processes, you identify any areas of concern, we expect you to have regard to Principle 6 (Customers’ interests) as well as Principle 11 (Relations with regulators) and act accordingly.”
So what does the FCA mean here? If you find failings, you should remediate customers, putting them back into the situation they would have been had you not fallen short of expectations, and also notify the FCA of both your findings and what you are doing to put it right.
At this point, to prepare for any further regulatory scrutiny, firms should consider the points raised in the letter regarding the process their firm follows when taking on new clients by carrying out a gap analysis of their compliance with COBS 2.1.1R (the client's best interests rule) and their AML procedures. For some firms, doing this through a mock s166 with an FCA panel firm (such as Huntswood) will be the right approach, helping them to demonstrate to the regulator that they have adopted a serious approach to this issue by ensuring they have the right levels of expertise to remedy any issues identified.
SIGN UP FOR REGULAR INSIGHT
Keeping up-to-date with the latest industry topics and regulatory issues can be quite time-consuming!
Thankfully, our regulatory experts are here to help you stay on top of it all. Fill in the short form below to receive a monthly round-up of our insight, news and analysis.