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, how that new trader is marketed to determines whether they open an account with a particular broker.
Rarely, does the individual understand how to review a broker’s offering, this guide will show you how.
Perhaps the main consideration when choosing a broker is regulation
When you deposit your funds with a brokerage firm, you want to be sure that all industry standards are enforced and upheld and that your money is held safe. There are many regulatory bodies in the CFD, spread betting and forex industry, which differ by many factors such as capital requirements, maximum leverage and fair market pricing, to name a few, and we’ll cover the main market regulators in the following lines.
The way to check where a broker is regulated is to view their website – in developed jurisdictions the broker normally carries a notice in the footer of their site. If there isn’t one there, that probably tells you all you need to know and you should move on.
The CFD trading industry in the United Kingdom is arguably the most mature CFD market in the world. As at 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.
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. However, the nature of CFDs makes fair market pricing difficult to implement in practice.
One problem that often arises during very volatile market conditions or when trading less-liquid CFDs is that the price can change in a matter of milliseconds, often before the broker receives your trading order. Nevertheless, this phenomenon, known as slippage, sometimes works in favour of the trader and sometimes to the benefit of the broker.
Over a large enough sample of trades, the costs of slippage should become symmetrical and average over time.
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 it financial standing, that the employed 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. In our opinion, this capping of leverage is a direct result of private traders not understanding the dangers of leverage and how to manage it, something we cover in our courses.
Traders, especially profitable day traders, need leverage and the fairly clunky, one-size-fits-all change in rules have resulted in two outcomes, both of which are negative.
Firstly, brokers have offered to upgrade ‘retail’ traders meeting certain criteria to ‘professional’ traders so as to obtain the levels of leverage previously available. This is a technical regulatory change in client classification which strips back the protections previously available to individuals and has made somewhat of a mockery of the changes.
There is now less protection and if you are considering becoming a professional client, make sure you understand what the protections are you are giving up – the broker must tell you what these are, so make sure you ask.
The second outcome is traders are moving their accounts offshore, outside the EU. 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.
I’m afraid the hard-won consumer protections, developed over decades, provided by trading with an FCA broker have been decimated by one clumsy piece of regulation. Individuals moving their account from the EU, especially from the UK, sometimes just assume there are protections like client funds segregation and fair market pricing. There aren’t, so make sure you know what it is you are signing up for.
The main objective of the regulators was to protect new traders and yes there are now probably fewer new traders from the EU losing their shirt by not understanding leverage, which a good thing. But people still want to trade and I’m afraid in practice the changes have pushed new traders offshore, or into the professional classification, away from the very protection the regulators were seeking to afford them.
As the UK leaves the EU the rules will no doubt evolve, so keep yourself informed.
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 authorises 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 business is done with ASIC brokers. It is in similar time zones and can afford the trader a good level of protection.
Other important regulatory bodies are listed below.
- 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 licence 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, 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, take your time and place regulatory protections at the top of the criteria you use to choose your broker. Let’s move on and look at the various types of broker.