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ESMA Leverage Restrictions

What are they & will you be affected?

 

by Christopher Butcher, 24/07/2018

 

Trading is changing. You've probably heard that the new ESMA (European Securities & Markets Authority) restrictions on leverage are due to come into play imminently. The big question is… will this affect you? Well the aim of this short article is to show you just that.

Firstly let’s start with some terminology. Here in Europe we have the freedom and flexibility to trade leveraged products in the form of CFD’s or spread-betting. Leverage gives you the ability to place a trade worth more than what you have in your account. For example, typical leverage of 100 to 1 would mean that if you had a trading account of £1000, you would technically be able to place a trade worth up to £100,000.

“Margin” is the requirement from the broker that you must have in your account for you to be offered the leveraged trade. And so in the previous example, for us to place a trade worth £100,000 with 100 to 1 leverage, the margin requirement would mean that we would need at least £1000 in our account.

 

A good way to look at how this works is to compare it to buying a house – the house deposit is the equivalent of the margin requirement. And when the deposit is paid, you’re then offered the leverage on the remainder of the house, usually in the form of a mortgage.

 

So what are the new rules?

The new ESMA rules are going to be restricting that leverage to 30 to 1. So in a nutshell it means that the maximum underlying value of the trades you can place will be restricted. The concern for a lot of traders is that they will no longer be able to trade in the same way.

 

Let’s go through an example of a typical spread-bet trade under these new rules :

Let’s say we wanted to buy EURUSD for £5 per point at 1.1689

 

The underlying value of this trade is £5 (position size) x 11,689 (price in points)

                                                                 = £58,445

Under the new 30 to 1 leverage rules, if we wanted to place this trade it would mean we’d need to satisfy the margin requirement:

 

Margin Requirement = Trade Value / Leverage

                                       = £58,445 / 30

                                      = £1,948.17

 

So £1,948.17 is the amount we need in our account in order to place the trade.

 

Therefore, if our account size was anything less than £1,948.17 it would mean that we need to reduce our position size.

 

Who is really going to be affected?

Short-term traders

If you trade from short timeframe charts, you would typically trade larger position sizes. A larger position size means a larger underlying trade value.  You are going to be restricted here because obviously ESMA want to cap silly leverage on how large these underlying trades can be.

 

Traders with lot’s of positions

For traders that like to have a lot of trades running at once, you are likely to face some challenges - especially if you tend to enter them all within a short space of time of each other.

 

Each trade will have it’s own margin requirement from the broker, and if the total of all of that margin is larger than your account balance, you will have to be selective. An alternative to being selective is to simply reduce your position sizes overall. If you tend to enter into more trades as your open trades turn into a profit, then you will be less affected.

 

Uneducated gamblers

 

This is the market the rules are really aimed at - those who believe they have the ability to run before they can walk, and jump straight into trading without educating themselves. Unfortunately, if you do throw yourself in the deep end of trading without understanding how the logistics work, you are highly likely to lose ALL of your money.

 

Leverage is an extremely powerful tool that can be amazing when things go right for you – however the danger is when they don’t. The new ESMA restrictions will help prevent amateurs placing trades with excess leverage they do not properly understand.

Remember: it was excessive leverage of Mortgage-Backed Securities that killed Lehman Brothers.

 

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My Conclusion

My honest opinion is that the new restrictions are only a good thing. The trading industry is branded with the bad name that comes from the horror stories of people blowing their accounts. Those stories are usually the result of a lack of education and understanding of how leverage works and the risks involved.

 

The new leverage restrictions will mean that only people who can afford to trade will be able to trade.

 

For the traders I manage, I see no reason to believe they will be affected due to how the rules and process of my strategy works.

We should probably remind ourselves that leveraged CFD’s are banned in the US, and as a result it is a complete nightmare to have a reliable route to retail trading.

 

In Europe, we should consider ourselves fortunate that these products are available for us to trade, and as I have mentioned above, putting restrictions on position sizes is only a good thing for preserving the industry in the longer term.

 

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