How futures work
Futures are standardized forward contracts on, among other things, financial instruments and commodities. They contain a contractual obligation to deliver (short position) or take delivery (long position) of a specified quantity of an underlying asset (contract item) at a price fixed at the time the contract is concluded and at a later date, which is also agreed at the time the contract is concluded.
Requirements for trading in futures
In order to trade in futures, trading participants must deposit collateral with the futures exchange in the form of a capital contribution (margin) to ensure future fulfillment of the concluded transaction. The amount of collateral is determined by the futures exchange and is generally based on the risk or volatility of the underlying asset under the futures contract.
In addition to the minimum capital contribution (initial margin), a certain margin account amount is set by the futures exchange. This amount may never fall short of the maintenance margin, which is the minimum limit for the amount of collateral to be provided by retail investors and is set slightly below the initial margin. If this limit is not met, the investor receives a margin call to replenish the account. If this does not happen, the broker closes the position by closing out the contract. This is called a forced liquidation or forced closure.
An obligation to make additional contributions, so called “margin call”, arises if the collateral paid in by the investor is insufficient to compensate for losses incurred after a forced closure has taken place and the investor therefore has to compensate for these losses from other funds.
In the past, especially in the case of exceptional market events (so-called “black swan” events), significant price fluctuations have confounded the expectations of investors and resulted in high additional funding obligations.
The amount of any loss compensation under an obligation to make additional contributions is not limited to the original amount, and may be much higher.
Restrictions on margin calls already in force
Already, on May 8, 2017, BaFin had banned the distribution of CFDs with margin calls to retail customers in Germany after significant margin call obligations arose in January 2015 in connection with the “Swiss Franc Crash.”
With a general ruling dated July 23, 2019, BaFin restricted so-called contracts for difference (CFDs), which may now only be marketed to retail investors under certain conditions, for example, if it can be ensured that investors do not have to make any additional margin payments and any loss is limited to the amount invested (so-called “negative balance protection”).
Furthermore, statutory exclusions apply to additional funding obligations in Germany. For example, asset investments with an obligation to make additional contributions are prohibited under section 5b (1) of the German Asset Investment Act (Vermögensanlagengesetz). Section 152 (1) of the German Investment Code (Kapitalanlagegesetzbuch) also excludes any obligation for limited partners of limited investment partnerships to make additional contributions.
Legal basis
The planned restriction is in line with art. 42 (1) MiFIR. Pursuant to art. 42 (2) MiFIR, BaFin may prohibit or restrict the marketing, distribution or sale of financial instruments with certain characteristics (and so futures, as legally defined) if it is reasonably satisfied that the financial instrument raises significant investor protection concerns, existing regulatory requirements under EU law applicable to the financial instrument do not adequately address the risks identified in art. 42 (2) MiFIR, and the concerns would not be better addressed by stronger supervision or enforcement of the existing requirements. In addition, the measure must be proportionate, taking into account the risks identified, the level of knowledge of the investors or market participants concerned, and the likely impact of the measure on investors or market participants.
Investor protection concerns
Furthermore, from BaFin’s point of view, there are considerable concerns related to investor protection within the meaning of art. 42 MiFIR. This is due to the fact that the legal and financial consequences of the obligation to make additional contributions are felt more by retail investors, who risk incalculable losses. Given this possibility, BaFin places particular emphasis on the risk that small investors may lose more than their invested capital – indeed, virtually unlimited amounts.
In the general view of BaFin, concerns related to investor protection are magnified by the leverage effect inherent in the product and in credit-financed transactions as well as due to the distribution and sales practices used in futures trading.
In case of very high price swings, in particular, the outstanding margin may exceed the amount already invested. There is no upper limit for the margin payment. In fact, the margin – and therefore any possible loss – may be unlimited, at least in principle. Indeed, as the market investigation conducted by BaFin showed, in a highly volatile market in some cases six-digit amounts were demanded from retail investors following a forced closure.
It should also be noted that intermediaries are not required to notify retail investors of margin calls, and that even if intermediaries did notify investors of a shortfall, the investors would need to be available at all times to make a timely response.
Retail investors as customers
BaFin also believes that the nature of retail investors as customers points to a need for regulation. Retail investors generally have no opportunity to trade directly on futures exchanges, having access to futures exchange only through financial intermediaries, which in turn operate directly on the exchanges.
BaFin’s intended exclusion of margin calls would therefore reduce the risk from credit-financed speculation by limiting the amount actually invested and available. For that reason, BaFin considers the general ruling necessary to protect retail investors from losses that exceed the amount deposited in their trading accounts, thereby spilling over to the investor’s other assets.
Existing regulatory requirements as an alternative?
According to BaFin, neither the requirements of EU law nor national provisions – laid down, for example, in the German Securities Trading Act (WpHG) – can adequately address the risks faced by investors in connection with margin calls in futures.
BaFin examined whether more stringent enforcement of the provisions on fair customer information pursuant to sections 63 (1), (6) and (7) of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG) would help minimize investors’ risk. However, it concluded that a clear and transparent presentation of the rules to customers does not protect retail investors from the risk of being required to make additional contributions.
Section 64 (3) of the WpHG, which requires intermediaries to obtain the necessary information about the customer’s knowledge and experience when providing investment advice, does not offer any added value either, since futures with margin calls are usually sold without advice.
The provisions on product monitoring in sections 63 (4) and (5), 80 (9) to (13), 81 (4) WpHG and sections 11 and 12 of the Ordinance Specifying the Rules of Conduct and Organizational Requirements for Investment Services Companies (Wertpapierdienstleistungs-Verhaltens-und-Organisationsverordnung) were also reviewed for their effectiveness in minimizing risks when trading futures. It was found that a determination of the target market would be possible and so there was no risk of futures with margin requirements being marketed to retail investors. However, this would require several intermediate steps before implementation, and in the meantime it could not be ruled out that investors would suffer further high losses from trading in futures.
General ruling is necessary and appropriate
Finally, BaFin also considered that the general ruling was a necessary and appropriate measure. BaFin reached this conclusion on the basis that, among other things, trading in futures was not being prohibited outright; rather it was still possible but without a margin call. BaFin also recognized that less coercive measures, such as a limitation of the leverage in futures trading or a margin increase in case of volatile market movements, still presented an unpredictable risk of loss.
Furthermore, BaFin’s market investigation showed that even with an exclusion of the margin call when it comes to retail investors, futures trading still appears to be economically viable for financial intermediaries.
In addition, futures with margin calls covered by the restriction under the general ruling may continue to be marketed to professional investors without any restrictions.
According to BaFin, the impact of the general ruling on other market participants, such as market operators, is also justifiable. Futures trading by retail investors accounts for only a fraction of the total trading volume, so even if the demand for futures contracts decreased, the economic impact would be marginal.
Companies affected by the general ruling
The general ruling targets both securities trading companies that have their registered office in Germany and distribute (or intend to distribute) futures with margin requirements to retail investors in Germany, as well as those that have their registered office in another member state of the EEA and conduct (or intend to conduct) futures trading to retail investors in Germany. The restriction therefore does not apply to securities trading companies that have their registered office in Germany and distribute futures with margin requirements to retail investors exclusively in other member states of the EEA.
Effective date
BaFin has set a time limit of three months from enactment of the measure for its implementation. This transitional period is intended to enable the target companies to adapt their business terms to comply with the envisaged restrictions.
In light of BaFin’s general ruling described above, it will no longer be possible for intermediaries to trade in futures with margin calls when it comes to retail investors. It remains to be seen how financial intermediaries and investors will react to this.
In-depth 2022-046
