Findings from our review of appropriateness assessments for sales of contracts for difference (CFD) products, through a sample of 23 firms.
This review was a follow-up to our Dear CEO letter issued in February 2016 which raised concerns regarding the take-on process for non-advised sales of CFD products.
Chapter 10 of the Conduct of Business Sourcebook (COBS 10) sets out firms’ obligations and relevant guidance in relation to assessing appropriateness for non-advised services.
Our Dear CEO letter asked all firms to consider whether their client take-on processes for CFD business comply with our requirements. Firms were reminded to have regard to Principle 6 (Customers' interests) and Principle 11 (Relations with regulators) when remediating any concerns they identified. We re-emphasised this message during our CFD industry briefings in July and August 2016 and on our CFD webpages.
Conclusions from the review
The review found that despite our 2016 communication outlined above, it appears that key areas of concern remain:
Inadequate assessments of prospective clients' knowledge
This is a separate consideration from a clients’ experience and we also found a reliance on irrelevant or unsupported information in assessments. In accordance with COBS 10.2.1R, a firm must ask a client to provide it with information that will enable it to undertake an appropriateness assessment. A firm’s assessment questions should aim to obtain from the client relevant information about the client’s knowledge and experience (including relevant qualifications), and seek evidence in support of answers provided.
A particular concern identified relates to assessment questions which ask applicants to confirm that they have attended a seminar or course about CFDs, or whether they have used a demonstration platform to gain "experience". Although these services may improve a prospective client’s knowledge, an assessment of appropriateness should not give undue weight to these factors.
Knowledge assessments benefit from inclusion of general risk management-based questions (for example, knowledge and use of leverage, stop-losses etc). Assessments of appropriateness that do not adequately evaluate a prospective client’s knowledge and experience will not comply with COBS 10.2.1R.
For example, in line with the European Securities and Markets Authority’s (ESMA) Q&As, an assessment process which fails to properly consider whether firm-sponsored seminars, courses, training programs or use of demonstration accounts have, in fact, provided the client with relevant knowledge and experience is unlikely to comply with COBS 10.2.1R.
Insufficient account of clients' previous transactional experience
This finding relates to a failure to take adequate account of the nature, volume and/or frequency of prospective clients' previous transactional experience, or the time period over which such transactions had been carried out. This is required by COBS 10.2.2R(2).
Inadequate risk warnings to prospective clients who fail appropriateness assessments
In line with ESMA Q&As, risk warnings should be designed to interrupt the application process. They should use clear language to communicate that a specific product or service is not appropriate for the applicant because the applicant’s answers lead the firm to the view that the applicant does not have the knowledge and experience to properly understand the risks involved, with a clear recommendation against proceeding with the transaction.
As such, when presenting a risk warning, applicants should not be asked to confirm an intention to proceed with a transaction as the next step in the application process. Examples of good practice in this regard include implementation of a mandatory "cooling off" period after the risk warning, and/or requiring the applicant to submit or respond to a separate communication in which they must acknowledge the risk warning, such that they do not have the option to proceed immediately. Our review found that where prospective clients fail the appropriateness assessment, but can easily override the risk warning and proceed to open an account, a high proportion of clients proceed to enter into CFD transactions.
Failure to evaluate whether failed applicants should be allowed to make CFD transactions
This finding relates to a failure to evaluate adequately whether applicants who fail the appropriateness assessment (and receive a risk warning), but who nonetheless wish to trade in CFDs, should be allowed to proceed with CFD transactions (COBS 10.3.3G).
In most cases, firms did not give meaningful consideration to whether the applicant should still be permitted to proceed. This allowed prospective clients to override the appropriateness assessment and risk warning and proceed to trade without substantive deliberation.
As ESMA’s Q&A’s state:
"taking into account the complex nature of CFDs and other speculative products and the best interests of the client, in cases where the assessment of appropriateness indicates that the product or service is not appropriate for a retail client or where insufficient information is available to assess appropriateness, the best practice would be for the firm to not allow the client to proceed."
As such, it appears that some firms may be failing to comply with their obligations in relation to customers' best interests under COBS 2.1.1R and Principle 6, as well as acting contrary to our guidance in this regard (COBS 10.3.3G).
Poor oversight, weak controls and inadequate management information
It is vital that firms have appropriate, accurate management information and meaningful board level discussions relating to appropriateness assessments. Our review found firms lacking evidence of such discussions or of appropriate challenge, such as board minutes or contemporaneous notes of senior management discussions. Failure to conduct business with due skill, care and diligence, or failure to take reasonable care to organise affairs responsibly and effectively, may constitute failure to comply with Principle 2 or 3 respectively.
We continue to have serious concerns about the distribution of CFDs to retail clients. In particular, we are concerned that these complex, speculative products are reaching a wider target market than is likely appropriate. As such, the quality of firms’ policies and procedures in relation to client on-boarding and assessment of appropriateness will remain a key focus for us. Our work in this area will continue and we will consider enforcement investigations or other action as appropriate, including in relation to firms that were included in the review.
Furthermore we encourage firms to assess their systems and practices in view of pending obligations under the Markets in Financial Instruments Directive II (MiFID II), which takes effect (for firms) on 3 January 2018. Firms should carefully consider enhanced product governance requirements and take steps to ensure compliance with the new rules. Future reviews will assess firms’ arrangements under the new provisions.