Why CFD Providers Cannot Use the Price and Value Test for Wholesale Clients: Everything You Need to Know

Introduction

Contracts for Difference (CFDs) are versatile financial instruments that allow investors to speculate on price movements of underlying assets without owning them. For CFD providers, understanding the regulatory framework is crucial to ensure compliance and protect both the business and its clients. In Australia, the distinction between retail and wholesale clients under the Corporations Act 2001 significantly impacts the level of regulatory protection and the obligations of financial service providers.

This guide provides an in-depth exploration of the regulatory measures governing CFDs, with a specific focus on the prohibition of the Price and Value Test for wholesale client classification. We will delve into the implications of this regulatory change, alternative classification methods, and the importance of compliance in safeguarding investors and maintaining market integrity

Understanding CFDs and Their Regulatory Framework

What are Contracts for Difference (CFDs)?

CFDs are derivative financial instruments that derive value from an underlying asset, such as shares, indices, or commodities. CFD trading allows investors to speculate on price movements without owning the asset. In a CFD trade, the buyer and seller agree to exchange the difference between the opening and closing price of the underlying asset.

A defining feature of CFD trading is its leverage, enabling traders to control large positions with a relatively small initial margin. While leverage can amplify potential profits when the market moves favourably, it also increases the risk of significant losses if prices move against the trader. In some cases, these losses can exceed the initial investment, making risk management a crucial consideration for CFD traders.

The Role of the Australian Securities and Investments Commission (ASIC) in Regulating CFDs

ASIC regulates CFD trading in Australia. ASIC has raised concerns about retail clients engaging in CFD trading due to the high risk of financial losses. Regulatory reviews have repeatedly shown that most retail traders incur losses when trading CFDs, highlighting these instruments’ speculative and volatile nature.

ASIC has implemented specific regulations for CFD providers in response to these concerns and to protect retail investors. These regulations include:

• Mandatory margin close-out protection: CFD providers should close out a client’s CFD positions when their account equity falls below a certain percentage of the required margin.
• Negative balance protection: Ensures that retail clients cannot lose more than the funds in their CFD account, limiting losses to their initial investment.
• Restrictions on maximum leverage: Sets limits on the leverage CFD providers can offer to retail clients, varying leverage limits based on the underlying asset class.

The Importance of Client Classification

Australian regulations distinguish between retail and wholesale clients in the financial services industry. This distinction is crucial because it determines the level of regulatory protection afforded to clients.

• Retail clients: Are generally provided with a higher level of protection under the law, recognising that they may be less financially sophisticated and more vulnerable to risks associated with complex financial products like CFDs.
• Wholesale clients: Are considered more financially experienced and capable of understanding and managing investment risks, thus subjected to fewer regulatory protections than retail clients.

Client classification significantly impacts the obligations of financial service providers, including CFD brokers:

For retail clients, providers must adhere to stricter requirements, such as:

• Issuing disclosure documents like Product Disclosure Statements (PDS) and Financial Services Guides (FSG).
• Providing access to dispute resolution through the Australian Financial Complaints Authority (AFCA).

These protections are not mandatory for wholesale clients, assuming they are better equipped to protect their interests and manage financial products and CFD trading risks.

The Price and Value Test Explained

Definition of the Price and Value Test

The Price or Value Test is a method used to classify clients as wholesale if the financial product’s price or value exceeds AUD$500,000. This classification is outlined in section 761G(7)(a) of the Corporations Act 2001 (Cth). Meeting this threshold suggests several key aspects about the client:

• Substantial Transaction: The client is undertaking a significant financial transaction.
• Financial Resources: The client possesses sufficient financial resources.
• Investment Experience: The client has considerable investment experience.

This test is just one of several criteria that classify a client as wholesale. Notably, only one test must be satisfied before a client can be classified as wholesale.

Historical Context of the Test

The Price and Value Test has been a widely accepted criterion for wholesale client classification across various financial products. It has traditionally served as an indicator of a client’s financial capacity and investment experience, based on the premise that a significant transaction size suggests a certain level of financial sophistication.

However, the suitability of the Price and Value Test has been reassessed specifically for CFDs due to the unique characteristics of these financial products, including:

• Derivative Nature: CFDs are derivative products.
• High Leverage: CFDs involve substantial leverage, amplifying profits and losses.

These factors distinguish CFDs from other financial products where the Price and Value Test is typically applied, necessitating a reevaluation of its effectiveness for classifying wholesale clients in the context of CFD trading.

Exclusion of the Price and Value Test for CFD Issuers

Regulatory Basis for Exclusion

Corporations Regulation 7.1.22AA(1) prohibits CFD issuers from using the Price and Value Test when classifying clients as wholesale. This regulatory stance, implemented by ASIC, means that the standard Price and Value Test does not apply to Contracts for Difference.

This exclusion is a specific rule within the broader regulatory framework governing financial services in Australia. ASIC communicated this regulatory change to the financial services industry and provided a period for licensees to adjust their processes to comply with this amendment to the Corporations Act 2001 (Cth). This proactive approach by ASIC underscores the importance of correct client classification in the CFD market.

Rationale Behind the Exclusion

The primary reason for excluding the Price and Value Test for CFD issuers is the inherent leverage associated with CFDs. These derivative financial products allow traders to control a substantial position in the market with a relatively small initial margin. Due to this margin trading mechanism, a CFD position with a notional full value of AUD 500,000 can be established with a significantly smaller initial outlay. As a result, the AUD 500,000 threshold in the Price and Value Test does not accurately reflect a client’s financial sophistication or ability to manage CFD trading risks.

This exclusion is intended to prevent inexperienced investors from being misclassified as wholesale clients simply because they trade CFDs with a notional value exceeding AUD 500,000. Such misclassification would strip retail clients of crucial regulatory protections designed to mitigate the risks associated with CFD trading. These protections include:

• Disclosure documents: Retail clients are entitled to PDS and FSG, ensuring they receive essential information about the financial product.
• AFCA complaint access: Retail clients can lodge complaints with the AFCA for external dispute resolution.
• RG 146 qualified staff: Financial services staff dealing with retail clients must hold appropriate RG 146 qualifications, ensuring a minimum competency standard.
• Client money handling: Retail client money is subject to specific segregation and protection rules, offering safeguards for client funds.

By excluding the Price and Value Test, ASIC ensures that CFD providers utilise alternative, more stringent tests to classify clients as wholesale. These alternative tests are designed to assess better a client’s financial standing, professional expertise, and investment experience. 

Implications of the Exclusion for CFD Providers

Impact on Client Onboarding Processes

CFD issuers should revise their client onboarding processes to ensure they no longer classify clients as wholesale based on the Price and Value Test. This means CFD providers must prevent new clients from being classified as wholesale through the Price and Value Test.

To achieve this, licensees need to:

• Update Systems and Procedures: Modify existing systems to reflect the regulatory change.
• Remove Price and Value Test Criteria: Ensure the Price and Value Test is no longer valid for wholesale client classification for CFDs.

Reclassification of Existing Clients

Licensees should identify existing wholesale clients, initially classified using the Price and Value Test. These clients must be reassessed to determine if they meet any alternative wholesale client criteria, such as the Net Assets and Income Test, the Professional Investor Test, or the Sophisticated Investor Test.

For clients who no longer qualify as wholesale under these alternative tests, CFD providers must reclassify them as retail clients. This reclassification process involves:

• Informing Clients: Notify clients of their change in status.
• Issuing Disclosure Documentation: Provide the necessary documentation relevant to retail clients.
• Advising on Enhanced Protections: Explain the enhanced customer protections to which they are now entitled.
• Reconciling Client Money: Ensure client funds adhere to retail client money handling regulations.

Alternative Tests for Classifying Wholesale Clients

Net Assets and Income Test

The Net Assets and Income Test offers an alternative method for classifying clients as wholesale by evaluating their financial capacity. To qualify for this test, an individual must meet one of the following financial thresholds:

• Net Assets: At least $2.5 million.
• Gross Income: $250,000 or more for the previous two financial years.

To verify these financial conditions, certification from a qualified accountant is required. This certification confirms that the individual meets the necessary financial benchmarks. It’s important to note that this certification is valid for two years, after which renewal is required to maintain wholesale client status under this test. This ensures that the client’s financial situation meets the criteria over time.

Professional and Sophisticated Investor Tests

Beyond the Net Assets and Income Test, additional avenues exist to classify clients as wholesale through the Professional Investor Test and the Sophisticated Investor Test.

Professional Investor Test

The Professional Investor Test encompasses several categories of entities considered inherently professional in financial matters, including:

• Holders of an Australian Financial Services Licence (AFSL).
• Bodies regulated by the Australian Prudential Regulation Authority (APRA).
• Trustees of superannuation products with net assets exceeding $10 million.

These entities are recognised for their advanced understanding and capacity to manage financial risks, qualifying them for wholesale client status.

Sophisticated Investor Test

The Sophisticated Investor Test is more subjective and relies on the assessment by an AFSL holder of a client’s investment expertise. To classify a client as a sophisticated investor, the following conditions must be met:

• Investment Experience: The client must have sufficient prior experience in using financial services and investing in financial products to understand the associated risks.
• Formal Assessment: The AFSL holder must provide a written statement detailing the reasons for satisfying that the client meets the criteria for a sophisticated investor.
• Client Acknowledgment: The client must sign a written acknowledgement confirming their understanding of the classification.

Additional requirements include:

• Exclusion of Certain Products: The financial product must not be a general insurance, superannuation, or Retirement Savings Account (RSA) product.
• Limited Business Use: The financial service or product must not be predominantly used for business purposes.

Even when classified as a sophisticated investor, clients benefit from protections under client money segregation rules, ensuring their funds remain safeguarded.

Risks Associated with Misclassification

Regulatory Penalties for Misclassification

Misclassifying retail clients as wholesale clients poses significant risks for CFD providers. This primarily stems from potential breaches of legal obligations. ASIC enforces strict regulations on wholesale client classification to protect investors within the financial services industry. Failure to comply with these regulations can lead to severe consequences for CFD providers.

Potential penalties include:

• Regulatory action: ASIC may take enforcement measures against CFD providers who fail to correctly classify clients.
• Financial penalties: Non-compliance can result in substantial fines imposed by ASIC.
• License repercussions: In extreme cases of misclassification and non-compliance, CFD providers may face suspension or revocation of their AFSL.
• Legal breaches: Misclassification can be considered a violation of the Corporations Act 2001 (Cth) and related regulations, leading to legal consequences.

Consumer Protection Concerns

Incorrectly classifying retail clients as wholesale clients raises serious consumer protection issues. Retail clients are entitled to specific protections designed to mitigate the inherent risks of trading complex financial products like CFDs. When these clients are misclassified, they lose access to essential safeguards.

These protections include:

• Disclosure documents: Retail clients must receive important documents such as PDS and FSG, which provide detailed information about the financial product and the service provider.
• Access to AFCA: Retail clients can lodge complaints with the AFCA for external dispute resolution, offering a pathway to resolve grievances with CFD providers.
• RG 146 qualified staff: Ensures that staff interacting with retail clients meet RG 146 standards, guaranteeing a minimum level of competency and professionalism.
• Client money segregation: Requires that retail client funds are segregated and protected, safeguarding their investments.
• Margin close-out protection: Limits potential losses by mandating that CFD providers close out positions when account equity falls below a certain threshold.
• Negative balance protection: Prevents retail clients from losing more than the funds in their CFD account, ensuring that losses do not exceed their initial investment.

The Importance of Regulatory Compliance

Maintaining Client Trust

Adhering to ASIC regulations, especially concerning client classification, is essential for CFD providers to foster trust and confidence. By demonstrating a strong commitment to regulatory compliance, CFD providers can significantly enhance their reputation and credibility in the financial services industry.

This trust is crucial for:

• Building long-term client relationships
• Developing a positive brand image

Clients are more likely to trust and engage with transparent and diligent providers in meeting their regulatory obligations.

Long-term Business Sustainability

For CFD businesses, regulatory compliance is not just about avoiding penalties; it is fundamental to long-term business sustainability. By ensuring that all operations and client classifications meet regulatory standards, CFD providers can minimise the risk of regulatory breaches and associated penalties.

Compliance supports business sustainability by:

• Minimising the risk of regulatory breaches and associated penalties
• Ensuring the continued operation and growth of the business within the regulated financial market
• Demonstrating a commitment to ethical practices and investor protection

Maintaining these standards is increasingly important for sustaining a successful and reputable business in the financial sector.

Conclusion

The prohibition of CFD providers in Australia from using the Price and Value Test for wholesale client classification is a crucial regulatory measure. This measure is in place to protect retail investors from the inherent risks associated with CFDs, particularly due to their leveraged nature. CFD providers must recognise and strictly adhere to these regulations by employing alternative tests for wholesale client classification. Ensuring proper client categorisation is not only a matter of compliance, but also essential for safeguarding investors and maintaining the integrity of the financial services industry.

It is essential to seek expert guidance to navigate the complexities of CFD regulations and ensure accurate client classification. Contact AFSL House today to explore our specialised knowledge in financial services compliance and discover how our proven solutions can assist your business in maintaining regulatory excellence and building client trust in the CFD market.

Frequently Asked Questions