ESMA and the Tale of the 5 Leverages

No. This is not the title of the next Lord of the Rings instalment or a Game of Thrones knockoff, but it has turned out to be a horror story to many retail brokers. So? How do the new legislations affect you — the retail investor.

Firstly, that "whooshing" sound you heard last week was probably the sound of your broker heading off-shore, far away from the new European regulations which will come into force this summer. Soon, you will be getting the phone calls from salesmen offering you huge leverage on FX, CFD's, metals and crypto insisting that that is the only way to go. Upon investigation, you will find that they are regulated in Antarctica or somewhere equally exciting.

Just to clarify, the new leverage caps imposed by the European Securities and Markets Authority (ESMA) look like this:

• 30:1 for major currency pairs;

• 20:1 for non-major currency pairs, gold and major indices;

• 10:1 for commodities other than gold and non-major equity indices;

• 5:1 for individual equities and other reference values;

• 2:1 for cryptocurrencies

This is a major drop from current levels and, believe it or not, it is a good thing.

Just today, I received an email from a broker offering 1:3000. Let me be totally clear to any retail investor who wants to listen. Any broker offering ridiculous leverage like this is not interested in helping you make any money. They are only interested in one-way traffic: from your wallet.

There are many ingredients to a great formula for profitable trading. These include education, homework, discipline, a plan, risk management, descent spreads and, yes, a little bit of leverage. Trading is not about making massive gains in one trade, one day, or even one week. It is about a consistent progression of winning trades balanced with proportionally smaller losses.

You don't need big leverage to do this. If you are interested in blowing up your account, with reckless trading and no risk management, then big leverage is your best friend. In this case it's also the broker's best friend. This is why the powers that be have imposed leverage limits on brokers.

I can safely say, that as an educator, that I have never had a student phone me in tears after blowing up their account. Others have. I ensure that students understand risk management, position sizing and that they are using a responsible broker who is on their side.

It is very difficult to accidentally blow up an account at 1:30 leverage.
Leverage can be a great tool if used well but dangerous if abused. Even at an institutional level, when the markets go out of control, leverage can destroy. Just last month, Jerome Schneider of Pimco reminded us of the danger of leverage during a crash. Big losses are magnified quite quickly. Those of us who monitor the markets often hear the term "real money" buyers or sellers. These are usually banks or big funds operating strictly with cash... no leverage.

You may be asking, "Why are there different leverages for different markets?". The answer is simple: volatility.

In general, the forex markets are less volatile than say, equities, with crypto being the most volatile. This has been taken into account by ESMA in an effort to protect the retail investor. I surveyed a few retail brokers and most are offering 1:3 on Bitcoin and dropping to 1:2 is actually a big drop. I found one broker offering 1:20, which doesn't sound like much, but with crypto, this will be enough to destroy an account quickly.

My point is that with volatile assets like Bitcoin, traders don't really need to be looking around for leverage. There are trading platforms like Coinify which allow a trader to easily buy Bitcoin as you would have bought equities years ago. Mark Højgaard, CEO at Coinify, told us, "the ESMA ruling on leverage caps does not affect our services...we want to make trading simple, safe and accessible to everyone— from curious beginners to expert investors."

The moral of the story is the metaphor "horses for courses". Low volatility instruments such as forex, gold, and indices require some leverage to trade; equities require less; and high volatility assets such as Bitcoin and other cryptos require very little or none.

Your relationship with your broker needs to be a two-way street...not one-way from your wallet.