Regulation of Binary Options

/Regulation of Binary Options

Binary Options

One of the newest trading instruments to gain popularity in recent years are binary options. Although various regulators have moved at different speeds towards either regulating these tradable products or not, binary options are typically classified as either  gaming or gambling product, or into the category of derivatives.

Binary options are typically available alongside forex, CFD offerings, and/or traditional vanilla options contracts that are traded either alongside listed-products on many of the world’s stock exchanges or in over-the-counter (OTC) markets and off-exchange.

The classification or lack thereof, for binary options, largely depends on the relevant regulatory jurisdictions and any efforts made within various countries towards a required framework for the products to be legally implemented by companies and offered out to clients.

What are Binary Options?

The reason binary options are called ‘binary’ is because of the nature of risk when buying options which is limited to the entire premium (i.e. the cost of the trade). It gives the appearance that it’s an all-or-nothing trade or a trade that results either in a 100% gain or 100% loss, hence a dual or binary nature.

However, this is not always the case as some binary options trading instruments can be exited early, or feature other risk-management  features depending on the contract specifications, and underlying market movements, as well as the brokerage or exchange offering the products.

Options Risk Profiles Across Products

For some people, this type of investment appears highly aggressive or akin to gambling. In reality trading listed options in the US stock markets can be the same or even-more risky, and typically requires advanced approval for level 1, 2 and level 3 options trading (reserved only highly experienced and sophisticated investors) as certain options trading can carry unlimited risk (i.e. risk greater than the initial deposit or margin collateral).

Therefore, despite binary options labeled by some as a gimmick or sounding like a gambling product, the many billions of US Dollars worth of options that trade on the US stock markets operate in a similar manner where the premium paid is the maximum risk when buying either long calls or short puts in the options market. Conversely, selling options short or writing naked puts to collect premium from buyers can carry unlimited risk in some cases, whereas trading binary options in this case would be safer. At the end, it really depends on the specific product features and the trading venue where the contracts can be traded.

Trading Community Observations

Despite the risks, investors and speculators love trading options of all sorts as they can serve as a tool to hedge either the underlying instrument or correlated asset and/or enter the market for fix amount of time and price target. This contrasts spot trading which can be subject traders to getting a stop-out or margin call from underlying price movement that can result in a prematurely liquidated trade whether in equities or forex and other markets.

With the right approach, various options contracts including binary options can serve a purpose within an investor’s portfolio or traders’ strategy, and based on suitability and risk-appetite and other common attributes that vary per customer.

The reason for any negative association with this industry is the unfortunate number of unscrupulous brokers that have emerged in recent years – many of which operate either illegally or lack any regulation or oversight, and who employ questionable ethics in their business and towards their clients. The same occurred within the foreign exchange market as it evolved along with related regulations across the world in the last twenty years, and despite ongoing challenges that still exist.

Therefore, a strong self-regulatory effort is needed and Financial Commission can help companies offering these products achieve that through the membership criteria and advantages provided to clients when firms become members.

Legal Status and Reforms

Overall each regulatory jurisdiction has their own opinion or lack thereof regarding binary options and either attempts to classify these products within any local framework and based on existing laws or has not yet done so. As a result, the consensus towards these products varies across different countries.

This means that some regulators allow binary options trading with proper licensing, whereas others have banned it completely, meanwhile some countries not having done anything on whether binary options are permitted or not locally.

Regulations normally lag behind new technologies or approaches and the same can be said for these products, while the length delay appears to be shortening as reforms have been put in motion in some countries.

Contrary Approaches

In some countries, Binary Options (BO) have been criticized by regulators and other authorities (e.g. Italy, France), together with proposals to classify these instruments as gambling. Elsewhere, they all fall under a ban, such as in Canada and Israel. Yet this could be a stepping stone for any future reform and to clean up firms operating in these locations, and after numerous warnings have been issued against related companies.

On the other hand, in the most developed countries in terms of the regulation of financial markets, these instruments are classified as financial derivatives and are regulated accordingly – for example countries such as the USA, UK, Japan, Cyprus and other European countries under MiFID Directive (although the French AMF regulator considers MiFID insufficient to offer a license for firms to offer BO in France).

In order to understand the reasons for the negative relation to these instruments from a number of countries, Financial Commission analyzed official statements and publications from regulators and other authorities, excerpts of which have been paraphrased and collated in the table below.

The main problem Causes Solutions
  • Denial of service providers (non-regulated), to meet their obligations to customers. For example, in its release, the Commodity Futures Commission noted that the big  number of claims related precisely to the failure to satisfy the requests for withdrawal of funds belonging to clients.
  • Cancellation of a positive result that the client had received from transactions with binary options (i.e. cancelled profit)
  • Because there is high demand for new instruments such as binary options, it becomes a weapon of choice for fraud. New, so-called screen, under the guise of which the funds are raised.
  • Binary options are attracted not only retail investors with no experience, but also the businesses without it. As a result, this leads to bankruptcy for companies scammed.
  • Undeveloped market. Not a standardized market, causing it no effective hedging instruments.
  • State regulation and oversight will help to deter fraud, to solve the problem of unqualified personnel in the industry, as well as to monitor the adequacy of firms own capitalization to ensure fair dealing and the safety of customer funds.
  • Aggressive practices of sales and insufficient disclosure of risks.
  • Often, the use of a very similar position to gambling. (Get rich quick & easy)
  • Provision of “poor quality” analytical support – in this paragraph notes the work of personal trading advisors
  • No requirements / standards concerning the process of attracting customers
  • Lack of requirements for managing and trading advisor.
  • Governance of marketing and sales processes, as well as requirements to people, engaged in sales.
  • Internal audit and information storage requirements.
  • Manipulations in the platforms.
  • Changing the terms of the options, after the trade is conducted.
  • Input unexpected, non-prescribed limits, and creating other difficulties to the client.
  •  Lack of control over pricing.
  • Lack of standards and rules for carrying out transactions.
  • The absence of dispute settlement mechanisms, and a lack of expertise.
  • The low level of product awareness
  • Regulation and monitoring of the pricing process.
  • Standardization of contracts.
  • Ensuring consideration of ways and the settlement of disputes.
  • Reporting and storage of information requirements.
  • Control of honest disclosure to the client

 

It is important to note that some regulators explain binary options as gambling because they see it as a market of purchasing predictions rather than actual securities and where the probability of correct market predictions at short time intervals is highly random. Thus making these trading instruments based on guessing rather than the overall forecast over either a short, medium or longer term period. In addition, these views may be taken in order to fit binary options within the existing gaming regulations applicable, if no such rules apply within the financial investment authorities for a given jurisdiction.

Some broad opinions from the other side are that these definitions are just as suitable as any other speculative transactions on the market. Also, if the underlying asset of a binary option is a security, and the payment of the cost of the contract is determined by the volatility of the underlying asset in a financial instrument, then trading in such instruments should be monitored by the appropriate supervisory authority.

Jurisdictional Differences

Looking at the experience of the US and Japan, it is clear that a compromise was found and implemented by introducing specific conditions for providing BO trading. Regulators are trying to help increase awareness for clients regarding binary options so that investors trade binary options more consciously, as some believed that trading in very short intervals is devoid of any analytical component. Also, trading longer intervals eliminates the possibility of price manipulation.

For example, in the United States, the minimum option duration is 5 minutes, and in Japan it is 2 hours, and issues like these vary across parts of the world. Initially, binary options were very standardized products yet have become more varied and diverse in recent years, as different providers continually customized their related products and platform offerings over time. In addition, across various jurisdictions, binary options are required to meet certain standardized criteria related to their contract specifications and/or functions.

The Financial Commission is able to help the binary options industry by supporting firm’s own self-regulatory efforts through a voluntary membership structure using an external dispute regulation (EDR) platform that the organization provides and through its Dispute Resolution Committee (DRC) that brings extensive experience across the online brokerage industry. In addition, companies must meet minimum standards to join the Financial Commission as well as demonstrate ongoing compliance as needed in order to maintain membership – such as in cases of customer claims or disputes that are brought to the Financial Commission to be heard.

2016-05-06T00:00:00+00:00May 6th, 2016|