Position on the Conduct of Investment Firms in the Forex Market

FINANCIAL SUPERVISORY AUTHORITY
Warsaw, July 1, 2013
DRK/WRMJ48S/55/ /55/2013/PT

Dear Sir/Madam,

Head of the Brokerage House
Director
Brokerage Office
Organizational unit of a bank conducting brokerage activities Branch of a foreign investment firm

In connection with the observed dynamic development of the area of brokerage services whose subject matter is derivative instruments not admitted to organized trading, especially those subject to transactions in the Forex market, and taking into account previous conclusions arising from current supervision and control activities performed, The Office of the Financial Supervisory Authority (hereinafter: the Office, KNF) wishes to present the attached Position (hereinafter: Position, Letter).

The reason for sending this Letter to investment firms is the observed dramatic expansion of investment firms towards providing brokerage services on the Forex market. The dynamic interest of investment firms in development in this segment of the capital market has, in turn, resulted in conditions of stronger competition where diverse and at the same time intensive forms of advertising and promotion of services and instruments are used. New methods of assessing appropriateness are being developed, or a wide spectrum of technological solutions is being implemented, often using services provided by third parties.

Based on the analysis of the previous conduct of investment firms: on the "external" plane (i.e., in relations with clients), as well as "internal" (relating to the conditions technical and organizational of the conducted brokerage activity), the Office has decided to initiate this Position to draw attention to the nature of investments made in the Forex market, the regulations of applicable law having fundamental significance in this matter, and their practical understanding. It should be noted, however, that the subject Position does not cover all aspects related to the manner and mechanism of providing services in the Forex market. The Letter presents those aspects of activity that were noticed during the exercised supervision and raise concerns on the part of the Office.

KNF expresses the conviction that presenting market practices related to the functioning of the Forex market and the Office's position (regardless of other actions such as:
meetings with entities within the framework of CEDUR) will constitute useful knowledge, taken into account in the current activity of investment firms. This applies to both entities providing brokerage services that are already active in this area of the capital market as well as those planning to introduce this type of activity into their offer. At the same time, the Office notes that some comments and observations are of universal character and will find application in relation to other spheres related to the trading of financial instruments.

At the same time, the Office states that the comments contained in the Position regarding the regulations of the Regulation of the Minister of Finance of September 24, 2012 on specifying detailed technical and organizational conditions for investment firms, banks, referred to in Art. 70 para. 2 of the Act, and trust banks, as well as conditions for estimating the internal capital of a brokerage house, and comments contained in point 5 regarding outsourcing of information systems used in the Forex market do not apply to branches of foreign investment firms.

2

Attachment
Position on the Conduct of Investment Firms in the Forex Market General Remarks In the recent period, an intensified scope of activity of investment firms in the sphere of derivative instruments not subject to organized trading has been observed. The behavior of supervised entities often takes the form of highly intensified actions aimed at persuading the client to take advantage of the offer of services or products. To this end, various methods of encouraging potential clients to invest monetary funds in the capital market are used. The result of these actions may be increased interest of investors in this type of activity. It should be kept in mind that derivative instruments have the character of complex financial instruments, and thus are burdened with high investment risk. The riskiness of the undertaking results from the effect of financial leverage, resulting in the fact that with a small initial leverage of own equity capital it is possible to conclude transactions whose subject matter is financial instruments with a nominal value many times greater. As a consequence, it is possible to achieve in the future potentially significant profits. Investments in this type of instruments appear to the investor as a highly attractive form of allocation of available funds. However, it is worth noting that carrying out this type of investment is associated with simultaneously high risk of loss of the investor's own funds, significantly greater than the level of capital involved in concluding the transaction. In this context, it is necessary to take into account the fact of significant asymmetry between investors who have made a profit and investors who have incurred losses from activity in the Forex market for derivative instruments. As studies conducted by KNF in the period from January 1, 2011 to December 31, 2011 show, 82% of active clients using internet trading platforms in the Forex market incurred losses, while 18% of active clients using internet platforms in the Forex market achieved profits (see:
http://www.knf.gov.pl/Images/KNF_forex_18_04_2012_tcm75-30319.pdf). This trend persisted in 2012, and the cited indicators were at a similar level.

In the opinion of the Office, several factors influence this state of affairs. One of the basic circumstances is the fact that beneficiaries of the offer of investment firms in terms of services on the Forex market are investors classified into the category of retail clients. These persons in most cases possess significantly less practical and theoretical knowledge in the field of investing in the capital market than professional clients or authorized counterparties. Thus, the aforementioned category of investors is characterized by the fact that they do not possess adequate awareness of the risk associated with making investments in the aforementioned financial instruments.

An additional determinant in this regard is the fact that clients who decided to take advantage of services provided by investment firms are persons who were not at all or were only minimally active investors in the Forex market.

It should be kept in mind that capital market law provisions ensure an elevated level of protection for the retail client, with special emphasis on cases when they make investment decisions regarding complex financial instruments. The scope of this protection is comprehensive and includes the appropriate manner of conduct of investment firms in advertising and promotion of services and financial instruments, the scope and standard of information provided upon concluding a contract, conditions for conducting appropriateness assessment of the service or instrument, as well as taking actions executory, in connection with the concluded contract.

It should be kept in mind that the issue of investors concluding transactions on the market of derivative financial instruments not subject to trading on an organized market (Forex) has significant importance and is the subject of constant attention, both of the Financial Supervisory Authority, as well as European supervisory authorities. It should be mentioned here, in addition to the aforementioned Commission communication, the following:

• KNF communication of June 22, 2011 on CFD contracts
  (http://www.knf.gov.pl/rm/des/KNF_CFDs/Cm_75-25606.pdf),
• Commission communication of March 6, 2012 on CFD contracts
  (http://www.knf.gov.pl/rm/des/instrumenty_na_rynku_forex/Cm_75-19711.pdf),
• ESMA communication of December 5, 2011 on investing in the Forex market
  (http://www.esma.europa.eu/system/files/2011-410_pl.pdf) and
• joint ESMA and EBA communication of March 28, 2013 on Contracts for Difference (CFD) (http://www.esma.europa.eu/system/files/investor_Warning_cfds_cfd12013_00070000_pl_cor.pdf).

Although the positions listed above are not addressed directly to investment firms but to investors, the fact of their development and the frequency of publication clearly illustrates the current scale of investments in this segment and the weight of problems resulting from transactions concluded in the Forex market. These communications are simultaneously a certain reflection of the approach of supervisory authorities in terms of guaranteeing the appropriate level of protection of the interests of retail clients - entities that by virtue of their theoretical and practical experience or the value of the capital possessed, in the absolute majority of cases invest in derivative instruments available on the Forex market in an environment of significantly elevated risk, taking into account their individual situation. In the opinion of KNF, the fact that supervisors pay special attention to the protection of the inherently weaker category of investors should be naturally taken into account also by entities authorized to perform services in this area of the capital market.

KNF wishes to point out at the outset that the fundamental principle of functioning of investment firms in relations with clients is the principle expressed in Art. 83a para. 3 of the Act of July 29, 2005 on the trading of financial instruments (hereinafter: the Act) - the rule of acting in the best interest of the client. Attention is drawn to the fact that the application of the aforementioned rule of conduct in practice has two dimensions.

The first of them lies in the manner of interpretation of regulations contained in executive acts to the Act. It should be indicated that in provisions relating to the manner of shaping relations between the investment firm and the client, or potential client, a number of precise provisions have been included aimed at protecting their interests, especially the investor classified into the category of retail client. The inclusion at the statutory level of the requirement to act in the best interest of the client triggers implications in relation to these precise norms resulting from lower-ranking acts. The manner of interpreting regulations and creating appropriate norms of conduct for investment firms should be determined by the fundamental mandate to act with regard to the best interest of the client. Circumstances that should be taken into account in the manner of interpreting regulations concerning the conduct of investment firms are, in particular: the category to which the client belongs and the determination of whether the actions taken by the investment firm take into account in an optimal way the preservation of the client's interests in the sphere of protection.

The second area relates to the statutory principle of acting in the best interest of the client in relation to the area of activity of the investment firm not covered by detailed regulations.

In this regard, it should be indicated that in the sphere of the manner of conduct of investment firms, a number of regulations exist specifying the manner of conduct of the investment firm relatively precisely. There is also a wide sphere of activity that has not been subjected to precise regulation by the legislator. In this aspect, the application of the principle of acting in the best interest of the client means that this rule binds the investment firm, also in areas that have not been subject to detailed regulation.

1. Standard and conditions for providing information to the client or potential
   client

As mentioned at the outset, a phenomenon noticed in connection with the exercised supervision is the conduct by investment firms of intensified actions of advertising-promotional character, which widely propagating investments in the Forex market aim to persuade investors to conduct investment activity in this area.

Not denying the increased intensity of this type of actions by investment firms, taken within the framework of business strategy, the Office wishes, however, to draw attention to the basic legal circumstances that should determine the conduct of marketing actions in a proper manner.

In this regard, the Office draws attention to the fact that the legislator in a special way emphasizes the significant importance of the correctness of the investment firm's action when advertising or promoting the provided brokerage services. It does this by formulating at the statutory level - in Art. 83a para. 2, a superior mandate that information disseminated by the firm for the purpose of advertising or promotion of the aforementioned services must be reliable and understandable.

Analogously, as in the case of the statutory canon regarding taking into account the best interest of the client, also in relation to the statutory requirement concerning the characteristics that information intended to persuade the investor to take advantage of the offer of the investment firm should have, it is possible to formulate two rules for the manner of determining the proper conduct of the firm, i.e.

• taking into account the principle of the investment firm acting in the best interest
  of the client when interpreting precise provisions of lower-ranking acts determining detailed aspects of promotional-advertising actions,
• accepting the rule indicated in Art. 83a para. 2 of the Act as the main guideline
  for determining the expected conduct of the investment firm in the sphere not regulated in detail by executive acts to the Act.

In the scope of regulations of lower-ranking acts, the Office wishes to draw attention first of all to the provision of § 9 of the Regulation of the Minister of Finance of September 24, 2012 on the procedure and conditions for the conduct of investment firms, banks, referred to in Art. 70 para. 2 of the Act on trading of financial instruments, and trust banks, which formulates the basic parameters of information disseminated by the investment firm:

In particular, it should be indicated here the principle provided for in § 9 para. 1 of the Regulation, according to which information directed by the investment firm to clients or potential clients should be reliable, not raising doubts and not misleading.

First of all, KNF states that in conflict with the provision concerning, among other things, reliable information to the client or potential client, as referred to in § 9 para. 1 of the Regulation, is the practice, in the light of which the investment firm creates misleading impressions regarding the character or manner of providing the given service in the Forex market. In the light of previous observations, this concerns in particular cases where the investment firm publicly presents the offered service as the organization of a certain systematized place of trading financial instruments analogous in terms of functionality to types of organized trading. In the content of the message, this type of action by the investment firm is usually referred to as the organization of a "Forex platform" or with the use of similar formulations. Such presentation of the adopted model of operation does not raise any objections when the investment firm, using its own IT and organizational resources, with the involvement of its own capital, creates a system enabling clients to conclude transactions in an organized, frequent, and systematic manner. However, the formula of some models of operation of investment firms in the Forex market actually consists not in organizing their own "Forex platform", but in providing brokerage services through other entities that execute orders placed by clients in various ways, which stands in contradiction to the informational message suggesting that the investment firm independently organizes trading.

Additionally, KNF wishes to draw attention to the correctness of terminology in determining activities provided to the client. The circumstances indicated above result from the fact that in informational materials analyzed by KNF, expressions were noticed for determining services provided to the client, which do not correlate with the catalog of services from brokerage activity, specified in Art. 69 para. 2 and 4 of the Act. An example of this type of formulation is the use by the investment firm of the formulation that it provides the client with the service of "intermediation in the Forex market" or "enables investment activity in the Forex market". Legal regulations concerning the provision of brokerage services do not identify this type of services provided by investment firms. Moreover, such formulations often make it impossible to correctly identify the character of the activity of the investment firm, e.g., whether "intermediation" involves providing the service of executing orders or the service of accepting and transmitting orders. This practice conflicts with § 9 para. 1 of the Regulation, as it does not contain reliable and non-misleading information regarding the character of the activity (provided service) of the investment firm to the client.

Another behavior observed in the activity of investment firms in the context of incorrect implementation of the principle referred to in § 9 para. 1 of the Regulation is the excessive highlighting of the role of demonstration accounts (demo accounts). The Office does not deny the undeniable benefits flowing from the possibility of using this type of application in order to assimilate the basic rules of investing in the Forex market, as well as familiarizing oneself with the technological infrastructure accompanying this market (functionality of software provided to the investor for investment activity). However, KNF considers that in the light of § 9 para. 1 of the Regulation, it is correct to indicate all aspects and conditions associated with hypothetical investing. Indeed, investment decisions made without real involvement of own assets, using a demo account, are associated with less emotional involvement of the investor, and thus differ from investments using real monetary funds. Thus, the degree of rationality of actions taken in the demo account environment and real investments is different. In the opinion of the Office, the investment firm should include information whose essence would be to signal that investing in the demo environment and real investments does not show analogy in terms of conditions for making investment decisions. This remark is particularly justified, as the client encouraged by achieving positive results in the Forex market using demo accounts may assume the achievement of identical results in reality.

Regardless of the above-presented comments, based on previous supervisory experience, it becomes important in the opinion of the Office to present also a set of detailed comments regarding, in particular, the manner of presenting information about investing in derivative financial instruments.

In the opinion of KNF, the practice of directing to clients, especially to retail clients, messages within advertising-promotional campaigns, which contain information about possible benefits flowing from investing in the Forex market while simultaneously omitting information about the possibility of incurring losses, should be considered as conflicting with the principle expressed in § 9 para. 1 of the Regulation.

Another practice that should be considered improper is also the behavior consisting in the lack of consideration (balancing) in the informational message between: on the one hand, possible benefits that can be obtained by investing in specific instruments in the Forex market, and on the other hand, risks of incurring losses on the aforementioned transactions. The Office notes that asymmetric information should be considered not only the lack of balance in terms of content itself, but also disproportion in other planes, e.g., in the situation of presenting potential benefits and losses prominently or also differentiating the placement of one of the two aforementioned elements in advertising-promotional messages.

Based on supervisory observations, the Office states that the practice of informational messages, which concentrates in promotional-advertising materials only on chances and possibilities that investing in the Forex market offers, violates especially the principle of reliability of information, as well as not misleading clients. This remark finds application especially to the expansive highlighting in promotional-advertising materials of supervised entities of benefits flowing from the so-called effect of financial leverage, which, as is known, is an extremely risky mechanism when investing in derivative instruments, which the retail client may not be aware of or their knowledge does not allow them to perceive the essence and scale of risk associated with this mechanism.

The Office draws attention to the fact that this type of practice, besides conflicting with § 9 para. 1 of the Regulation, would be in conflict with § 9 para. 2 point 3 of the Regulation.

As a result of the exercised supervision, the phenomenon was also noticed consisting in placing in the informational material content that uses an advanced conceptual network from the field of economics and finance as well as complex vocabulary. Such practice in shaping the content of the message probably appears fundamentally as negative in the light of § 9 para. 2 point 2 of the Regulation in the case of directing the informational message to investors who would have or possess the status of retail client. According to the aforementioned regulation, information should be presented in a manner understandable to the average representative of the group to which it is directed or to which it may reach. It is difficult to assume that recipients of this type of information, who are potential retail clients or retail clients, possess extended specialized knowledge in the field of economics and finance.

The finding of probable impropriety in formulating the informational message using advanced economic-financial nomenclature is strengthened by closer analysis of the content of the provision of § 9 para. 2 point 2 of the Regulation. The Office draws attention to the fact that the aforementioned regulation, as a reference point for the requirement of understandability of disseminated materials, assumes the average representative of the group. It does not refer to the average representative of the given category of client. In the designated category of retail client, various groups may be included. In practice, this means that if the information is directed to a wide circle of recipients, the information must be formulated in such a way that it is understandable to the average representative of the group that potentially may become acquainted with the given informational material. Often, especially in the case of disseminating content in a public manner, this will mean the requirement of such shaping of content so that it remains understandable to the typical representative of the circle of persons with the lowest awareness of the rules of functioning of the derivative instrument.

In the context of the standard of information directed to the client or potential client of the retail client, the Office also draws attention to the regulation of § 9 para. 4 of the Regulation. According to the cited regulation, investment firms direct to retail clients or potential retail clients information that may contain an indication of results achieved in the past in connection with investing in a given financial instrument or in connection with a specific index or with the provision of a specific brokerage service, as referred to in Art. 69 para. 2 of the Act. This provision simultaneously establishes the conditions for presenting past data, stating that news