Resolution no. 20975

Prohibition of the marketing, distribution or sale, in Italy or from Italy, of binary options to retail clients within the meaning of art. 42 of Regulation (EU) n. 600 of May 15, 2014

LA COMMISSIONE NAZIONALE PER LE SOCIETÀ E LA BORSA

HAVING REGARD to Council Regulation (EU) n. 600/2014 of the European Parliament and of the Council of May 15, 2014 on markets in financial instruments and amending Regulation (EU) n. 648/2012 (hereinafter: MiFIR), and in particular Article 42;

HAVING REGARD to the Commission Delegated Regulation (EU) 2017/567 of May 18, 2016 supplementing Regulation (EU) n. 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions, and in particular Article 21;

HAVING REGARD to the Italian Legislative Decree of February 24, 1998, n. 58, containing the Consolidated text of the provisions on financial intermediation (hereinafter, the Consolidated Law on Finance - "TUF") and in particular Article 7-bis;

HAVING CONSULTED Banca d’Italia, within the meaning of Article 7-bis, paragraph 6, of the TUF and taken note of the evaluations expressed by the same;

HAVING CONSIDERED the following:

1. Introduction

In the course of the last few years there has been a rapid increase of the offer in Italy of binary options (BO) to retail investors, mainly by EU intermediaries, especially under the freedom to provide services. These products are inherently risky, complex and speculative and may entail the loss of the entire capital invested for the investor.

The offer of BO to retail investors is increasingly characterised by aggressive sales techniques and by the lack of transparent information; this does not allow retail investors to understand the risks of the products in question.

In February 2017 CONSOB published an investor protection warning to particularly highlight the fact that BO - and other similar products - are products which are inherently very risky and complex as also expressly recognised by ESMA (European Securities and Markets Authority) and as such are not considered suitable for the majority of retail clients.

Despite this there has been a steady increase in the number of reports by retail investors who have complained of having suffered monetary losses, even significant, in relation to the activity of trading on BO. CONSOB therefore feels there are significant investor protection concerns.

Similar concerns have induced ESMA to adopt, pursuant to art. 40 of the MiFIR with the collaboration of CONSOB and the other competent national authorities, on May 22, 2018[1] for three months with effect from July 2, 2018, an intervention measure aimed at prohibiting the supply of BO to retail investors in the European Union. ESMA, having considered significant concern for investor protection to be persistent, has renewed the prohibition three times. These renewals by ESMA were also based on surveys conducted in collaboration with the competent national authorities in order to assess the impact of said intervention measure as well as the information transmitted by the competent national authorities. From the information collected it emerged, at European level, as reported by the ESMA in the renewal measures, that there was substantial compliance with the European authority’s measure and it also emerged that since its announcement no new permissions have been granted to companies that market, distribute or sell binary options.

In renewing its measures[2] ESMA has obtained new information according to which the binary options characterised by a sufficiently long-term (equal to or greater than 90 days from the date on which the product is first issued), are accompanied by a prospectus and are fully hedged by the provider or another entity in the provider's group, are unlikely to give rise to the significant investor protection concern identified in Decision (EU) 2018/795. An example of this kind of binary option is an «inline warrant» that cumulatively meets these conditions. While the degree of complexity of this specific type of binary option is comparable to that of binary options generally, according to ESMA, the minimum term requirement ameliorates the negative effects of complexity and opacity for investors. The BO cumulatively having the aforesaid characteristics were therefore excluded from ESMA’s decision starting from the first renewal.

Taking into account that the ESMA measures are temporary and are not renewable indefinitely, given that at the end of the period of effectiveness of these measures the binary options may be offered again - in Italy or from Italy - to retail clients and that, therefore, significant investor protection concerns arising from operations on the products in question would persist, CONSOB considers it is necessary, through the adoption of a proper intervention measure within the meaning of art. 42 of the MiFIR, to permanently prohibit the marketing, distribution and sale of such products to retail investors.

2. Scope of application of CONSOB’s measures

A binary option is defined as any derivative with cash adjustment in which the payment of a fixed monetary amount depends on whether or not one or more specific events relating to the price, level or value of the underlying occur by the date of expiration of the derivative^[3] (for example, the underlying has reached a specific price ("strike price") at expiry).

Binary options allow an investor to bet on the occurrence of a specific event related to the price, the level or the value of one or more underlying (for example a share, a currency, a commodity or an index). If the event does not occur, the investor loses the money invested (i.e. the option becomes "out of the money"). If, instead, the event occurs, the option produces a gain or the option contract remains in place, with the possibility of achieving a gain if a further event occurs (the option ends "in the money"). In this sense, binary options can be considered as “yes or no propositions”. Often, the “yes or no proposition" concerns the possibility that upon expiry of the binary option, the price of the underlying will be above or below a certain reference price (so-called "strike price"). In some cases, the strike price corresponds to the market price of the underlying at the time of subscription of the binary option or at a future specific time. However, intermediaries supplying binary options offer a series of possible market outcomes on which investors may bet[4].

All binary options, even where they are marketed, distributed or sold under another name, fall within the scope of application of the present Decision. They include, for example, the forms known as "all or nothing", "up or down", trend options, digital options and "one touch" options.

The present intervention measure also includes the binary options that have various different fixed conditions that must be met (or not) so that the payment can be made.

BO characterised by a sufficiently long term (equal to or greater than 90 days from the date on which the product is first issued), that are accompanied by a prospectus and are fully hedged by the provider or another entity in the provider's group, are excluded from this resolution because, as identified by ESMA[5] in the review of its measure, are unlikely to give rise to the significant investor protection concern identified in Decision (EU) 2018/795.

As recalled by ESMA in its decisions[6], various competent national authorities have expressed the concern that binary options do not correspond to any actual need for investment for retail clients (unlike other types of options, which can play a useful role for hedging exposure with respect to specific activities). Concerns were also expressed for the risks associated with the intrinsic characteristics of binary options as well as to conflicts of interest inherent to these instruments and difficult to manage, relating to the supply of these products to retail clients. These risks are often amplified by the aggressive marketing techniques used by intermediaries supplying binary options. Various competent national authorities have also pointed out that this type of product often induces compulsive behaviours typical of gambling.

As stated by the IOSCO (International Organization of Securities Commissions)[7] in the report on the investigation on retail OTC leveraged products, this market sector has been the subject of thorough regulatory control in various jurisdictions not belonging to the European Union due to the complex and random nature, inter alia, of binary options and the cross-border dimension of many intermediaries supplying these products, which primarily operate via the internet. According to the IOSCO report, "recent research reports in the several national markets have shown that a large majority of investors in [binary options and other speculative products] very often lose money".

3. The existence of significant investor protection concern (Article 42, paragraph 2, letter a) of the MiFIR)

The condition referred to in Article 42, paragraph 2, letter a), of the MiFIR is the existence, inter alia, of a significant investor protection concern. In order to determine the existence of this concern, CONSOB has assessed the relevance of the criteria and of the factors referred to in Article 21, paragraph 2, of the Commission Delegated Regulation (EU) n. 2017/567. After taking into account the criteria and the relevant factors, CONSOB has concluded that this significant concern is present for the reasons listed below.

3.1 The degree of complexity and transparency of binary options

Binary options are complex financial instruments. The complexity of the pricing structure involves the risk of significant information asymmetries between intermediaries supplying options and retail customers; this leads to a significant investor protection concern. Moreover, binary options have various intrinsic characteristics that make them complex and difficult to understand for retail clients.

Intermediaries supplying binary options generally price them based on the probability, market-implied or otherwise modelled, of the occurrence of a specific event, before applying a differential or another type of transaction fee to each option, such as to generate a negative expected return for theclient.

Normally. binary options offer a comparatively large return for a statistically less likely event and vice-versa.

This pricing structure of binary options presents a series of difficulties for retail clients. In particular, the pricing structure requires to retail clients to accurately assess the value of the option in relation to the likelihood that the reference event occurs. Although they may have recourse to common research and pricing tools to fix the price of the binary options, such as the Black-Scholes formula, retail clients suffer significant information asymmetries with respect to the suppliers of these products. In fact, providers have a much greater range of information at their disposal and systems for the proper pricing and evaluation of these products. In particular, binary options providers have access to historical price data - for example, price information supplied by a stock market or by a supplier of commercial data for a given underlying - which are not generally available to retail clients. They also have much more experience in pricing the contracts with respect to the majority of retail customers, and are more likely to have developed sophisticated price formation methods. In addition, retail clients may not understand that, if a trade has a very short term or if a position is closed close to the expiry, certain parameters used to secure the option price such as the historical volatility of the price itself will have little impact on the value of the option. These elements limit the ability of retail clients to adequately assess the option, even if they use the available pricing tools. In addition, owing to the application of differentials and other transaction fees, retail clients should significantly exceed the expected return on investment ("beat the odds") regularly to make profits from trading activities. For these reasons it is considered difficult for retail clients to make an informed assessment of the risk/return profile of the product[8].

The combined effect of the pricing structure and of the application of fees to each trade translates into an overall loss for the great majority of retail client accounts (although they may record profits in the short term).Providers, which are typically direct trading counterparties, obtain profits from clients in the long term through clients’ trading losses and through transaction fees.

Some intermediaries offer the purchase and sale price on an ongoing basis, allowing clients to enter and exit the trade within the term of validity of the binary option. Where this modality is applied, a client can exit from their position before the expiry of the binary option by reselling the option to the supplier or in any case renouncing the payment conditional upon expiration. In this case, the client will receive a payment from the supplier, determined on the basis of the continuous price offered by the same, which depends on the difference between the current market price and the fixed strike price of the underlying and the time to expiry of the option.

The availability of the purchase and sale prices is a further characteristic which can be offered by intermediaries supplying binary option. This feature adds an extra layer of complexity that makes it difficult for retail clients to evaluate the products accurately or obtain a return on investment. In fact, retail customers should continually monitor the price and estimate the expected result. Moreover, exiting from an operation and entering into a new one incurs an additional cost for the client as a result of the application of a spread to the offer price or transaction fees.

In addition, retail clients typically invest in OTC binary options, with the result that the pricing, performance and settlement of binary options are not standardised. This makes it difficult for them to understand the contractual terms of the product. This further element is in addition to the differences in the types of "yes/no propositions" at the basis of binary options, the complexity of the pricing structure (which may also include purchase and sale prices) and the existence of even more complex products (for example, options that constitute "packages" of various binary options), increasing the complexity of these products and further undermining the ability of retail clients to understand that the specific characteristics of a type of binary option are not necessarily present in another.

Moreover, intermediaries supplying binary options normally act as counterparties in trades with their retail clients; therefore, it is the provider that determines the price at the time of execution and payment on maturity. In addition, intermediaries often ask clients to be aware of the fact that the prices used to determine the value of the binary option may differ from the price available in the market of the relevant underlying. Accordingly, it may not always be possible for retail clients to verify the accuracy of the prices received from theprovider. These factors make it extremely complex for retail clients to objectively evaluate binary options. The high level of complexity and lack of transparency of binary options therefore confirm the existence of significant investor protection concerns.

The properties and characteristics of binary options, which constitute the main source of the disadvantages of these options for retail clients, do not change irrespective of the fact that these products are traded in a trading venue or are securitised. In other words, the binary options offered in a trading venue have a negative expected return for investors and their payoff structure makes them unsuitable for use for the purposes of hedging or other economic functions which could provide a compensatory benefit. In particular, these properties are present at any time prior to the expiry of the option. Therefore, the specific existence of a secondary market does not alter the fundamental characteristics of binary options that damage retail clients.

3.2 Particular characteristics or components of binary options

Binary options are typically short-term investments, which may expire even only a few minutes after the purchase; this makes the products extremely speculative in nature.

As instruments with a binary outcome, these options are predominantly used for speculative purposes. The payment of a fixed sum of money or equal to zero limits the value of binary options as a hedging instrument with respect to traditional options that allow the client to manage their risk by setting a “ceiling” or a "floor" for a specific asset in which they have a direct exposure. This limit is exacerbated by the typical short term of binary options.

Moreover the price of binary options is determined based on the probability of occurrence of an event, with respect to which the payoffs are quoted in a manner similar to that of traditional betting at fixed odds (for example sports betting or betting on electoral results). For the most part trades are of very short terms and investors have two possibilities: to obtain a high return or, conversely, lose the entire investment. These fundamental characteristics are also intrinsic to gambling, which is associated with addictive behaviour from betting and negative results for consumers.

Binary option providers usually act as direct counterparty to the client recorded in their book. This business model puts the interests of the provider in direct conflict with those of its clients; this increases the risk that the supplier may manipulate the price of the underlying at the expiry of the binary option or lengthen the term of the option by a few seconds or even fractions of a second so as not to have to pay a profit to clients on the option contract. The risk of a conflict of interest is particularly acute for binary options, since the payment structure depends on the fact that the underlying has reached or not reached the strike price specified at expiry. Practices have been observed through which intermediaries supplying binary options apply an asymmetric or inconsistent mark up to the main differentials on the underlying with the consequence that at expiry the option will be out of the money where instead it would have been in the money. Furthermore, distribution models observed in this market sector carry specific conflicts of interest, some of which are structural, whose probability is increased by the need to continually attract new clients.

Given that binary options structurally have negative expected returns, the greater the number of positions that an investor assumes, the greater the probability is that they will cumulatively experience a loss[9].

The high risk that binary options are traded in a speculative manner as well as the conflict of interests between binary options providers and their clients confirm the existence of significant investor protection concerns.

3.3 Magnitude of potential negative consequences and the degree of disparity between returns for investors and the risk of loss

The number of clients who subscribe these products is highly variable, due to the relatively short useful life of client accounts in binary options and the cross-border nature of the activities.

Based on data collected from numerous national competent authorities, ESMA has estimated that the number of trading accounts of retail clients with CFD and BO providers headquartered in the EEA amounted to approximately 1.5 million in 2015, increasing to around 2.2 million in 2017[10].

According to the IOSCO the most frequent complaints in all jurisdictions relating to authorised providers concern the performance of the products (i.e. losses incurred by investors), the lack of understanding of the product or service (and associated risks) by clients, difficulty in withdrawing funds, aggressive and/or misleading marketing tactics and manipulation of prices or trades[11].

ESMA has detected that the negative expected return is one of the fundamental characteristics of BO[12] together with the high risks related to these products.

The offer in Italy of BO to retail clients predominantly came from EU investment firms and banks authorised in other Member States who operate cross-border (especially under the freedom to provide services) and only residually from investment firms and banks established under Italian law.

In particular CONSOB has noted that the number of Italian retail clients who have trade in binary options increased in 2016 by 2.4%. CONSOB has also noted that up to 74% of Italian retail clients who invested in binary options in 2016 suffered significant losses, with an average loss of about 590 euros.

3.4 Type of clients involved

The binary options are widely marketed, distributed or sold in the mass retail market. However, their complexity, illustrated in the present decision, makes it difficult for the majority of retail clients (unlike professional operators) to understand and duly evaluate the real risks that they incur in investing in these products. Data on losses held by CONSOB in retail client accounts described in the present decision show that binary options are not suitable for these clients.

3.5 Marketing and distribution related to binary options

Despite their complexity, for the most part binary options are offered to retail clients through electronic trading platforms, not accompanied by investment advice or portfolio management services. In such circumstances an assessment of appropriateness is required pursuant to Article 25, paragraph 3, of the MIFID II. However, this assessment does not prevent binary options providers or their clients or potential clients proceeding from executing the operation, following a simple notice to the client. This allows retail clients to have access to products, such as binary options which, because of their characteristics, should not be distributed to them.

Moreover, in this market sector the existence of aggressive practices and deceptive commercial messages has been noted. Some examples include the use of sponsorships or affiliations with major sports teams that causes the misleading impression that complex and speculative products such as binary options are suitable for the mass retail market, thanks to the widespread popularity of the brand.

The fact that the average life of a client account is often relatively short entails the need for providers to maintain a continuous influx of new clients; this in turn can push these operators to adopt aggressive marketing and sales techniques that certainly do not meet the interests of retail clients.

A common characteristic of the marketing and sales techniques adopted by the binary options sector is the offer of benefits (monetary and other) of trading, such as bonuses to attract and encourage retail customers to invest in binary options, offering gifts (such as holidays, cars, electronic equipment), trading courses or reduction of costs (for example of the differential or fees) .

Bonuses and other advantages of trading can serve to distract the investor from the high risk inherent to the product. Typically these are aimed at attracting retail customers and encouraging trading. Retail clients can consider these promotions as a central feature of the product, so as not to properly assess the level of risk associated with the same.

The practice of bonus systems is inspired by the online betting sector. Some providers who market the relevant products offer "welcome bonuses" (for each account opening) and bonuses based on the amount invested (amount bonus), for example, or in the form of an additional amount of "virtual cash" under certain conditions.

The general conditions applied to promotional offers are often misleading and many clients have reported difficulties in withdrawing funds when they try to use these bonuses or are not aware of the fact that access to the bonus or to funds is subject to a specific trading volume. In light of the negative expected return associated with trading in binary options, this often means that clients suffer more monetary losses from trading and more frequently than they would have had they not received a bonus offer.

In addition, CONSOB has concerns about the compliance of binary options providers with the obligation to give fair, clear and not misleading information to clients or to act in the interests of the clients. Concerns also exist regarding the quality of the information provided to retail clients (for example on the websites of supplier intermediaries) on the functioning of binary options and, in particular, the risks that these instruments entail. Some examples of non-compliance with the obligation to provide correct, clear and not misleading information and the use of techniques designed to attract the attention of customers but that do not necessarily reflect the suitability or the overall quality of the instrument or of the financial practice are the following:

1. the provision of content or information on websites in a language other than that of the Member State in which services are provided, or in the official language but with translations of insufficient quality, likely to hinder comprehension of the information;

2. the provision of information which exalt the possible benefits associated with the investment in binary options without conversely providing a proper and evident indication of the relevant risks, giving the impression that these speculative products are suitable and appropriate for all investors or that it is easy to achieve a profit. For example: "Trading in binary options is as easy as 1-2-3"; "Trading has never been so easy", "Start your career as a trader right now", "Get up to 85% return every 60 seconds", "95% return in a few minutes", and "What you can do in 60 seconds? Trade in binary options and double your money" .

The marketing and distribution practices associated with binary options described above confirm the existence of serious investor protection concerns.

3.6 Extent to which the financial instrument in question may undermine investors’ confidence in the financial system

The combination of the degree of complexity and lack of transparency of binary options, the negative expected return of the product for investors, the lack of reasonable investment objectives, the misleading and aggressive nature of various marketing and distribution activities, the conflicts of interest of supplier intermediaries as well as the magnitude of the potential negative consequences are all factors that contribute to undermining the confidence of retail clients in the financial system.

In light of the high probability that customers suffer losses as highlighted in the present resolution, investors without previous experience of investments in financial instruments and that have been attracted by the aggressive marketing strategies adopted by binary options providers could conclude that these products are representative of all financial instruments. This concern is particularly significant in light of the large number of retail clients of intermediaries supplying binary options and the high number of complaints related to these products.

4. Applicable regulatory requirements in accordance with EU Law do not address the significant investor protection concern identified (Article 42, paragraph 2, letter b), of the MiFIR)

As provided by Article 42, paragraph 2, letter b), of MiFIR, CONSOB has considered whether the applicable regulatory requirements in accordance with EU Law to the relevant financial instrument or the activity are able to cope with the threat. The applicable regulatory requirements in force are those contained in Directive 2014/65/EU (MIFID II), in MIFIR and in Regulation (EU) n. 1286/2014 (PRIIPs). In particular, they include: (i) the requirement to provide customers with adequate information referred to in Article 24, paragraphs 3 and 4, MIFID II; (ii) the suitability and appropriateness requirements referred to in Article 25, paragraphs 2 and 3, MIFID II; (iii) the best execution requirements referred to in Article 27 MIFID II; (iv) product governance obligations referred to in Article 16, paragraph 3, and Article 24, paragraph 2, MIFID II; and (v) reporting obligations referred to in Articles 5 to 14 of PRIIPs regulation.

In this respect, it can be observed that the scope and content of various regulatory requirements applicable for the purposes of MIFID II and the MiFIR regulation are similar to those already laid down in Directive 2004/39/EC (hereinafter also MIFID I). Although the adoption of MIFID II and the MiFIR regulation aims to improve several important aspects of investment services and activities to strengthen investor protection (also by means of intervention powers on products), the improvements to various relevant provisions do not tackle the specific concerns described in this resolution.

The obligations to provide appropriate information to customers were specified in greater detail in the MIFID II, which has considerably strengthened the disclosure requirements of costs and charges, requiring investment firms to provide aggregated information about all costs and charges related to investment services and financial instruments. However, the rules relating to the disclosure of information alone - including the improvement of information on costs - are clearly insufficient to cope with the complex risk stemming from the marketing, distribution or sale of binary options to retail clients.

In particular, Article 24, paragraph 3, of the MIFID II stipulates, inter alia, that all information, including marketing communications, provided by investment firm to clients or potential clients are correct, clear and not misleading. Article 24, paragraph 4, of the MIFID II also provides that clients or potential clients are provided, in a timely manner, with appropriate information about the investment firm and its services, financial instruments and the strategies proposed, the execution venues and all costs and charges, including, in particular, guidelines and advice on the risks associated with investments in those financial instruments, and an indication of whether the financial instruments are intended for retail clients or for professional customers. In light of the description of the investor protection concerns relating to binary options (in particular as regards their complexity, risk and negative expected return), CONSOB considers that the risk of damage to investors cannot be controlled in a way that is comprehensive and adequate by the mere application of said rules. In fact, the abovementioned communications do not sufficiently warn clients on the specific consequences (expected return negative) of investment in these products and do not meet the concerns expressed with regard to the characteristics of the product.

The PRIIPs regulation establishes uniform rules on the format and content of the document containing the key information that must be provided by the producers of packaged retail and insurance-based investment products ("PRIIPs") to retail investors, in order to enable them to understand and compare the characteristics and the key risks of PRIIPs. In particular, Article 5 of the PRIIPs regulations, as further implemented by the Commission Delegated Regulation (EU) 2017/653 defines, inter alia, the methodology for the presentation of the synthetic risk indicator and the relevant explanations, including whether the retail investor may lose all the invested capital or whether they may sustain additional financial commitments. However, this type of communication does not sufficiently warn retail clients on the specific consequences of investment in binary options. For example, the performance ratio refers only to the single binary option and does not provide the customer with the overall percentage of retail client accounts who suffer monetary losses.

More in general, a regulatory solution based on disclosures to clients is inadequate for these products, which are themselves unsuitable for retail clients.

The evaluation of suitability has also been strengthened in MIFID II Directive, which redefines this assessment by providing that the customer is given a specific report. In particular, pursuant to Article 25, paragraph 2, of MIFID II intermediaries are required to obtain the necessary information concerning the knowledge or experience of the client or potential client in the investment field relevant, inter alia, to the specific type of product, the financial situation of the client or potential client including their ability to bear losses and their investment objectives, including their risk tolerance, so that these intermediaries are able to recommend those investment services and financial instruments that are appropriate to the client or potential client and compatible with their risk tolerance and their ability to sustain losses. However, the assessment of suitability is applicable only to the provision of investment advice and portfolio management and are therefore normally not relevant in relation to the marketing, distribution or sale of binary options, which occurs mainly on electronic platforms, without the provision of consultancy services in the field of investments or portfolio management.

Moreover, the objectives of the suitability (i.e. the examination of the products against the experience, knowledge, financial situation and investment objectives of the client) are substantially unchanged with respect to the scheme referred to in MIFID I and, as evidenced in the present resolution, are not sufficient to prevent the damage to investors identified.

Similarly, the requirements on appropriateness have been strengthened by MIFID II mainly through the restriction of the list of non-complex products which resulted in the reduction of the scope of products for execution-only services. Article 25, paragraph 3, of MIFID II provides that intermediaries must ask the client or potential client to provide information regarding their knowledge and experience in the investment field relevant, inter alia, to the specific type of product or service offered or requested, in order to allow to the intermediary to determine if the product is suitable for the client or potential client. Where it considers that the product is not suitable for the client or potential client, the intermediary warns them of this situation. Binary options must be classified as complex financial products and are therefore subject to the verification of appropriateness referred to in the aforementioned Article 25, paragraph 3 of MIFID II.

However, this requirement was already provided for by Directive 2004/39/EC, which provided for substantially the same appropriateness test as the one set out in MIFID II. As highlighted in this resolution and as resulting from supervisory experience the appropriateness test has not been sufficient to assuage investor protection concerns.

It is therefore unlikely that the verification of suitability and appropriateness pursuant to the regulatory requirements in force are sufficient to ensure that the modalities of trading in binary options of retail clients are such as to respond to significant investor protection concerns.

As regards the best execution, most of the rules already existed under Directive 2004/39/EC; however, they were strengthened by MIFID II. In particular, Article 27 requires investment firms to adopt "all sufficient steps" (and no longer "all reasonable steps") to obtain the best possible result for their clients when executing orders. In addition, market participants must publish disclosures; in particular, investment firms must disclose the first five execution venues where they have executed client orders and the results achieved in the execution of the same. Rules on execution under the best conditions do not tackle, per se, the risks inherent to the characteristics of the product other than execution, nor those connected to the extensive marketing, distribution or sale of binary options to retail clients.

In relation to these substantially similar regulatory requirements in force, ESMA has repeatedly pointed out the risks described above in its "Questions and Answers (Q&As)" and in its opinion on "MiFID practices for firms selling complex products". CONSOB believes that despite the non-binding instruments available to ensure a uniform and effective application of the regulatory requirements in force, investor protection concerns will persist. In particular, it is noted that the above requirements do not tackle the concerns for the reasons described in this section.

The product governance rules referred to in Article 16, paragraph 3, and Article 24, paragraph 2, of the MIFID II require intermediaries that make financial instruments (including therefore binary options) to be offered for sale to clients to ensure that these products are designed to meet the needs of a particular target market of end clients identified within the relevant category of clients; that the strategy for distribution of the products is compatible with the target; it is further envisaged that intermediaries should adopt reasonable measures to ensure that the financial product is distributed within the target market identified and regularly review the identification of the target market of the products that they offer and their performance. Intermediaries must know the financial instruments offered or recommended, assess their compatibility with the requirements of the clients to which they provide investment services, also taking account of the target market of end clients and do so in such a way that the financial instruments are offered or recommended only when it is in the interest of the client. Moreover, intermediaries wishing to distribute a financial instrument not made by them must have adequate mechanisms to obtain and include relevant information relating to the process for approval of the product, including the identified target market and the characteristics of the product. Intermediaries who distribute financial instruments made by suppliers who are not subject to the product governance requirements referred to in MIFID II or by third country providers must also have adequate mechanisms to obtain sufficient information on the financial instruments in question.

The product governance requirements were introduced for the first time into EU Law by MIFID II and are accompanied by the "Guidelines on MIFID II product governance requirements" of ESMA.

The purpose of the product governance obligations is to restrict the type of client (i.e., the target market) for which the financial instruments would be appropriate and to which they should therefore be distributed. In light of the characteristics of binary options (high rate of losses, negative expected return, short-term of contracts, complexity of pricing structures and, in general, a lack of reasonable investment objectives), CONSOB, as considered by ESMA in the above cited prohibition measures, considers that a retail target market cannot be identified for these instruments. Many investment firms have continued to sell binary options on the mass market even after the implementation of MIFID II and product governance obligations.

Despite the existence of these regulatory requirements, evidence shows that retail clients have continued to suffer financial losses in trading binary options. Therefore, the present intervention measure is necessary in order to tackle the existing threat.

5. CONSOB’s intervention measure addresses a significant investor protection concern identified and is proportionate in relation to the nature of the risks identified, the level of sophistication of investors or of market participants concerned and their likely impact (Article 42, paragraph 2(a) and (c) MIFIR)

In light of the size and nature of the significant investor protection concern identified, CONSOB considers it necessary and proportionate to impose a permanent prohibition on the marketing, distribution or sale in Italy or from Italy of binary options to retail clients. This prohibition tackles the concern, guaranteeing an appropriate and uniform level of protection to retail clients that trade in binary options without having disproportionate negative effects on the efficiency of financial markets or on investors with respect to the benefits.

In order to assess the modalities and the degree of risk posed by binary options for investor protection, CONSOB has taken account of the analysis and considerations of ESMA on the distribution of the returns of investors[13]. Said analyses, as known, have identified two important characteristics: i) the high level of risk associated with binary options for which the investor risks losing the entire sum invested; (ii) the negative expected return of the product which constitutes material injury in this context and applies to all the binary options.

The second characteristic, the negative expected return of the product, constitutes material injury in this context and applies to all the binary options. Unlike financial investment in the strict sense, the products in question are typically of very short term and do not offer a contribution to the growth of the value of the underlying. Moreover, unlike traditional options, often used for hedging purposes, the binary options offer a fixed payoff upon the occurrence of a specific event. Conversely, the payoff of a typical option is subject to variation in the price of the underlying once the option is active (in other words, the payoff is variable). This intrinsic characteristic of the products in question restricts their value as a hedging instrument, while other types of option are used for levelling or limiting the price of an asset to which an undertaking or an investor have a direct exposure.

In addition, the typically short term of binary options allows the trader to make many trades sequentially. This, together with the negative expected return, leads to an increase in the probability for the investor to cumulatively lose most of the trades carried out. This is a statistical property of repeated trading in situations of negative expected return.

An even more important circumstance is the fact that the expected return is usually an integral part of the business model of the provider, since it generally represents the source of expected profits. The binary option obliges the binary option provider to pay the investor a fixed amount upon the occurrence of a specific event; therefore, because the intermediary achieves the expected profit, the investor must incur an expected loss. Moreover, supplier intermediaries may impose additional charges.

In particular, for binary options offered through the system for determining the purchase and sale price on a continuous basis, since the supplier intermediary will offer a price that will allow them to generate the expected profit, the quotation of the same cannot improve the expected return for the investor. In fact, in the extent to which investors resell positions purchased before expiry, their expected return will be less than in the case in which they maintain the position until expiry. The magnitude of this expected incremental loss will vary from provider to provider and on a case by case basis, but the expected value for the investor implicit in the offer of the purchase and sale price will normally be negative, just as the initial price of the product implies an expected negative return for the investor.

This combined effect illustrates a fundamental characteristic of binary options due to their negative expected return: if the retail customer makes a large number of investment, or if many different investors make an investment each, the overall probability of achieving a profit is very low.

The analyses on the distribution of the return of binary options performed by ESMA highlight the high degree of risk for retail clients to lose a substantial portion (often the entire amount) of its investment and obtain a negative expected return. These characteristics are also combined with a general complexity and lack of transparency related to the characteristics of the product, unfair marketing and distribution practices and inherent conflicts of interest. These negative elements are not offset by any corresponding benefit. Together, these characteristics cause considerable damage to existing and potential retail clients.

The marketing, distribution or sale of investment products assume that a given product is able, at least potentially, to satisfy general interests and objectives and that it does not disproportionately jeopardise the need to ensure a minimum level of investor protection.

CONSOB considers the effectiveness of non-binding instruments available in relation to binary options to be exhausted. In particular, reference is made to the principles drawn up by the European supervisory authorities with regard to product governance or: the high level principles applicable to the control and governance processes of financial instruments of the Joint Committee of the ESAs of November 2013[14], the ESMA opinion of February 2014 on MiFID practices for firms selling complex financial products[15] and the ESMA opinion of March 2014 on “Structured Retail Products - Good practices for product governance arrangements”[16]. Reference is also made to the CONSOB Communication of December 22, 2014 on the "Distribution of complex financial products to retail clients" that incorporates the principles enunciated by ESMA.

Despite the above mentioned oversight principles and regulatory requirements mentioned in the present decision, recent years have seen the extension of damage associated with marketing, distribution or sale of binary options to retail clients.

CONSOB therefore considers that intervention measures which impose the prohibition of the marketing, distribution or sale to retail clients of all types of binary options (whether or not traded in a trading venue) are the appropriate way to deal with the investor protection risks.

CONSOB is aware of the fact that this measure will lead to possible financial consequences for providers and an increase in the costs of the same due to the need to redirect their activities and guide their customers towards other financial instruments and products.

However CONSOB considers that the following advantages of tackling the significant investor protection concerns are prevalent with respect to the potential negative impact of the measures:

i. reduction of the risk of abusive sales and related financial consequences, which constitutes one of the major advantages for retail clients and for the financial markets as a whole;

ii. restoration of retail clients’ confidence in the financial markets.

This CONSOB resolution shall apply with effect from the day following the cessation of the effectiveness of the similar temporary ESMA measures in this matter. This allows the beneficial effects of the ESMA measures in terms of retail investor protection to continue seamlessly.

6. CONSOB’s measures and limitations do not have a discriminatory effect on services or activities provided from another Member State (Article 42, paragraph 2(e) of MIFIR)

The measures referred to in this resolution shall apply to binary options providers having their registered office in Italy and providers with registered office in another Member State. Investment firms with registered office in another Member State which provide investment services in Italy fall within the scope of application of the measures which are the subject of this resolution as well as those with offices in Italy. It is therefore considered that the measures do not have a discriminatory effect on services or activities provided from another Member State in so far as the same shall apply to the marketing, distribution or sale of binary options regardless of the Member State from which such services or activities are carried out.

7. Consultations and communications (Article 42, paragraph 2, letters d) and f) of MIFIR and article 42, para. 3)

CONSOB has consulted, pursuant to Art. 42, para. 2, let. d) of MIFIR, the competent national authorities of the other Member States of the European Union, since they are potentially affected by the measures subject to the present resolution. No objections were received from these authorities.

CONSOB has also consulted, pursuant to art. 42, para. 2, let f) of MIFIR, the Ministry of Agriculture, Food and Forestry and Tourism, which has raised no objections on the measures subject to the present decision.

CONSOB has made, pursuant to art. 42, par. 3, of the MIFIR, a communication to ESMA and the competent national authorities of the other Member States of the European Union. ESMA has issued its opinion, pursuant to art. 43, para. 2, of the MIFIR, considering the measures subject to the present resolution to be justified and proportionate; the opinion has been published on the ESMA’s website.

HEREBY RESOLVES

Article 1
Prohibition of binary options in respect to retail clients

1. The marketing, distribution or sale in Italy or from Italy of binary options to retail clients are prohibited.

2. For the purposes of paragraph 1, regardless of whether or not trading takes place in a trading venue, a binary option is a derivative that meets the following conditions:

(a) it must be settled in cash or may be settled in cash at the option of one of the parties (other than by reason of default or other termination event);

(b) it only provides for payment at its close-out or expiry;

(c) its is limited to:

(i) a predetermined fixed amount or zero if the underlying of the derivative meets one or more predetermined conditions;

(ii) a predetermined fixed amount or zero if the underlying of the derivative does not meet one or more predetermined conditions.

3. The prohibition provided for in paragraph 1 shall not apply to:

a) a binary option for which the lower of the two predetermined fixed amounts is at least equal to the total payment made by a retail client for the binary option, including any commission, transaction fees and other related costs;

b) a binary option that meets the following conditions:

i) the term from issuance to maturity is at least 90 calendar days;

ii) a prospectus drawn up and approved in accordance with Directive 2003/71/EC (i.e., in the future, of EU Regulation 2017/1129);

iii) does not expose the provider to market risk throughout the term of the binary option and the provider or any of its group entities do not make profits nor suffer losses from the binary, except for previously disclosed commissions, transaction fees and other related charges .

Article 2
Prohibition of participation in elusive activities

It shall be prohibited to participate, knowingly and intentionally, in activities the objective or effect of which is to circumvent the requirements referred to in Article 1; this includes the prohibition to act as a substitute for the binary options provider.

Article 3
Entry into force and application

This decision will be published on the CONSOB website. It enters into force on the day following that of its publication in the Official Journal[17] and shall apply from July 2, 2019 until eventual withdrawal, where the conditions provided for by art. 42, para. 6 of the MIFIR are met.

June 20, 2019

THE CHAIRMAN
Paolo Savona

Footnotes:

[1] EUROPEAN SECURITIES AND MARKETS AUTHORITY DECISION (EU) 2018/795 of May 22, 2018 to temporarily prohibit the marketing, distribution or sale of binary options to retail clients in the Union in accordance with Article 40 of Regulation (EU) No 600/2014 of the European Parliament and of the Council (OJ L 136, 1.6.2018, p. 50). 

[2] See Decision (EU) 2018/1466.

[3] Usually, but not necessarily the lowest of the two monetary payoffs is zero. Binary options are distinguished from other speculative products sold to retail clients, such as CFD, due to the fact that the payment is a fixed monetary amount, not directly connected to the size of the variation in the price, the level or the value of the underlying.

[4] For example, investors can bet that the price of the underlying falls within a specific range or that it reaches a specific level during the period of validity of the binary option.

[5] See Decision (EU) n. 2018/1466 of September 21, 2018.

[6] See Decision (EU) n. 2018/795 paragraph 2.

[7] Report on the IOSCO Survey on Retail OTC Leveraged Products, December 2016.

[8] See Decision (EU) 2018/795 paragraph 2.1.

[9] See ESMA document Product Intervention Analysis: Measure on Binary Options, 2018.

[10] See ESMA Decision (EU) 2018/795 paragraph 2.3.

[11] Report on the IOSCO Survey on Retail OTC Leveraged Products, December 2016, pag. 46.

[12] See ESMA Product Intervention Analysis: Measures on Binary Options, 2018.

[13] See note 10.

[14] ESAs Joint Position on «Manufacturers' Product Oversight and Governance Processes» (JC-2013-77).

[15] «Opinion on MiFID practices for firms selling complex products» February 7, 2014 (ESMA/2014/146).

[16] “Opinion on Structured Retail Products - Good practices for product governance arrangements” of March 27, 2014 (ESMA/2014/332).

[17] Published in the Official Journal of the Italian Republic no. 150 of June 28, 2019.