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Ban the CFD casino - true brokers don't bet against clients

We all know the shtick. A presentable young person, usually male, explains to us earnestly about the latest happenings on the sharemarket.

We all know the shtick. A presentable young person, usually male, explains to us earnestly about the latest happenings on the sharemarket.

In the background, we can see clearly the company logo as the young folk look down the barrel of the television camera and intone their opinions of the day's events.

Often those logos belong to businesses that are principally in the business of selling complex derivatives called contracts for difference (CFDs).

I am uncomfortable about how these CFD businesses have marketed themselves on television as stockbrokers when their main business is nothing of the sort.

In fact, as I hope to explain, the largest providers of these contracts have a business model that is the antithesis of the principles in place to protect people when they trade through a stockbroker.

The marketing employed by CFD providers includes gullible media - including print media - turning to analysts from these businesses for "market update" fodder.

But while these businesses, such as IG Markets and CMC Markets, have insinuated themselves into media commentary positions through their stockbroking arms, which do buy and sell stocks on behalf of clients, their main game is selling CFDs.

Now I have no problems with these people's credentials as individuals. But when the Australian Securities and Investments Commission is voicing its concerns about how CFDs are marketed, it should look at how these businesses are marketing themselves without spending a cent.

The benefit for the CFD provider of such placements seems to be along the lines of: "Gee, I saw them on TV [or in the paper], they must be all right."

But these contracts are very different from buying and selling a stock. Here is why: when you buy a stock through, say, E*Trade, you are entering a relationship in which the stockbroker is acting as your agent.

That relationship includes certain responsibilities for the stockbroker, principally the obligation to act in your interests.

When you buy a CFD from, for example, CMC, you are entering a financial fairyland in which the CFD provider has no obligation to act in your interests.

Quite the contrary. The CFD provider reserves the right to enter into positions that may be against your interests.

As CMC says in its product disclosure statement (with my emphasis added): "We will always act as a principal, not as an agent, for our own benefit in respect of all transactions with you."

At its bluntest, in the financial casino you are entering when you trade CFDs, if you lose, they win. To follow the casino analogy, when you are buying a CFD, you are making a bet against the house.

Now this particular business model brings with it a couple of problems. The first problem is that, because the house is putting its money at risk if you win, the CFD provider has a strong financial incentive to target dupes and gulls and fools.

It is much easier taking the role of the house if you take bets by mug punters who are much more likely to lose than win.

The second problem is that the house does not always get it right - so acting as the house can make the whole business prone to big losses.

Now CFD providers will rush to say on these points that, of course, they make sure their clients qualify to trade CFDs, so they don't target the naive and the foolish (although to date their efforts as an industry on this front haven't overly impressed the Australian Securities and Investments Commission).

They will also say that, of course, they hedge their exposures to reduce their risks or, in betting terms, they will lay off the bets they take so they don't have to make such big payouts if they lose.

But here's where you once again run up against the impenetrable nature of CFDs.

CMC says it is under no obligation to tell you how much it hedges in general, meaning you have a very limited ability to judge the risk the house is taking.

In this column last week I argued that the terms and conditions in CFDs were so stacked against retail investors that they were being handed a financial machine-gun that was pointing at them.

In the case of CMC's latest disclosures, there was no contractual need for CMC to honour market prices, and CMC's so-called stop losses, designed to minimise losses, were not guaranteed to work.

This week I have tried to show that people are being encouraged to regard these businesses as stockbrokers. What they are actually seeing is a branding exercise for businesses whose main operations have principles more like the house in a casino than the sharemarket.

Under their business model, they have a financial incentive to target the mugs, and it is hard to tell how risky their business model is because of an almost complete lack of information about their policies for hedging.

Having sat down with someone who regarded themselves as a sophisticated investor but was bankrupted after starting with relatively small CFD positions, I see the risks for investors as very high.

Potentially unlimited losses and a business model more like a casino than a financial product should mean enough is enough: it is time for regulators to ban CFDs.

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