Punters learn CFDs' painful truth

Until the credit crunch hit Australian shores last August derivatives known as contracts for difference (CFDs) were the fastest-growing investment products on the local market.

But in recent months, the CFD industry has started to show cracks as they, and their investors (including DIY super funds), battle high levels of volatility in the equities market and rising costs of debt.

CFDs have been around in Australia for about six years and are not for the faint-hearted. They are outlawed in the United States by the Securities and Exchange Commission because most of them are traded off-market; in Australia the Australian Securities & Investments Commission website describes them as “much riskier than a flutter on the horses or a night at the casino” because potential losses are unlimited if their bet sours. (To read more on how they work, see CFDs: Dangerous liaisons.)

Indeed, one of the biggest sharemarket gamblers around, Chris Murphy, famously told online share forum HotCopper: “I don’t trust CFDs. I own the stock.”

Given Murphy had one of the biggest margin accounts with the collapsed Opes Prime, and loan to valuation ratios of more than 95%, this is quite a statement.

CFDs involve borrowing money to bet on share price and foreign exchange movements. But it is far worse than gambling because investors who do not take “stop loss” measures to limit losses can shed much more than the money that they bet.

CFDs can be used to trade anything – from BHP shares or pork bellies, to Hong Kong's Hang Seng index and the gold price. They allow investors to take long or short positions – betting securities will rise or fall – and, unlike futures contracts, have no fixed expiry date or contract size.

The sub-prime crisis has created a double-whammy effect on leveraged products such as CFDs: the cost of debt has gone up and the products they invest in have become so volatile that they are triggering margin calls at unprecedented levels.

The risk that traders face was highlighted by the fate last month of British CFD provider Global Traders Europe, when the inability of just one trader to meet large margin calls over two speculative positions resulted in all client accounts being frozen.

Global Traders Europe went into administration after the UK's Financial Services Authority launched an investigation into some of its clients' affairs. The company was not allowed to return funds to clients.

Some CFD traders have moved to protect themselves from the tough conditions by charging higher margins. MF Global – the local affiliate of troubled Wall Street-listed MF Global, whose share price has fallen 60% this year – has gone on record as saying that as the market situation worsened, MF Global had increased its initial margins several times.

While this is a sensible cause of action, some traders believe that the recent moves by CFD providers to increase margins have added to market volatility as clients, unable to find the cash or transfer investments to other brokers, are forced to sell, close or short positions.

At least one other CFD provider has decided to try and cut costs by reducing the amount of hedging it does from 80% to less than 50%, which adds to the risk.

Tough market conditions means some of the CFD providers’ biggest clients, with credit exposures of up to $1 million, are facing margin calls as share prices tank. Interestingly, some clients that are big CFD investors also turned up as unsecured creditors at Opes Prime, adding pressure to their already stressed wealth portfolios.

It is not known how many investors trade in CFDs but the CFD industry estimates that more than $400 billion of CFD trades are carried out in Australia each year, representing more than 15% of trades on the equities market. Most trades are done outside the Australian Securities Exchange, in a poorly regulated over-the-counter market.

Latest data from the Australian Financial Markets Association, says the over-the-counter market turned over $81.4 trillion last year, compared with $38.9 trillion for the total exchange-traded markets, which includes the ASX and the Sydney Futures Exchange, also owned by the ASX. In other words the over-the-counter market – the market where CFDs now dominate – is almost double the size of the “traditional” stockmarket, comprised of the ordinary shares, options, warrants and futures.

There are about 20 CFD operators in Australia who invest heavily in advertising through the mainstream press, along with sponsoring books and websites. To get into the business of offering CFDs all you need is a basic ASIC licence and a product disclosure statement (PDS). That’s why it is important to read a PDS carefully before signing up.

Any investor considering investing in CFDs should first check the product disclosure statement to see who owns what if the business goes into receivership.

The country's biggest CFD provider, CMC markets, has in its product disclosure statement a clause: “Should there be a deficit in the segregated trust accounts and in the unlikely event CMC Markets becomes insolvent before it topped up the segregated trust account in deficit, you will be an unsecured creditor in relation to the balance of the moneys owing to you.”

The second-biggest CFD provider, IG Markets, has in its product disclosure statement: “Your money may be co-mingled into one or more separate accounts with our other customers' money; we are obliged to pay any money due to you in relation to dealings in CFDs into a separate account; the obligations to you under the Customer Agreement and the CFDs are unsecured obligations, meaning that you are an unsecured creditor of ours.”

The rise of CFDs has been so great that many have blamed them for contributing to instability in the market and triggering fluctuations at odds with market fundamentals that have caught many retail investors by surprise.

The ASX publishes details of CFDs taken out by its clients. But in most cases, investors cannot find out if fellow punters are using CFDs to bet a certain share will rise or fall, leaving them open to potential exploitation by insider traders.

Given the abundance of CFDs, a taskforce set up by ASIC last November will investigate CFDs as part of a review of the $2 trillion retail investment sector. The taskforce is examining risks to retail investors and will respond with specific projects to help address these risks.

Simon Bond, a dealer at ABN-Amro Morgans, says CFDs – offered by brokers and specialist providers such as CMC Markets and former spread-betting operator IG Markets -- have been an accident waiting to happen.

“I know a few people who have lost their shirts by trading CFDs,” he says. “They didn't know what they were doing and they lost a lot of money.”

The problem with CFDs, also nicknamed Casinos For Delinquents, is that they are sophisticated derivative plays aimed at the retail investor base, and the regulators have allowed them to become mainstream.

However, it should be pointed out that while individuals can easily lose money in CFD trading, the specific risk of CFD houses “going under” in the style of Opes Prime and Lift Capital is greatly restricted by the automatic trading platforms employed by CFD houses. This means margin calls are automatic and carried through swiftly in the world of CFDs. In contrast, one of the failings in the execution of margin calls among Opes Prime and Lift Capital clients was the regular reticence among brokers to actually make the margin call on favoured clients.

Last year the Australian Taxation Office allowed CFDs to be included in DIY super, and the providers themselves spent millions of dollars a year targeting retail investors through the popular press. And when the Australian Securities Exchange started offering CFDs at the end of last year, it made the product appear all the more mainstream.

There are two types of CFDs: “market makers” and direct market access (DMA). Market makers are pure bookmaking. The CFD provider is a bookie with an internet platform. It makes a market in a stock, quoting the bid and offer at which it is prepared to write contracts. If the punter gets it wrong, they lose their money.

With DMA, the bid and offer are derived directly from the ASX prices and the CFD provider quotes a “spread mark-up” on that, and a commission on top of that. Physical stock is either borrowed or bought to support the trade. It is this form of hedging that adds to the volatility on the ASX.

In the past few months investors with an appetite for leverage have been very lucky if they haven’t faced margin calls. With banking stocks such as Westpac, NAB and Commonwealth Bank falling more than 35% in the past six months, even investors who thought their portfolios were safe have taken a belting.

For those with an even bigger appetite for leverage, CFD punters, the margin calls have come thick and fast, particularly in those organisations that have requested a higher margin.

If the markets continue on their rocky ride, volatility remains, and orders start to dry up, it would not surprise if stresses start to appear in some of the standalone CFD operators, which operate off small capital bases but offer big leverage packages. For many, if they go under, the investor will be at the back of the queue as an unsecured creditor, carrying a pocket full of debt.

Adele Ferguson is a senior business writer for The Australian.