Who's afraid of CFDs?

Talk to anyone involved in the booming CFD industry and they will admit privately that there is a slightly unpleasant odour hanging around that won't go away.

Heavy sponsorship of newspaper special reports and constant advertising in print and electronic media have failed to help this fledgling sector of the derivatives industry shake its cowboy image.

The image problems are likely to persist as long as there is poor regulatory oversight, lack of a co-ordinated approach to address flaws in trading models and continued pointed criticism by the ASX of over-the-counter CFD providers.

CFDs, or contracts for difference, are agreements between buyers and sellers to exchange the difference in value of a contract between when the contract is opened and when it is closed. The difference is determined by reference to an underlying instrument such as a share or index.

Retail customer numbers are now somewhere between 150,000 and 180,000 and notional turnover in CFD shares and indices is running at about $10 billion a month, according to industry sources. Estimated annual turnover of $120 billion would make the retail CFD market bigger than the wholesale over-the-counter equity derivatives market.

The industry's problems are quite clear, according to the ASX, which offers the only exchange traded CFD service. It says the market maker pricing model for over-the-counter CFDs is open to abuse by CFD providers and is fundamentally unfair and inequitable.

It says that allowing the trading, reporting, price and volume to be determined by the CFD provider means you are "betting against the house”. A market maker using this model would only make a price where they can make a profit from the trade.

The industry's dominant player in Australia, CMC Markets, uses this market maker model. Its product disclosure statement says that the price quoted by CMC does not necessarily reflect the price of underlying shares and that it can quote different prices to different clients.

Rival firm IG Markets, which is the second largest CFD provider in Australia, says it does not use the CMC market maker model because it would breach its obligation to provide clients with "best execution”. This obligation is imposed on the firm by the EU directive called MIFID that came into force in November last year.

IG Markets says it gets it prices of underlying securities fed directly from the ASX. Tamas Szabo, chief financial officer at IG Markets and chairman of the AFMA CFD sub-committee, says it is up to customers to choose which business model suits them.

He says there is no need for the industry to have a common CFD pricing approach.

Another market maker approach to pricing is used by City Index. It refers to itself as a straight-through-processing provider. All clients see the same price as each other at the same time and that price is determined by what is happening in the underlying market.

However, City Index reserves the right to hedge a client's trade when it deems it necessary.

The third over-the-counter pricing model is called 'direct market access' (DMA) where the prices of underlying shares are fed directly from the ASX computers. MF Global provides the technology platform for this pricing approach to a number of companies including CommSec, e-Trade and Westpac. There are other DMA technology platforms.

This trading approach also has its critics. It is claimed that because the system is automated it cannot cope with stop loss orders. It is possible that when share prices "gap” down losses will not be stopped. That means losses will be potentially unlimited on transactions with leverage of up to 100 per cent.

For example, with a sell stop loss order, the computerised DMA model will automatically hit the next bid in the market once the market trades at the client's designated stop loss level. In illiquid markets this can lead to "out-of-market” trades.

DMA providers have to get clients to nominate how far away from their designated level they authorise the DMA provider to fill their order. With most products the range the DMA provider allows is only seven ticks. It is not uncommon for the market to gap through a client's stop loss and keep going lower, in which case the client's stop loss order will not be filled.

Some providers such as MF Global will make best efforts to contact a client when a contingent order level has been breached. City Index says its stop loss orders are done at the next available price so that a guaranteed stop loss is tied to market transactions, not bid and offer.

The ASX admits that big moves in markets means that stop loss orders can be gapped out and not filled. It has warned its customers that if they want a guaranteed stop loss they should take out a separate put option over the underlying security. It says the exchange traded CFDs have the advantage that the price discovery is determined by a group of market makers.

But the critics say that the ASX pricing model means there is no connection between the customer and the CFD provider. They say the poor trading figures for exchange traded CFDs show customers are voting with their feet and using other pricing methods.

The anecdotal figures show that despite warnings about the problems inherent in various over the counter trading systems, retail investors are unperturbed.