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Thursday 22 July 2010

How well do investors understand CFD risks?


ANECDOTAL evidence suggests that the market for contracts for differences (CFDs) has grown strongly over the past few years and shows no signs of slowing down. No one knows just how big the local market is, since these instruments are traded over the counter (OTC).

But thanks to aggressive advertising and marketing by the big CFD players, an increasing number of retail investors are known to be trying their luck in the CFD arena, probably also encouraged by the fact that several local brokers have also jumped on the CFD bandwagon.

This is fine - the more financial instruments there are available to the investing public, the better. But CFDs are highly complex instruments with plenty of inherent risk.

With a currency CFD for example, it is possible to enjoy 100 times leverage, an attractively high number if the market moves in the investor's favour. But what is sometimes forgotten in sales pitches is that the knife cuts both ways.

So you have to wonder: Are retail players fully informed of all the risks? Or is the financial industry's approach the same as it was on the sale of the failed structured products such as Lehman Minibonds - that is, to focus almost exclusively on high potential returns and downplay the high risks?

You also have to ask, for example, why it is that CFDs are not allowed to be sold to retail investors in the US. And why it is that in the UK, retail investors have to take a suitability test before being allowed to trade CFDs?

Australia has, until now, had no major restrictions on CFDs. But last week, the Australian Securities and Investments Commission (ASIC) - the country's corporate regulator - said that it was looking to clamp down on the CFD industry because of widespread ignorance of the risks.

Ignorant of dangers

The Australian Financial Review, in its July 12 edition, quoted ASIC commissioner Greg Medcraft as saying: 'People just don't understand how dangerous (CFDs) are. There is a real lack of understanding about the impact of leveraging and how it can devastate them.

It's actually riskier than going to the bookies, because with bookies, if you put down $10,000 you only lose $10,000. Here, you put down $10,000 and you've lost your house and whole life savings.'

In the course of its investigations into the Aussie CFD market - estimated to be A$350 million last year but thought to be much larger today - ASIC found that investors were not only ignorant of the risks involved, but also were not being warned by those selling CFDs because the sellers themselves did not fully understand the risks.

It was also reported that two market makers or providers - CMC Markets and IG Markets - control around 70 per cent of the market.

Should the Monetary Authority of Singapore conduct a similar survey here to see if the burgeoning number of investors in CFDs really know what they are buying into? The answer, judging by the experience Down Under, is why not?

Questions to ask

If there was to be such a review - apart from the obvious questions about understanding how leverage works - investors should be asked if they understand the exact nature of the product. For instance, that when they take a CFD position, it is the market maker who is on the opposite side of the trade, which means the playing field is slightly tilted in favour of the market maker because it knows what its customers' positions are and can hedge itself accordingly - usually in the underlying cash market.
(Createwealth8888: What made you think that you as retail speculators can beat the Market Maker at their game? Where does all the free makan and pens that these Market Makers provide at their free CFD semniars come from?)
The investor has no such knowledge. Nor does he know what positions the house has taken, so even though some people may think this is insignificant, there is nevertheless asymmetric information in a CFD trade.

Similarly, do investors realise that unlike margin loans, CFD positions are not closed - or force-sold - when the market moves against them, which in theory could mean potentially large losses if the position is not constantly monitored and/or if no stop-loss is implemented?

Additionally, do investors realise that holders of CFDs on stocks are not entitled to dividends, because CFDs are not shares? Do they know that unless they have some form of deposit insurance, there is a chance - albeit small - that they could lose all their money if the market maker goes bust?

Also worth asking is if whether the deposit money collected from opening a CFD account is placed into a pooled segregated account and if so, how this money is to be used if very large customers incur big losses and cannot pay up?

As stated earlier, this is not to say that CFDs are unsuitable investments for retail players. But clearly, these instruments, given their risky nature, are not suitable for everyone. Going by the experience of other developed markets - the latest being Australia - it is worthwhile for local regulators to check if there is adequate disclosure in the marketing of CFDs here.

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