It seems like constantly we are reminded that CFDs are risky instruments not suitable for the ‘average’ price investor. This time we present to you a paper titled ‘Contracts for Dummies? The Performance of Investors in Contracts for Difference’.

CFDs are an important innovation in the design of futures contracts and their adoption by private investors has fuelled significant growth in the derivatives market and has also generated some controversy, but to-date there have been no detailed academic studies examining CFD markets. In 2007, the Australian Securities Exchange (ASX) introduced exchange-traded CFDs on individual stocks and other financial instruments.

Lee, Adrian D. a Post Doctoral Fellow and honours student Choy, Shan both from the University of Technology (Sydney) examined the performance of investors who utilised ASX-listed stock contracts for difference to see if we are being taken for a ride. The two scholars used the S&P/ASX 200 Accumulation Index as a performance measure to compare traders’ performance on long (i.e. buy) trades in relation to short (i.e. sell) trades and reached a conclusion that individual CFD trades net modest but ‘statistically significant’ positive returns over daily trade horizons (daily price against closing price and next day’s closing) and lose on average when holding positions from one week to one year.

The research is hypothetical, in that trades held for weekly, monthly, half-yearly and yearly periods are assumed based on the available data. Having said that, the better returns were noticed over the two shortest holding timeframes. The findings show that inclusive of the bid-off spread but before other costs such as financing fees, investor CFD buys outperformed sell CFDs by 5.85 basis points per day over a one day holding period, with no statistically significant performance for longer holder periods of up to one year. Investors who continue holding positions to extended periods are unlikely to come ahead because of the financing costs. A fee is charged for holding CFD positions overnight (typically RBA cash rate + 1.5%) which can add up in the long term. Sellers on the other hand earn interest at the cash rate – 1.5%.

Good stock picking was also observed as investors in aggregate turned into shares with a high beta (which is a measure of a stock’s volatility) before the stock market rose, so as to beat the risk-free rate. If the scenario materialised, they would have demonstrated themselves to be good market forecasters.

The traders who took sizable positions ($20,000 to $50,000) experienced short-term outperformance suggesting that such traders are more likely to be sophisticated. The short-term outperformance was noted in both small (less than $10,000) and large trades ($20,000 or more) – even after financing fees.

The study also found out that ‘buy positions’ outnumbered ‘sell position’ by 2.47 basis points (0.0247 percentage points) per day (intraday) and by 6.10 basis points per day over a one-day holding period (measured against the next day’s return). The bid-offer spread for trading contracts for difference was an extra 3.46 basis points than when directly trading the underlying shares, the authors observed.

The report examined 270,584 trades spread over 71 exchange listed shares on the Australian exchange between Nov 2007 and Jun 2010. The Australian exchange nominates price makers to help boost liquidity to ASX-listed CFDs in periods where prices move away from the underlying share values. The paper admits that volume on the exchange is small compared to the wider market; the aggregate value of shares traded is almost 380 times greater than the value of ASX-listed CFDs over those shares. The number of deals traded on the Australian exchange is also a miniscule of the amounts traded in relation to its wider over-the-counter market rivals. CFD trade sizes average $21,734 versus $13,277 for conventional share dealing which is logical given that minimal execution fees and margins provide extra incentive to trade in larger size.

For the entire sample, the average CFDs trading volume is aggregately $7.8 million per day while trading on the underlying stocks is 382 times larger at almost $3 billion per day. Lee appears to conclude that traders who deal in CFDs traded on the Australian Securities Exchange don’t necessarily perform badly. ‘It’s a surprise finding that if you suspect retail traders using these ASX-listed CFDs are stupid, they’re not. Overall, they have slight trading ability on the day and the next day.’

There isn’t substantial research about private investors’ performance with derivatives trading although one European study by Bauer, Cosemans and Eichholtz noted that most investors lose money in options trading due to mainly poor timing and costs although the authors also suggest gambling and entertainment value as motivators.

The full text of the academic study can be found here [pdf format].

South Africa’s Johannesburg stock exchange plans to start offering CFDs on its platform early in 2013. The JSE released the announcement this morning citing increased awareness and demand for the leveraged retail product.  It plans to start offering CFDs as an exchange-traded product with trades being reported to the JSE to streamline risk management systems.

“This initiative forms part of the JSE’s focus to be more responsive to the needs of the market rather than develop products simply because they seem like a good idea.”

A spokesman for the Johannesburg stock exchange noted that it regards CFDs as a compliment to single stock futures and that both financial products can exist side by side.  In a similar way to an over-the-counter CFD, the JSE eCFD will carry an overnight holding charge and in this respect the exchange proposed that it will be using the South Africa’s Benchmark Overnight Rate, published daily by the SA Reserve Bank.

The impending European Union rules governing over-the-counter derivatives, central counterparties and trade repositories (EMIR) targets to adopt the G20 commitment to oblige clearing of standardised OTC derivative transactions by central counterparties by the end of this year. While European Union directives are planned to be in operation by the end of 2012, there will still be a number of steps that need to happen before market participants are subjected to a clearing mandate.

Clifford Chance LLP has drafted a briefing detailing these measures and setting out an tentative timeline showing the path to mandatory clearing in the European Union.

The update from Clifford Chance LLP can be found here [PDF format]

An investigation by ASIC has established that 8 out of 40 CFD providers and margin forex derivative providers are not complying with client money laws and have failed to properly deposit monies into a segregated trust account. The risk-based review which is still ongoing also found that 6 issuers haven’t deposited client monies into a compliant account on the day the funds were received or within one business day.

The review relating to potential requirements for unlisted, margined derivatives contracts available to private investors was launched by the Australian Securities and Investments Commission last December, one month after the MF Global collapse where it was found that the company was commingling client monies with its own to hedge trading positions instead of using the firm’s capital.

The main objective of the risk review is to help protect the interests of market participants who trade in CFDs and margin forex by requiring market participants to transparently disclose risk while improving credit risk management and permitting investors to be adequately compensated in the event of loss. The review is also intended to ensure that providers are adequately capitalised and are financially stable.

ASIC has followed up with providers to make sure they have a clear understanding of what is expected of them and of their obligations under the law. This would include feedback on effecting daily client monies reconciliations, making sure that there is an appropriate segregation of duties and that the eventual reconciliation is finally signed off by upper management, and recording policies for dealing with variances.

ASIC Commissioner Greg Tanzer emphasised that client money provisions are essential to protect the interests of private investors particularly where leveraged instruments are concerned. The fact that these contracts are not traded through exchanges introduces an element of risk since traders and investors who wish to trade these financial instruments are exposed to the risk of default and also the operational risks undertaken by the party issuing the derivatives contracts. Mr Tanzer said that the announcement should serve as a warning to those providers who aren’t complying with the law and ASIC will be considering strong action against any providers who are found to be breaching the client money rules.

In July 2010, ASIC issued a Regulatory Guide relating to dealing in over-the-counter derivatives (RG 212). The guide provides a basic overview of the statutory client monies provisions in particular those relating to derivatives.

Section 981D of the Corporations Act in Australia specifically states that client monies held by providers can be utilised for the means of satisfying obligations in relation with guaranteeing, margining, securing, transferring, adjusting or settling dealings in derivatives by the operators (which would include dealings on behalf of people other than the client). Some CFD brokers were even surprised by this seemingly lax nature of Australia’s laws on the protection of client monies and at their competitors’ lax attitude to adhering to those rules.

‘When Capital CFDs entered the Australian market, we were shocked to discover that the Corporations Act permitted operators to make use of client funds to finance operational costs, which is without doubt not in the best interests of clients,’ stated managing director of Capital CFDs Andrew Merry. ‘We brought with us the United Kingdom practice of ringfencing client monies and not utilising the monies for any operational purposes at all, including the hedging of client positions.’

Meanwhile, the CEO of Saxo Capital Markets, Anthony Griffin, noted categorically that protecting client monies in segregated accounts was sacrosanct. A number of CFD providers, including CMC, GFT, IG Markets, City Index, Capital CFDs and Saxo, have rallied together to form the Australian CFD Forum earlier this year – a key objective of the body being to push for stricter rules to help protect their industry from unscrupulous providers.

After the publication of 15 revised drafts of the long-awaited Regulation of the European Parliament and Council on OTC Derivatives, Central Counterparties and Trade Repositories (commonly known as “EMIR”), you would be forgiven for thinking that the Europeans were never likely to see a conclusion to legislative attempts to regulate their over-the-counter (“OTC”) derivatives market. However, on 9 February 2012, a trialogue meeting of the European Parliament, the Council and the European Commission at long last reached agreement on the final text of EMIR1, and since we last provided an update on OTC derivatives reform in the EU2, the wheels of the legislative process have turned extensively, even if slowly.

Although the publication of the legislation finally puts in place the broad regulatory framework to govern the OTC derivatives market and establishes common rules for central counterparties and trade repositories, much of the real detail has yet to be drafted. The European Securities and Markets Authority (“ESMA”) now has responsibility for putting the flesh on the bones, in the form of drafting scores of technical standards to implement the EMIR provisions.

Even before the final text of EMIR was released, ESMA published a draft discussion paper (the “Paper”) setting out some draft proposals for some of these technical standards, and requesting views. Insights that can be gleaned from the Paper into ESMA’s thinking are somewhat mixed. In some areas, ESMA has clearly had time to develop its analysis and has provided a detailed view of the appropriate technical standards that it currently considers should be applied, subject to the views and comments of affected parties (referred to in the Paper as “stakeholders”). In other places, it is clear that ESMA has a more nascent view of the position that it wishes to take, perhaps because the relevant requirement for a technical standard has appeared relatively late in the EMIR negotiation process and it simply has not had enough time to develop its thinking. In these cases, ESMA has still invited stakeholder views generally, although this questioning is much less focused and provides limited guidance to the stakeholder.

This update aims to summarise where the final provisions of EMIR ended up and set out ESMA’s initial views on how the key parts of EMIR will be applied. The full regulatory update from Morrison & Foerster LLP can be found here [PDF format]

The Monetary Authority of Singapore (MAS) is planning to tighten its rules regarding CFDs trading. More onerous terms for the increasingly popular financial instruments could be on the way, in a development that is likely to affect thousands of private traders and investors in Singapore.

MAS is presently looking at preparing a consultation paper on the product. The Authority is particularly looking to target overseas providers that operate outside the regulations imposed by the Monetary Authority of Singapore.

‘If investors would like lower trading margins and the margins offered by local providers aren’t attractive, it is presently easy for people to use offshore brokers. These providers are not subject to local MAS rules and hereby represent a higher risk for investors as regards client monies and recourse in case of issues.’

The Authority is also looking at limiting the amount of leverage that retail investors can access for such ‘complex products’. MAS is also evaluating the possibility that such derivatives be moved into ore transparent trading systems and clearing houses. The Authority is consulting with the industry to understand better the costs and benefits of a trading mandate, taking into consideration the particularities of the local market.

Asian markets continue to keep abreast of regulatory in the USA and Europe. Meanwhile and separately in October in 2011, the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) also jointly published a consultation paper on the proposed regulatory regime for the ‘Over the Counter’ derivatives market in Hong Kong.

NYSE Euronext (NYX) announced that it planning to launch a new derivatives marketplace in the United Kingdom and Europe in 2013 that will permit private traders and investors to trade CFDs mirroring currency pairs, commodities and other markets, according to insider sources.

The exchange intends to create a web-based market in so-called contracts for difference; futures-like financial products which have dramatically increased in popularity amongst retail traders in recent years.

The size of the market is thought to be massive according to a NYSE Euronext official with foreign exchange linked CFDs making up an estimated $8 billion market.

It is understood that NYSE Euronext intends to setup an exchange-like model that depends on market-makers to transact business with private traders. The company has already committed $11 million to developing the new market this year and aims to launch the first contracts in the first quarter of 2013; according to an investor prospectus.

Providers like IG Group plc (via IG Markets) have for over a decade quoted markets in CFDs, but NYSE Euronext aims to take a different approach by setting up an exchange-like model that relies on market-makers to do business with retail investors as opposed to it acting as a counterparty. Specifically Euronext intends to rely on market-making companies and professional traders to take the other side of trades with private retail customers in a multilateral trading facility (MTF). The MTF will allow contracts on securities and products listed on any exchange.

Garry Jones, NYSE Euronext’s head of global derivatives emphasised that this is very exciting as the size of the market is massive. He added ‘We’ll have first-mover advantage in the sense that we will not be trading against our clients,’ noted Garry Jones, NYSE Euronext’s head of global derivatives.

NYSE Euronext is about to sign understandings with partners to help it launch the venture and the company intends to use external technology to develop a new web-based platform.

Six leading CFD brokers in Australia have joined in an initiative to produce a set of industry standards as they attempt to win back the trust of traders and investors hit by the demise of MF Global.

CFD providers have been discussing the standards for over 9 months and aim to project the CFD industry as a well-governed business. CMC Markets head of Australia and New Zealand Louis Cooper noted ‘There’s an element of the industry that has given the more well governed and credible businesses a bad name’.

The six CFD companies – Capital CFDs, City Index, CMC Markets, GFT Forex, IG Markets and Saxo Capital Markets – have agreed to form the Australian CFD Forum. The founding members of the forum constitute about 90% of CFD accounts across Australia, however forum membership will be open to any CFD company that agrees to implement a set of 16 industry standards targeted at protecting clients by making sure they understand the risks, as well as the potential returns, involved with CFDs.

The standards aim to exceed ASIC’s obligations which were laid down last year before the demise of derivatives broker MF Global, after it was reported that the American company mixed client monies with its own to fund a multi-billion bet on sovereign European bonds that went sour.

ASIC chairman Greg Medcraft welcomed the news, noting that industry groups generally perform an important role in helping maintain investor confidence. He commented ‘We look forward to engaging with the Australian CFD Forum and learning more about their best practice standards.’

The forum’s best practice obliges providers to hold all client monies separately from their own. Louis Cooper of CMC Markets noted that segregation of client funds is a main issue and this will be a basic minimum industry requirement for any CFD company looking to join the group. Other key issues discuss disclosure and consumer education which are also included in forum’s basic code of standards.

One issue that the board weren’t able to reach an agreement on revolves around the use of credit cards to fund an account. Some members believe that the ability of prospective clients to open and fund an account with a credit card isn’t a sensible choice, but others argued that clients strongly favoured the flexibility of being able to fund their account in that way.

The Australian Securities & Investments Commission has taken its crackdown on misleading ads for financial products and services one step further by issuing a guide that strives to restrict the language of financial planners.

Guidelines prepared by Peter Kell, an ASIC commissioner focus on promoters highlighting the risk element of financial products to consumers so that they are aware of the high risk of financial trading.

‘Ads that do not accurately represent the financial product or its key features and risks, or the nature and scope of financial advice, can create unrealistic expectations that lead to poor financial decisions,’ he said.

Kell noted that the Australian Securities & Investments Commission has already been successful in eliminating a few of the ‘bad apples of poor products’ from the financial industry, with almost 120 adverts banned or changed since July 2010.

However, he emphasised that in future penalties will be harsher for adverts that the Australian Securities & Investments Commission didn’t perceive to be transparent, accurate or balanced.

‘The outcomes we will aim for when confronted with suspected breaches will involve potentially stronger penalties than we have sought in the past,’ said Kell. The 47-page guide includes 38 examples of such adverts and follows on from a consultation issued by ASIC last year.

Those found guilty will face fines, injunctions, public warning notices and in severe cases jail sentences under new guidelines published by ASIC. ASIC enforcers will also ensure that advertising catch words like ‘guaranteed’, ‘secured’, ‘stress free’, ‘low rosl’, and ‘protected’ are used in a proper context.

The guidelines in particular state that:

‘Information about the risks of a financial product should be clear, and not hidden or difficult to understand, and should be given sufficient prominence to information about returns and benefits. The tone of the advertisement should not undermine the importance of the risks.’

The guidelines cover superannuation products as well as insurance policies and CFDs. ASIC referred to CFDs as risky financial products that can expose investors to large losses and ads shouldn’t allude to the contrary.

‘Build personal wealth with low-risk trading strategies’ or ‘Safely harness the leverage power of CFDs’ were phrases singled out by ASIC as examples of misleading ads that didn’t properly reflect the risks involved in trading in CFDs.

Kell stated that the Australian Securities & Investments Commission would be looking more closely at ads that target vulnerable retirees and would also look at clamping down on the online and mobile environment.

‘These continue to be growth areas for the promotion of finance advice and services,’ said Kell, who added they have already taken action against a number of online promoters.

“But we would prefer to see them get it right the first time,” he said.

IG Markets has launched a new platform designed to help traders research markets events and analyse data. The new research software application which IG has dubbed as the new Insight platform is a centralised platform encompassing market data, live news and expert analysis on the financial markets.

With Insight you can:

• Access the economic calendar to track global financial events
• View client sentiment indicators, for a summary of IG clients’ positions
• See live Reuters news, filtered by market or region
• Get expert opinion on news, events and market movements
• Track and analyse historic data with our versatile in-page charts package

Insight is customisable and linked to IG’s web dealing platform, with dealing functions ranging from watchlists to working orders embedded in you analysis, including instant charts, streaming news from Thomson Reuters, corporate fundamentals and more.

Insight provides clients with a perspective on the most traded markets at IG, in particular how many people are long or short of a specific instrument and what other markets they have dealt.

This is because the application is designed to release details of IG’s clients’ net aggregate positions allowing better collaboration amongst traders. All data is anonymous and individual trades are not reported, but clients can check the percentage of long or short trades, other trades held by clients trading a particular market, the most popular markets overall, and more.

David Jones of IG Index stated that clients have been grabbed by aggregate trade data: ‘Clearly this can be used to gauge the sentiment of fellow traders and decide whether you want to join them – or if they are all barking up the wrong tree and you want to use it as a contrary indicator.’

We are told that with Insight you can also deal directly from any market page or chart. Christopher Beauchamp of IG Index believes ‘increased information about how other traders are positioned will also develop.’ He says traditional bulletin boards have provided traders with a place to share their thoughts and views (with the usual caveats about bias), but there are new ways of learning from others.

To access Insight, just log onto your IG Markets account and click the ‘Insight’ button.