In an effort to reduce suspect business practices, the Australian Securities and Investments Commission (ASIC) has tightened the rules governing contracts for difference which now require clearer disclosure in seven areas. ASIC has done this by issuing a regulatory guide for contracts for difference (CFD) issuers in order to provide greater disclosure to investors. The regulatory guide, entitled ‘Regulatory Guide 227: Over-the-counter contracts for difference: Improving disclosure for retail investors (RG 227) ‘, provides seven benchmarks for which CFD issuers are to adhere. The regulator has targeted several key areas including ensuring investor suitability, opening collateral, hedging, credit card payments, client money, margin calls and advertising that targets unskilled investors. The new benchmarks in particular call for financial institutions to adhere to strict guidelines to make sure that potential clients understand the risks and benefits of improved investor awareness.
In particular the regulator is requesting for prospective investors to be examined for suitability and skill levels. Greg Medcraft, the ASIC chairman, said in a statement ‘Most investors don’t understand that complexity and they don’t get independent financial advice’. He was quoted saying ‘We need CFD issuers to do a much better job of spelling out to investors the risks as well as the rewards of these complex products.’ As part of seven benchmarks outlined in a regulatory guide, the onus will be on CFD providers to ensure that investors have the ‘qualifications’ to invest in CFDs.
Although referred to as ‘disclosure’ benchmarks, the benchmarks may be better described as ‘policies and controls’ benchmarks, with the relevant disclosure being whether or not the policies and controls of the CFD issuer meet the benchmark and, if not, why not. The ‘if not, why not’ disclosures go into detail of how CFD providers operate their business, including product disclosures and disclosure of how CFD operators lay off the risk on clients trading positions as well as how much money they retain on their balance sheets to counter their risks. The disclosures are designed to eliminate shady practices utilised by some CFD providers in the past in which they categorised inexperienced investors as ‘cats’ meat’ and profited from their losses. The disclosures also request providers to explain their contingency policies (or lack of them) to show how their operation can withstand adverse market conditions. It also requests providers to spell out their protections (or lack of them) for client money they hold on balance sheets, including whether the money is mixed with other money to meet demands of other clients or the company.
ASIC is particularly concerned that ‘Mum and Dad’ investors were exposing themselves to high amounts of debt by borrowing money to open trading accounts for CFDs. ‘We are concerned that using a large amount of borrowed funds to open a trading account creates a situation of double leverage that may expose investors to the risks of increased losses,’ ASIC stated in a report. The Australian Securities and Investments Commission has suggested that a limit should be placed on the amount of funds that can be deposited from personal credit cards.
Contracts for difference allow for leveraged returns from movements in asset prices, such as a stock or commodity, without the need to put up a lot of money. However, just as CFD investors can gain significantly if the stock price of a company rises, they are also liable for any losses if the market moves in the opposite direction to their prediction.
The CFD providers have been requested to either disclose how they address the points raised, or explain why not in their product disclosure statements. ASIC expects issuers to provide updated disclosure to existing clients, and to update their PDSs for new clients, by 31 March 2012.
Who is affected?
Issuers of over-the-counter (OTC) contracts for differences. RG 227 also extends beyond CFDs to other financial trading products like margin Forex, but does not extend to exchange-traded CFDs, although ASIC does suggest that issuers of exchange traded CFDs may wish to pick up some of the concepts discussed in RG 227.
Presently there are thought to be about 39,000 active CFD traders in Australia and the CFD market has expanded more than fourfold in the past 5years to last year, according to a report published in 2010.