ASIC swoops on CFD providers

PORTFOLIO POINT: The watchdog is clamping down on the CFD market, and is concerned about many DIY funds being caught up in it.

The once-booming CFD market is in damage control. The recent collapse of CFD pioneer Sonray Capital threatens to turn regulators against a now flourishing derivatives market, while leading CFD houses are already moving to pre-empt sweeping regulatory changes.

One of the biggest CFD providers, IG markets, has already backed out of the DIY market, while several providers aim to pre-empt ASIC standards by announcing new guarantees on the wider treatment of client money.

Moreover, as the screws tighten on a market that few participants fully understand, it has become clear that many investors are unaware that CFD providers may access client funds to cover shortfalls caused by losses of other traders.

ASIC commissioner Greg Medcraft has revealed to Eureka Report that next month the regulator will unveil the first stage of a reform program aimed at cleaning up such practices in the industry.

"The industry's game needs to be improved immediately,'' Medcraft says. "CFD providers who don't respond will have to explain to investors why they don't comply with the regulatory guide, and if you're an alert investor you might have second thoughts about dealing with such providers.''

What are CFDs?

Modelled on wholesale futures instruments, CFDs are highly leveraged trading products that can magnify the gains or losses of traders who are often only required stump up an initial outlay that equates to 1% of their trading exposure.

With equity-based CFDs, investors can elect to take a short position if they believe a listed stock is going to fall in value or a long position if they think it will rise.

If the invisible hand of the market moves against a trading position, the client is required to commit more cash on a daily basis to meet margin calls.

According to their product disclosure statements, many CFD providers claim a discretionary right to close out contracts when a stock stops trading due to events such as takeovers or capital raisings.

New risks emerge

On top of the turbo-charged market risk that CFDs promise, there is also the hazardous and highly conflicted terrain of counterparty risk that has emerged as a reform priority for regulators in Australia and overseas.

Amid mounting public concern over alleged unethical behaviour of some CFD providers, and reports of naive speculators being hauled through the bankruptcy courts, ASIC has been conducting a wide-ranging review of practices across the sector.

There are at least 16 over-the-counter CFD operators in the local market and all, except for Macquarie Prime, currently require new clients to make cash in their accounts available to meet potential shortfalls in the providers’ own hedging positions.

Such shortfalls usually arise when one or more clients default on servicing loss-making positions, or when a part-hedge over a client risk becomes ineffective.

To cover themselves against these situations, most CFD providers reserve the right to draw on the cash in the accounts of profitable or dormant traders to make up the deficiency.

It is a suspect practice that in certain circumstances affords some CFD operators with their only protection against insolvency. Such activity is facilitated by the industry convention of co-mingling or pooling of clients' funds.

It might shock many CFD investors to know that their funds can be used for purposes beyond their direct transactions with providers, even though such conditions are spelt out in most product disclosure statements.

ASIC to step up regulation

In several reports issued in July, ASIC put the industry on notice that it wanted to see client money accounts ring-fenced from such exposure but the industry is yet to respond. ASIC acknowledges that legislative reforms may be necessary if the industry fails to comply with the new standards.

"What we will be saying in our coming regulatory guide is that we consider it to be best practice that client monies are clearly segregated with no co-mingling of accounts,'' Medcraft says.

He says the regulatory guide will also require providers to report specific changes in their counterparty risks to clients on an ongoing basis, not just in product disclosure statements.

"Investors need to do their homework on every aspect of counterparty risk '¦ the way in which counterparty risk is disclosed leaves a lot to be desired and needs to be rectified not next year nor tomorrow but immediately.''

In a remarkable admission, IG Markets, the largest provider of CFDs in Australia, says it is withdrawing from the SMSF market. At the same time, several other providers are trying to pre-empt the new ASIC standards by announcing in the coming weeks new guarantees on the treatment of client money.

Melbourne-based CFD issuer GET Financial is one of the providers flagging such a move. "GET is concerned about the protection of clients' funds and we're moving from a pooled account structure to individual accounts that are in a client's name,'' GET director John O'Shea says.

Most of the CFD providers contacted for this article said they would comply with ASIC's new benchmarks, but many resisted suggestions that they should be doing more voluntarily to inform clients about the financial health of their businesses.

IG Markets, which accounts for about 29% of Australia's 39,000 CFD traders, according to research collated by Investment Trends, is adamant that it already protects its clients' cash. However, this assertion appears to contradict aspects of its product disclosure statement, which states that the company may co-mingle clients' funds in a pooled trust account.

The biggest risks lie beyond our borders

The local CFD market is dominated by a clutch of British-owned companies, including IG Markets, CMC Markets and City Index.

These players are prudentially regulated at a group level by the Financial Services Authority and each is required to set aside regulatory capital to cover for risks as they expand globally. This affords some protection to Australian clients of these companies and also means that financial accounts of each are publicly available.

However, most of the locally owned providers, such as First Prudential, GET Financial and Marketech, are not required by ASIC to publish their accounts. And they don't.

James Martin, a director of Perth-based CFD provider Marketech, says: “We lodge accounts with ASIC as it’s part of the licensing requirement for holding an Australian Financial Service Licence. That’s for ASIC and the regulators to decide whether it’s necessary to make them public.’’

"I'm in full support of publishing financials and we may do that and we're actually considering that now,'' First Prudential managing director, Matt Murphie, says. "The reason we don't do it is that people tend to focus on net assets, but looking at this alone is not going to give you an accurate view on counterparty risk. If you were to look at Opes Prime before it collapsed, it had net assets of $50 million.''

Opes Prime was the Melbourne based brokerage that collapsed in 2008 with debts of more than $1 billion. (see Opes: Leveraged investors be warned).

Short of a blanket ban on over-the-counter CFD trading, there are probably severe limits on ASIC's ability to protect uneducated traders from racking up deep losses.

ASIC's challenge is compounded by the fact that CFDs are intrinsically speculative and highly leveraged, which means it is almost inevitable they will have far reaching consequences for the lucky and unlucky. "Most people use CFDs as a speculative tool; I can’t say that is not the case,’’ says Marketech's Martin.