Why Contracts for Difference Are Back Under Scrutiny
(Bloomberg) -- Contracts for difference, or CFDs, have hastened the demise of an Irish bank, triggered alleged Ponzi schemes in Chile, featured in a $100 million U.S. insider-trading racket and seen echoes of their use in the implosion of Archegos Capital Management. They’ve also spooked regulators because of the risks they pose to retail investors, sparking tighter rules in the U.K. and European Union. But new regulations didn’t stop amateur traders flocking to CFDs in 2020 as a result of volatility during the pandemic, and again in 2021 as part of a surge in retail interest in global markets.
1. What’s a contract for difference?
It’s a financial product known as a derivative that allows an investor to make a bet on the direction of stocks, currencies or commodities without owning them. Its value is reliant on or derived from an underlying asset or group of assets. It’s traded directly between counterparties, rather than through a public exchange. While such instruments are commonplace among traders at banks and asset managers, what makes CFDs unusual is that they’re also accessible to retail traders across the globe -- except in the U.S., where they’re banned other than for financial professionals.
2. Why are CFDs so risky for retail traders?
Retail investors can use borrowed money, or leverage, to magnify the size of their trades with CFD firms. Until recently, those in the U.K., Europe and Australia were able to increase their bets by hundreds of times, turning a $500 stake into a notional gamble of, say, $250,000. In such cases, just a slight market move in the wrong direction could wipe out the trader’s deposit. Amateurs tended to lose money on the vast majority of transactions and could even wind up owing money to CFD firms.
3. What else worried regulators?
CFDs have been around for decades but regulators became increasingly concerned some years ago about rising leverage and also how these complex derivatives were being pitched and marketed to unsophisticated amateurs. CFD firms had been increasing their reach by sponsoring soccer clubs including Real Madrid and Liverpool FC and players such as Cristiano Ronaldo and Andres Iniesta. Adding to concerns was the arrival of CFDs linked to cryptocurrencies. Also, while the industry had long been dominated by U.K.-based, publicly-traded firms including IG Group Holdings Plc and CMC Markets Plc, many new entrants had more obscure backgrounds and tended to obtain EU approval from a regulator in Cyprus while also keeping a presence in locations such as St. Vincent & the Grenadines or Belize.
4. What have regulators done?
Regulators have been introducing sweeping rules for CFD firms since around 2017, aimed not just at making the products less risky for amateurs but to reduce CFD trading volumes altogether. The European Securities and Markets Authority, the U.K. Financial Conduct Authority and the Australian Securities & Investments Commission have ushered in restrictions for retail traders across the globe including curbs on leverage and restrictions on the marketing, distribution and sale of CFDs. Brokerages dealing in the derivatives must also take steps to prevent their retail customers from winding up in debt when the trades start to go awry, and the FCA banned cryptocurrency CFDs outright.
5. Have the rules had any impact?
That’s a tough question. Retail traders officially have far less access to leverage than before and have more protections against losses as well. But the rules still allow them to borrow up to 30 times their deposits for CFD trades linked to currencies and some government bonds and up to 20 times for those linked to gold and stock market indices. And it’s unclear exactly how to police customers who manage to open accounts with offshore, unregulated entities. Also, the new regime didn’t stop punters flocking to CFDs to gamble on the pandemic-fueled market gyrations in 2020. Nor did they halt customers rushing to speculate on so-called “meme stocks,” shares that gained a passionate following among amateurs on social media in 2021. IG Group, CMC Markets and Plus500 Ltd., another publicly-traded CFD firm, disclosed surges in performance linked to these events, challenging the FCA’s stated intent to cull the numbers of traders in this market.
6. Why do financial professionals like CFDs as well?
CFDs are exempt from stamp duty in high-tax jurisdictions such as the U.K. But large investors also like the secrecy that comes with a product that isn’t traded on any exchanges and have used CFDs to amass clandestine stakes in publicly-traded companies. There were echoes of this in the collapse of Archegos.
7. What went wrong for Archegos?
The March 2021 fall of Archegos was one of the biggest blowups in Wall Street history. The investment firm, a so-called family office that invested the fortune of trader Bill Hwang, used derivatives called total-return swaps, which operate like CFDs, and billions of dollars borrowed from investment banks to build large stakes under the radar in U.S.-listed companies. When those bets lost value, the banks were left staring at massive potential losses. Credit Suisse Group AG lost about $5.5 billion, ousted nine executives and recouped about $70 million in pay, including bonus clawbacks, as it punished 23 people in all for their role in the scandal, while Nomura Holdings Inc. reported a $2.9 billion loss. The U.S. Securities and Exchange Commission has since begun exploring how to increase transparency for these types of bets.
8. Has anything similar happened before?
In Ireland, CFDs hastened the demise of Anglo Irish Bank Corp., which helped drive the country into an international bailout that resulted in years of austerity. Sean Quinn, then the country’s richest man, had used the derivatives to secretly build an exposure of almost 30% of the lender. Irish and U.K. regulators have since stopped that practice.
9. What else has happened?
The derivatives have emerged in some colorful stories in recent years. In Chile, a surge in interest in CFDs triggered a series of alleged Ponzi schemes and a congressional investigation. Some individual investors made big losses when the Swiss National Bank abandoned a peg against the euro in 2015, leading to wild currency swings. Later that year, 32 people were charged by the SEC for trading on information gained by hacking news releases and making more than $100 million with the use of CFDs.
The Reference Shelf
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