CFDs are they the devils spawn?

There has been some chatter on our mentor forum about CFDs – as such I thought it worthwhile to reproduce an article I wrote for the Trading Game Newsletter following the collapse of Sonray last year.

Over the past few weeks much of the chatter from brokers and others on the supply side of trading has been about the collapse of Sonray Securities which has left several thousand investors up the creek.

Much of this chatter has been about the evils of CFDs and how they are, if the commentary is to be believed, on the verge of bringing down civilisation as we know it. In truth much of the commentary has been largely self-serving, mostly ill informed and in some cases downright stupid.

I want to look at each of the concerns and provide a sensible rebuttal to each.

1. ASIC is so concerned about CFDs that they are putting out a position paper, which will look at the leverage and complexity of CFD trading.

There are several points that need to be addressed with this argument. Firstly, ASIC’s  role in looking at market conduct means that it puts out guidelines all the time for all market participants, so this in itself is nothing new. It is a good opening line and does a lot to get attention and perhaps stir the pot a little but it is not a true and accurate view of the role ASIC takes in overseeing markets.

For example, take a trip to the ASIC website and you will see a plethora of guidelines and reports on a variety of topics including reviewing the variations to the license of the ASX and SFE. Such reviews are a normal part of business. It does not mean that ASIC will immediately shut down either body.

Secondly, the notion of leverage is a misleading one for several reasons. Option, FX and futures trading can and does offer leverage of an equivalent size to CFD trading. Therefore, there is nothing actually new within this. Margin loan accounts can offer similar advantage to CFD trading on some shares due to the higher margin charged by CFD firms on some shares.

Leverage itself is not the issue – it is how traders use this leverage that is the problem. As much as regulators try, you cannot outlaw stupidity. There will also be people who are better off with their mums giving them fifty cents play lunch money tied into a hanky and stuck in their pocket. This way they cannot get into too much trouble but it is not the job of the regulator to be everyone’s mum.

Finally, CFDs are less complex than either options or futures; in fact, it is easier to get a trader to understand CFDs than it is to bring them up to speed with the notion of options trading. For example if you were buying a NAB CFD and you had traded NAB shares before then the transaction is very familiar to you. However, if you were trading NAB call options you will need to become familiar with option pricing, option market dynamics and the lack of an ability to place a stop within domestic option markets.

The implication within this argument is that CFDs are too complex and too dangerous for the average investor to master so they should stick to traditional shares where at least they own part of the company and brokers pick up your commission on the way through. As a counterpoint to this, consider that domestic fund managers invest only in traditional equities and many of them are still showing losses of the order of 40% on their funds post the GFC so it is not the instrument that is too blame. It is the end user.

2.      CFD providers suck people in with slick advertising and convince them there is money to be made. Their platforms are flashy and easy to use so this encourages people to trade.

To be honest I do not see any difference between the advertising of CFD providers and that of traditional brokers. All talk about their platforms and all are constrained by the same legislation as to what can and cannot be said in advertisements.

With regard to platforms, I would have thought that all domestic brokers would aspire to have easy to use interfaces as this would attract people to use them. However, this is not true. Most of the brokers’ platforms are arcane and are no more than slightly tricked up versions of what was floating around dealing desks in the early 1990s. WebIress, which is a popular infrastructure for many brokers, does not seem to have evolved much in a decade. I would also hasten to add that the majority of brokers still refuse to allow the placing of a stop loss position whereas with CFD providers this is a given.

3.      Sonray placed their clients’ funds into a pooled account so that traders with funds in their accounts have now become unsecured creditors.

That is true, it is unusual that most (read almost all) brokers, and CFD providers put client’s monies into segregated accounts that are secured against such events because they are segregated. However, if this were a traditional broker who did this the result would be the same.

4.      CFD firms are simply counterparties to your transaction so that if you lose they win. Therefore, they will set out to make certain you lose.

This is a somewhat disingenuous argument that I have seen raised by brokers because it misses the point that when you do an options or futures trade you will most likely be dealing with a counterparty. Market makers are an integral aspect of both options and futures markets. These markets would come to a complete halt without market makers.

However, the most disturbing part of this argument is the notion that somehow CFD providers set a different price to the market for a given equity and in some way manipulate that price so that it does not reflect the reality of the market. This is simply nonsense for a variety of reasons. First and foremost is that it would most likely be regarded as a form of market manipulation and would bring ASIC down on you like a ton of bricks.

Secondly, it shows a complete misunderstanding of how markets work. If there is a price dislocation between two identical instruments then that price differential can be exploited. For example if I were trading BHP and the market was quoting $37.30/32 and the CFD provider was quoting $37.40/42 then I could buy BHP on the market at $37.32 and sell it at $37.40 and I could do this all day locking in the $0.08  spread. This is known as an arbitrage and arbitrage trades have disappeared with the advent of the high-speed PC based trading.

If dislocations in the market are found then they are immediately exploited and they disappear. Think of it in terms of finding a short cut to work. The first day you do it there is nobody else on the road, the second day you do it the road is clogged with others. Your short cut arbitrage has disappeared.

Implicit within this argument is an inability to understand that it is the market that sets the price not the CFD provider.

5.      CFDs are banned in the US.

So are single share futures but they are offered almost universally on all other futures exchanges. To offer a statement that something is banned in the US so it is a good reason to be wary of them is to use a style of argument known as a red herring. The basic argument is about the collapse of a broking firm that offered CFDs to retail clients.

As I said in my introduction, a lot of this talk is self-serving and in broking circles is known as talking your book. Traditional brokers have cause for concern over the popularity of CFDs – their rise has been both dramatic and all encompassing.

In the UK, turnover on CFDs outstrips the turnover on the FTSE. This situation could have been avoided if brokers were more proactive in their approach and embraced such challenging ideas like a decent online platform, research that actually meant something and new-fangled concepts such as stop loss and contingent orders.

However, to offer a blanket condemnation of instrument because a broker blows up misses the bigger picture completely. Instruments are not the cause of brokers blowing up. Sonray’s problems may have arisen for a number of reasons, which will only become apparent when the liquidators have done their job.

However, I can guarantee you that the auditors will not say that they blew up because they offered CFDs as a tool, just as any of the traditional local brokers who have blown up did not do so because they offered share trading to clients.

Thus, whilst CFDs continue to be a threat to local brokers it is worth remembering that the world’s entire economic system was almost brought down by traditional bankers and brokers.

Postscript – As was thought by many inside the industry at the time Sonrays collapse was brought about by plain good old fashioned theft