Retail providers of Contracts for Differences (CFDs) and Spread Betting products in the UK were in shock Tuesday as their industry faces new controls from the Financial Conduct Authority. This move had been foreshadowed, but even so, it upends a business that started as a way to avoid UK stamp taxes and has grown into a major industry of its own.
This content requires registration. Get access today by signing up here.The proposals for CFD providers include:
- Standardised risk warnings and mandatory disclosure of profit-loss ratios on client
- Lower leverage limits for inexperienced retail clients who do not have 12 months or more experience of active trading in CFDs, with a maximum of 25:1
- Maximum level of 50:1 for all retail clients and lower leverage caps for specific assets classes
- Banning trading or account opening bonuses or benefits to promote CFD products
The mechanics of a CFD look an awful lot like a swap or, more distantly, a Single Stock Future. Retail investors place funds in a margin account and then have the ability to take out leveraged long or short positions. Positions are marked-to-market at least daily. If losses are approaching the amount in the margin account, more margin is called and if not provided, the positions are unwound. CFDs let investors avoid the UK’s 0.5% stamp duty charge on share transactions. CFDs can now be taken out on on-UK equities, indices or even FX, where the leverage ratio is much higher than for equities.
As a provider of CFDs (or the very closely related spread-betting product) it quite hard for the provider to lose money unless they take a directional bet against their clients. Operation of the margin accounts places very clear limits on how much the retail investors can lose. CFD providers do need volume though: following the FCA announcement, the share prices of the leading quoted companies of these products were down 30%.
The FCA is still at the proposal state – consultation continues until the March next year, with a “policy statement” planned for issuance in the Spring. The FCA has been digging around in this business since 2009. It started making louder noises in 2014, made it a topic of a FCA board meeting in July last year and sent CFD providers a “Dear CEO Letter” in February warning them to mend their ways. Any provider of financial products to retail investors really should get worried when the FCA starts talking about “appropriateness tests”.
Perhaps this latest news shouldn’t have been such a big surprise though: a key finding of a recent investigation was that a sample of 82% of CFD clients lost money over a one year period with average losses of £2,200. Knowing this, some canny CFD investors would have been wise to take out short positions several months ago, on their CFD providers.
A large part of the problem with retail CFDs is they live in a non-man’s land between betting and genuine investment. Some CFD providers actually started out as book makers. Are people consciously using CFDs to have a flutter (to use the English term) or make an investment? If it is gambling, is the FCA the appropriate regulator? At the same time, there are legitimate uses of CFDs as an investment product. Worried about your pension fund but with limited control over it or facing high fees for exiting funds, CFDs can be a very cost effective hedging mechanism. Want to go long on UK equities but want to be the same position as the synthetic position held by hedge funds, i.e., not paying stamp duty, CFDs are the only way to go.
In securities finance, if the proposals ultimately reduce CFD volumes there will be less business for the banks that provide CFDs to retail providers to hedge their positions. This will translate into less demand for lenders to borrow the stocks that are ultimately needed to hedge a short position. There will also be a loss of liquidity in share trading on the physical markets, again used today for CFD providers to hedge exposures.
If it is any consolation to UK CFD clients, they performed considerably better than their European cousins. A similar analysis in Ireland found an average loss or €6,900 and in France €10,887.
The FCA’s full proposal is available on their website.