cfds the next big risk

Interesting read in todays The Australian:



THE next ticking bomb for investors is the controversial financial instrument Contracts for Difference (CFDs), where many of the stand-alone entities work off an Opes Prime-style model that leaves its clients as unsecured creditors if the business collapses.

The Australian has examined contracts with some of the bigger CFD providers and buried in the product disclosure statement is a clause that states in the event of insolvency, the client becomes an unsecured creditor.

CFDs have been outlawed in the US by the Securities Exchange Commission because, unlike other securities such as shares and options, they are traded "off market".

In Australia, recent changes to legislation enable self-managed super funds to invest in CFDs, so, if they make the wrong bet, they risk losing their retirement savings.

The CFD industry estimates that more than $400 billion of CFD trades are carried out each year in Australia, representing more than 15 per cent of trades on the equities market. Most are trading outside the Australian Securities Exchange, in a poorly regulated over-the-counter market. The way it works is the CFD providers hedge their bets by either buying stock in the physical market or borrowing stock provided by superannuation funds.

Tom Elliott, managing director of Hedge fund group MM&E Capital, estimates that of the $200 billion stock that is available to be lent out, 10 per cent is carried out by the CFD industry, while hedge funds represent about 30 per cent.

According to the latest Australian Financial Markets Association data, the OTC market turned over $81.4 trillion last year, compared with $38.9 trillion for the total exchange-traded markets, which includes the ASX and the Sydney Futures Exchange, also owned by the ASX.

The country's biggest CFD provider, CMC markets, has in its product disclosure statement a clause: "Should there be a deficit in the segregated trust accounts and in the unlikely event CMC Markets becomes insolvent before it topped up the segregated trust account in deficit, you will be an unsecured creditor in relation to the balance of the moneys owing to you."

The second-biggest CFD provider, IG Markets, has in its product disclosure document: "Your money may be co-mingled into one or more separate accounts with our other customers' money; we are obliged to pay any money due to you in relation to dealings in CFDs into a separate account; the obligations to you under the Customer Agreement and the CFDs are unsecured obligations, meaning that you are an unsecured creditor of ours."

CFDs allow investors to bet on rises and falls in shares, currency, and indices using borrowed money. To make the model work the provider hedges its own bets by either buying stock in the physical share market or borrowing stock from super funds.

The Australian Securities and Investments Commission website describes them as "much riskier than a flutter on the horses or a night at the casino" because potential losses are unlimited if the bet sours.

Volatility in the Australian stock market in the past four months, triggered by the sub-prime collapse in the US and the collapse or near collapse of brokers including Tricom Securities, Opes Prime and Lift Capital, has prompted renewed concern about the regulator's ability to regulate the CFD market.

Simon Bond, a dealer at ABN AMRO Morgans, said CFDs were an accident waiting to happen.

"So far in 2008 the Australian stock market is littered with the trading corpses of the instant gratificationists. Over the past six months we have spent 80 per cent of our time trying to save people from themselves. Yet people continue to trade from their kitchen tables and take advice from a screen," he said.

"It is baffling to us how smart, educated, wealthy people who already have large investments seem to be intent on trading risky and volatile instruments. For those who do not understand CFDs, options and warrants, these are weapons of mass financial destruction."

One of the biggest share gamblers around, Chris Murphy, famously told online share forum HotCopper last December: "I don't trust CFDs. I own the stock."

CFDs involve borrowing money to bet on share price and foreign exchange movements. But it is far worse than gambling because investors who do not take "stop loss" measures to limit losses can shed much more than the money that they bet.

They allow investors to take long or short positions -- betting securities will rise or fall -- and, unlike futures contracts, have no fixed expiry date or contract size.

ASIC warns that CFDs "are like borrowing to gamble. You take a punt, with borrowed money, on whether a share price or market index will go up or down. You may be able to borrow up to 95 per cent or more of your bet. Because of this borrowing, it's much riskier than a flutter on the horses or a night at the casino. Your losses are potentially unlimited and can far exceed the money you've wagered".

In November, the ASX introduced ASX CFDs to the market. For the ASX, this adds money to its coffers.