No risk no GAIN
Investors are increasingly turning towards specialised financial instruments, with the CFD market reportedly doubling every year, writes James Dunn
IT’S long been a truism of the investment markets that every transaction involves a difference of opinion: for every buyer, there is a seller. Now that difference is tradeable. The instrument that accomplishes this is called a contract for difference ( CFD). CFDs arrived in Australia in March 2002, three years after their introduction in the United Kingdom.
Although no data on CFD turnover and client numbers has been released — providers are not obliged to report their volume, and each plays its cards very close to its chest — they all agree the market is growing quickly.
The market is doubling every year,’’ says Andrew Aitken, director of CFD provider Marketech. There are estimates that there are 50,000 people using CFDs in Australia at the moment. We know from experience that the number has grown very significantly. It’s certainly been very rapid growth.’’
David Trew, managing director of CFD issuer CMC Group, estimates that the CFD market in Australia will turn over more than $ 400 billion in 2007. ‘‘ That’s for a product that first traded in 2002. Back then, when we started, there were only two providers: now there are 20, plus the Australian Securities Exchange ( ASX).’’
Trew says that between 10 and 15 per cent of the volume on the ASX on a daily basis occurs as a result of a CFD trade somewhere in the market. That figure only counts equity CFDs, because with CFDs you can trade products that aren’t available on the ASX.’’
Trew says CFDs offer the cheapest leverage available in the stock market’’. On trades up to $ 10,000, we charge commission of $ 10. Above $ 10,000, it is 0.01 per cent.
‘‘ That’s why we see clients using CFDs instead of margin lending, as well as for selling short and for punting on the market’s direction. They are also proving popular because investors can put in place a guaranteed stop- loss order in the CFD market, which they can’t really do in physical shares.’’
In October, CFD provider Marketech made CFD trading even cheaper, with the launch of a zero- brokerage online trading platform. Marketech makes its profit on the overnight financing charge paid by investors with open long ( buying) positions,
There are three main pricing models for CFDs: market- maker, guaranteed market price and direct market access ( DMA). In the first, the CFD provider acts as principal: it provides a two- way spread, based on the market price, and the clients trade with it. In the second, the price is guaranteed to be the ASX price, as is the case with DMA, which simply refers to the fact that all CFD orders are replicated by the provider placing a corresponding stock order in the underlying market — the provider is hedging client business one- for- one on the ASX.
CFDs are provided by four so- called ‘‘ primary providers’’, who run their business on their own dealing platform: CMC Markets, IG Markets, MF Global ( formerly Man Financial) and Macquarie Bank ( which offers CFDs through Macquarie Prime, its all- in- one service that offers stockbroking, margin lending, stock lending and CFD trading).
There is also a larger group of ‘‘ whitelabel’’ providers, which re- badge another company’s platform ( effectively assigning the risk to a third party). E* Trade, for example, uses the Man Financial platform, and Man Financial is the counter- party to all the trades; Sonray Capital Markets, on the other hand, uses the global CFD platform of Danish bank Saxo. Other white- label providers include Tricom, BrokerOne ( owned by MF Global), Adest Trader, Marketech, WealthWithin, Halifax Futures, GET Futures, Spectrum Live, ProTrader, Tolhurst Noall, GT Financial, VBM Capital, Capital Markets Group, Pacific Investments Group and First Prudential.
Market- maker CMC is considered to dominate market share, accounting for about 50- 60 per cent of transaction volume. Next is considered to be IG Markets, which has two platforms — direct market access plus a market- maker model that guarantees that clients trade at the market price.
Third in the market is considered to be DMA provider MF Global ( including its white- label relationships), and then Macquarie Prime.
Because they allow simple leveraged speculation on the price of shares, indices, commodities and currencies, CFDs have become an enormously popular punting vehicle. But they can also be used as an effective portfolio hedging tool.
CFDs are one of the best products in the market for hedging purposes. The key reasons for that is that there is no set expiry — you can put the hedge on for as long or as short as you like,’’ says Dan Semmler, associate director, equity markets group at direct- market- access CFD provider Macquarie Bank. Whatever your holding is in the underlying share, you just put on an equal and opposite position via the CFD, and that effectively neutralises the share price on your holding.’’
Whereas exchange- traded options ( ETOs), for example, have to be done in 1000- lot parcels, Semmler says that because CFDs have a one- for- one relationship with the stock, the exact amount of shares can be hedged.
‘‘ If you’ve got 11,215 BHP shares you want to hedge, and you want to use options, you’d have to do contracts over 11,000 or 12,000 shares. But with CFDs, you can hedge 11,215 BHP shares.’’
When CFDs kicked
clientele was mainly professional active traders punting the market — speculating on direction. ‘‘ The market has evolved to become a lot more sophisticated, and we’re seeing all sorts of directed and self- directed investors.
About 2004 we started to see clients using CFDs as an alternative to margin loans; and using CFDs for easy access to overseas markets, because they wanted to diversify their portfolios. The difference was that these people were self- directed, with a keen interest in the stock market, but who were not professional traders.’’
By 2005, says Trew, CFD customers started to get interested in education on the product, particularly in learning how to use the stoploss facility. ‘‘ Again, it was the self- directed investor, but not necessarily a trader. It was retail investors, interested in limiting their downside to the market.
Over the last two years, we’ve found more people hedging long- term share positions with CFDs, in order to avoid the capital gains tax ( CGT) implications of having to sell them. We find a lot of people using CFDs in self- managed super funds ( SMSFs), because they can employ leverage in the super fund: a super fund is not allowed to borrow otherwise. A CFD may be used in an SMSF if the investment strategy of the fund envisages the use of hedging mechanisms. An SMSF can’t use CFDs for high- frequency trading but they can for portfolio hedging, if it is used as part of a portfolio hedging — or overseas- markets access — strategy.’’
With the CFD market opening up to new investors, Trew expects it to move more toward advisers advising on how to use the product. ‘‘ We’re starting to see snippets of financial advisers picking up on the benefits of CFDs. This is the next logical step — specialist CFD advisers, showing their clients how to combine a CFD with a guaranteed stop- loss, how to employ leverage in your SMSF, how to create your own mini- hedge fund. And so on,’’ he says.
Gavin White, head of sales at CFD provider City Index, says this increasing sophistication of the use of CFDs is just as important as market volume growth. ‘‘ The market is starting to take advantage of what the real benefits of CFDs are.
Investors — and journalists — have previously focused mostly on leverage as the most important aspect of CFDs, but it’s not: the most important aspect of CFDs stems from the fact that you can go ‘ short’ on individual stocks. Now, for the first time, individual traders can trade and put on strategies that are exactly what the hedge funds and investment bank traders do.’’
White says a perfect example is pairs trading. ‘‘ If people get a recommendation on a stock, they would previously have just bought it. Let’s say Fat Prophets says ‘ Lihir Gold is the well- run gold company, and we rate it a buy’. Usually, individuals who subscribe to Fat Prophets would react to that recommendation just by buying Lihir. We don’t think that’s the right thing to do, and it’s certainly not the way that hedge funds or investment banks would trade. They would look to buy Lihir and simultaneously to sell a gold producer that they thought was likely to under- perform.’’
An investor who expresses a positive view on a gold stock takes on at least three kinds of risk, says White: the company risk — all of the issues such as mine life and hedging policy that are specific to that company — as well as the systemic stock market risk and the commodity risk.
If you buy Lihir and the whole market goes down, you’re going to lose money. If you buy Lihir and gold goes down, you’re going to lose money, regardless of whether the opinion on the stock is right or not. But if you took a long CFD position on Lihir and simultaneously entered a short position on, say, Bolnisi Gold, you’re covering both sides.
You’re getting rid of the market risk, because if the market goes up, Lihir will outperform the other stock and you’ll make money; but if the market goes down, Lihir will outperform — that is, it won’t go down as far, and you’ll make money. If gold goes up, again Lihir will outperform, and you’ll make money on your long Lihir position/ short Bolnisi. You can do that with CFDs, for the first time ever,’’ says White.
Dan Semmler of Macquarie Bank ( left) and David Trew of CMC Group