No risk no GAIN

In­vestors are in­creas­ingly turn­ing to­wards spe­cialised fi­nan­cial in­stru­ments, with the CFD mar­ket re­port­edly dou­bling ev­ery year, writes James Dunn

The Weekend Australian - Review - - Wealth -

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

off,

says

Trew,

the

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.

Boom times:

Dan Semm­ler of Mac­quarie Bank ( left) and David Trew of CMC Group

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