Your Money Magazine has put questions to Deloitte, the administrator of MF Global Australia, MF Global Securities Australia and Brokerone, but has not as yet received a response.
ASIC spokesperson, Matthew Abbott says the corporate regulator has met with the administrators of MF Global.
“They are taking immediate steps to protect client interests by locking down the available assets. We have also been working with ASX to ensure the orderly unwinding of futures positions,” says Abbott.
“We are advised that proceeds of any clients' futures and CFD position close-outs will be put into trust accounts for dispersal once the administrator has reconciled positions and funds,” he says.
“The collapse of a market participant is a serious occurrence. ASIC's focus is the integrity of the market and we are working with all parties to ensure an orderly and timely progress of this matter.”
A small number of ANZ (e-Trade) and Westpac clients may also be impacted as they have MF Global as a counter-party.
He says the collapse of MF Global highlights the wider issues of client monies and counter-party risk.
“ASIC has issued a number of reports that urges CFD providers to lift their game and ensure retail investors are aware of the risks of trading CFDs – and this includes counter-party risk and how CFD providers treat client money.”
If you’re an investor
The Deloitte Partners Australian website currently urges investors affected to contact their broker or adviser. A dedicated email address is also being established for affected clients firstname.lastname@example.org.
Deloitte says it will take some time to unwind the complex operations of the three companies but it reports starting to send notices to clients from 2 November in relation to the close out of their trading positions.
The MF Global website appears unchanged.
How it happened
The Australian situation is a direct result of the collapse of MF Global believed to be caused by MFG holding $6 billion in Spanish and Italian debt. It announced a $US198 million loss recently, prompting ratings agencies to downgrade the company to ‘junk’, which caused its share price to collapse.
What do you need to know about CFDs?
The leveraged nature of CFDs can make them a great way to make money in rising and falling markets, but they’re for sophisticated, experienced investors only as the potential losses can be huge.
They’ve been advertised on daytime TV, websites and in free seminars as a great way to make money on rising and falling markets. The sales pitch is that contracts for difference or CFDs let you trade, diversify and hedge, all from the one account.
CFDs do give you access to trading opportunities in up or down markets. Some CFD providers have access to up to 2,900 markets including shares, indices and currencies, 24-hours a day and 5.5 days a week. Their best attribute is that they give Australian investors access to international markets and a chance to diversify their investment portfolios.
But they are for sophisticated, experienced investors only. So if you’ve seen the ads and been tempted to sign up for a trial period, here’s what you need to know about the ups and downs of contracts for difference.
What are they?
Contracts for difference are derivatives. The definition of a derivative is a financial instrument that “derives” its value from the value of another asset (a share, commodity or market index).
A CFD is an agreement between a buyer and a seller to exchange the difference in value of a contract, between when the contract is open and when it is closed. The difference is determined by reference to an underlying instrument, such as a share, index or currency.
Because CFDs are leveraged instruments, they increase your buying power. For a low initial margin, you can gain much greater market exposure from your funds.
Trading in CFDs involves taking a position on the change in the value of the underlying asset over time. You don’t ever own that asset but take a bet on whether its value will go up or down over the contract period compared to what it was when the contract was taken out.
CFDs are complex and speculative but they’re actually less complicated and easier to trade than most other derivatives. You only need to put forward a small percentage of the actual market value of the underlying asset, the contract provider covers the rest. Gains or losses will, however, be calculated as if you paid 100% of the market value.
If, for example, you purchase an ASX Listed CFD, you will be fully exposed to the price movements of the ASX without having to pay the full price of the contract.
This is one of the main attractions of CFDs. The investor may not have enough money to purchase the actual underlying asset but for a much smaller outlay they can share in gains (or losses) based on its whole market value.
The clincher is that gains and losses are both magnified. You’re relying on leverage – the percentage of the market value that the investor doesn’t put forward is really like borrowed money. You can end up losing much more money than you started with.
That means it is very important to understand both the upside and the downside of the risk.
The long and short of it
CFDs enable you to trade both rising and falling markets, or from both the long and the short side.
When trading shares, the investor buys first and sells later with the aim of making a profit from upward movement in the share price. With CFDs it is possible to sell first, called going short, to exploit falling prices and buy back later.
- If you take a long (bought) position, you are anticipating a rise in the value of the underlying instrument. If the value fell during the contract period, you would lose money.
- If you take a short (sold) position you are anticipating a fall in the value of the underlying instrument. If the value actually rose, you would lose money.
The problem is that it is difficult for even the most expert, professional investment manager to predict market movements, particularly over the short term.
Unexpected world events, new company information, government policy, changes in market conditions can all influence short-term market movements. And even short-term changes in the value of the underlying asset can have a huge impact on the outcome of a CFD.
The initial ‘margin’ you are required to put forward to enter a CFD will vary depending on the provider. Some providers require as little as 0.8% of the total market value of the underlying instrument. However, your gains or losses over the life of the contract will be calculated as if you paid 100%.
The initial margin will usually be taken out of your account when the provider places your trade.
Different providers will have different margins for the same underlying assets but the smallest margin is not necessarily the best.
The investor is still responsible for the full face value of trades made so paying a small upfront margin may mean even a small price fluctuation could result in a margin call. This occurs when a provider requires the investor to provide further cash to keep the trade open.
The provider will either withdraw funds from the client’s account to cover this margin call, require the client to deposit more money, usually on the same day, or close the trade, sometimes without notification. In which case you will have to cover losses.
Understand the asset
Before even thinking about how the actual contract for difference works, make sure you understand the underlying asset that the price of the contract will be based on. According to ASIC this can also be called the underlying security or reference asset. This is usually shares but it can also be commodities and foreign exchange.
So before becoming a CFD trader it is essential to get some experience in trading or investing in the underlying asset or at least studying how the underlying market works, the factors that influence price movements (up and down) in that market, before you decide what position to take on a CFD.
Some of the CFDs currently available to Australian investors include:
- Australian dollar versus US dollar, New Zealand dollar and a range of other currencies
- Movements in a certain market index, such as the ASX 100 which aggregates price movements of the top 100 stocks listed on the Australian Stock Exchange. To achieve a positive outcome from such a CFD you need to well-versed in the behaviour of that particular index along with each of the individual stocks that it is comprised of.
- Movements in the value of a certain commodity, such as the gold price.
- Movements in the price of individual shares
Understand the risks
Like any other derivative, foreign exchange contract or leveraged investment, CFDs can carry a high level of risk and may not be suitable for all investors.
It is possible to lose substantially more than your initial deposit and that’s even before considering the counter-party risk involved if a provider goes broke.
You don’t own or have rights to the underlying asset.
- Unlimited losses: you are potentially putting very high amounts of your own money at risk.
- Margin calls: if changes in market value have a negative effect on your trade, the CFD provider can demand that you put more money in at short notice to cover the change and keep your trade open. If you can’t meet this margin call you may have to complete the trade at a loss or the CFD provider may close out your trades at a loss without consulting you.
- Counterparty risk: when entering a contract with a CFD provider you are assuming they can meet their financial obligations to you. It’s not always easy to assess this counter-party risk as some CFD providers are boutique operations. You need to be confident the CFD provider will accept your trades, credit any gains to your CFD account after the closing of a position and transferring them to your bank account when you request they do so. Read Product Disclosure Statements carefully and shop around to find the right provider.
- Tracking differences: although the value of the CFD is based on the value of an underlying instrument it may not track that instrument’s value exactly and small variations between the price of the contract and the value of the asset can make a huge difference to your outcomes.
- Fees and interest: these are in addition to brokerage charged on each trade and can make a big difference to outcomes. Again, shop around for the best over-the-counter provider. Traders will incur interest for long positions kept open overnight, which adds to the cost of trades. Fees can also apply for access to research and information available on CFD trading platforms. These may be incorporated in brokerage and/or platform fees if you maintain a particular monthly trade volume.
Choose the right provider
CFDs must be gaining traction in the Australian marketplace if the number of global specialists opening shop here is any indication. Our own securities exchange, the ASX offers its own exchange-traded CFDs. They may be a safer bet when it comes to counterparty risk.
If you are intending to use an over-the-counter CFD provider, check out their financial statements (if available), make sure you are dealing with a substantial company.
You need to be convinced that boutique operators have the financial backing to accept and process trades, make payments owed to you while trades are open and credit proceeds of profitable trades to you and pay money out of your CFD trading account when you ask for it.
Find out what the provider intends to do with your money. Some CFD providers hedge your trades with other companies. If you place a CFD trade over a share or index, for instance, the CFD provider might take corresponding arrangements with another company to get exposure to that underlying asset. If the other party doesn’t deliver on their contract obligations, your CFD provider may close trades without warning or be unable to pay profits. On the other hand if a provider has hedging arrangements with several other companies with strong financial standing this can reduce their internal risks.
According to ASIC, most OTC providers pool clients’ money into one or more accounts. Some customer agreements enable the provider to take money out of these accounts and use it for a wide range of purposes. If your money is pooled in this way the actions and failures of other clients can also have an impact on the security of your own funds.
Understand the structure
There are three CFD ‘business models’ available in Australia. This determines how a CFD is structured and priced.
- Market makers: the CFD provider makes up their own price for the underlying asset. CFDs are traded directly between clients. Prices may or may not correspond directly with the underlying asset’s market price. More CFDs available because trades are not dependent on liquidity. Terms and conditions set by the provider.
- Direct market access: the CFD provider places orders into the market for the underlying asset and the price paid will be determined by the underlying market. CFDs traded directly between clients. Price corresponds with price of underlying asset. Less CFDs available because only available over assets with sufficient trading volume. Terms and conditions set by the provider.
- Exchange-traded: you are trading CFDs that are listed on the ASX and can only be traded through brokers authorised to trade these CFDs. Unique to Australia as CDFs are traded on the exchange and terms and conditions are standardised by the ASX. Client needs to open an account with a broker authorised to trade these CFDs, visit www.asx.com.au for more information.
Some providers offer both market-maker and direct market CFDs so ensure you understand which one you are trading.
Only trade CFDs if you already have extensive trading experience and understand derivatives like options and futures. Don’t start if you are risk averse or don’t have experience in volatile market conditions. And finally, CFDs are only appropriate for investors who can afford to lose all of the money they put in and more.
Get educated before starting to trade. Go to seminars, study underlying markets and be sure you can answer yes to the following questions:
- I have extensive share trading experience
- I understand the differences between investing in shares and trading CFDs
- Trading CFDs fit in with my investment goals
- I am willing to accept high levels of investment risk and I am confortable with volatile markets
- I am only going to invest a small percentage of my overall investment portfolio in CFDs
- I have access to additional funds if trades go badly and I have to meet margin calls or cover losses.
- I have plenty of time to devote to monitoring and managing trades
- I have shopped around and compared providers. I have read and understand their product disclosure statements
Go into trial offers for model portfolios and “no loss” periods with your eyes wide open. Don’t feel pressured into taking the next step of trading using your own money. Only establish an account with a CFD provider if you are confident you understand the product and risks involved and have strategies in place to cope with those risks.
Mind the gap
One of the main risks associated with trading CFDs is known as “gapping”. Market prices can move quickly and skip price points. For example, if a share price moves from $2.54 to $2.50 without trading at any of the prices in between, what will happen if you have an order to sell a CFD when the share price is $2.52? The order can only be executed at $2.50 or not at all.
There can also be a lag between when you place an order and when it is executed. If the market moves during that time lag, the trade could be executed at a worse price to when the order was made.