CFDs contain risks and trading

1/20/2012 12:40:01 PM

More risk than meets the eye Risk strategies don’t eliminate default There are many risks to trading contract for differences (CFDs), but one that is often overlooked is the choice of the CFD issuer. Says Simon Brown, an independent derivatives trader: “Though most CFD issuers reduce market risk by hedging the exposure of the CFD’s position, the costs of employing that hedge make the [CFD] business less profitable.” CFD issuers employ hedging to protect themselves from adverse market movements. Hedging out the market risk (risk of the asset’s value decreasing as a result of changes in market price) lessens the risk of the issuer defaulting. PSG’s John Vorster explains: “By hedging all our positions and making sure that our market maker is also hedged, we ensure that the only person exposed to the market risk is our client.” As a way of improving their margins CFD issuers might be tempted not to incur the costs of being fully hedged, preferring the option of “netting” instead. When a provider nets its market risk, only a portion (usually the majority) of the market risk is hedged, leaving the unhedged portion exposed to price changes in the market. “I think it’s important that retail investors find out from their providers if they are fully hedging out the [market] risk or simply netting,” says Brown. “The latter leaves a lot more risk on the books of the provider, which could make it more vulnerable to default during periods of high market volatility.” Brett Duncan, head of equity derivatives at Standard Bank, agrees. “At Standard Bank, specifically the CFD franchise, we are in the business of managing risk, not trading it, which is why we largely hedge all of our CFD positions and don’t net off. Fully hedging our positions is one of the ways in which we mitigate market risk.” Apart from Standard Bank, the SA CFD market has a number of issuers. The biggest are Nedbank, Global Trader, IG Markets, PSG and Standard Bank. The onus of sorting through the array of CFD providers and finding the most appropriate ultimately rests with the investor. Says JSE CEO Nicky NewtonKing: “It’s up to the client [investor] to assess the risk of the issuer.” She says that though over-the-counter (OTC) products have their place in the market, the trend worldwide is to ensure that products are traded through an exchange because of the regulatory and transparency advantages. Unlike single stock futures, which trade on the JSE where their settlement is guaranteed through a centralised trading platform, CFDs are unregulated. Investors in CFDs are exposed only to the CFD issuer (counterparty). If it defaults, the CFD becomes worthless. Though counterparty risk can be found in any financial contract, it’s far more pronounced when trading in CFDs. What makes CFDs even more risky is that when a default occurs, the investor’s claim can only be against the issuer. If that issuer can’t meet its liabilities, the investor will have to take the loss. However, when trading on an exchange and the issuer can’t meet its liabilities, the clearing member (highly liquid and well-capitalised SA banks) will absorb the loss. Apart from the immediate clearing member there is a further layer of security. In the event that the immediate clearing member cannot absorb the loss other members are available to step up to the plate. In the example of Cortex, the failed single stock futures provider, when it couldn’t meet its investor liabilities, Absa stepped up as a clearing member, coughing up just over R773m, excluding interest. Though highly unlikely, the only time an investor would have to take a loss is if a material number of clearing members went bust simultaneously. This event is often referred to as systemic risk. Investors might find some comfort in being backed up by a highly capitalised bank, but history has shown that the balance sheet of any institution is only as good as its risk management procedures. Global Traders head of risk Andrew Kinsey agrees. “A strong balance sheet is important but it’s no substitute for risk management. If the past few years have taught us anything, it’s that the size of your balance sheet is only as good as your risk management. “At Global Trader we run an aggressive margining process. If the market moves against the client, we don’t care who you are or how big your portfolio is, you’ll get an intraday margin call.” Which is where the CFD issuer asks the investor to top up his or her investment account with additional cash during the day. This is considered rather aggressive as usually the JSE only consolidates its positions at the end of every day. “We monitor the risk every second, and work on a noexception basis. In that way we protect our business, as well as the other clients,” says Kinsey. “We don’t just sit back from a risk management point of view and rely on the ability of banks to backstop us against defaults. Our risk management is pre-emptive, we monitor all of our clients irrespective of size and when they run into difficulty, we close them out intraday.” CFD issuers employ a number of strategies to ensure that their credit risk is well managed. Some of the techniques include aggressive risk management, counterparty assessments (balance sheet argument) and hedging to safeguard themselves against market risks. While the strategies don’t prevent a default from taking place they can provide early warning signs and, in the event of a default, reduce its impact. The layers of risk should serve as a warning to investors of the dangers that lie within these instruments. Over the past few years retail investors have been lured into these derivative instruments in pursuit of substantial profits. Seduced by the use of leverage, which allows investors to gain exposure to an underlying asset in exchange for paying a small margin of between 5% and 20% of the value of the asset, investors have taken to these products in droves. But with the collapse of well-capitalised banks such as Lehman Brothers, investors not only need to satisfy themselves with the size of their counterparty’s balance sheet, they also need to understand that balance sheets are not a panacea. As for managing risk, a system is good only until the day it fails.

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