RR Phantom
Location : Wasted Space
Job/hobbies : Cayman Islands Actuary
 |  Subject: Can derivatives traders win? Or are they bound to be swallowed alive?  Sat Aug 28, 2010 3:17 am | |
| Can derivatives traders win? Or are they bound to be swallowed alive?
Suicide attempts. Threats of assault by distressed investors. Debt collectors pushing investors towards bankruptcy. It is hardly the promise of wealth and success offered by providers of contracts for difference (CFDs), as they target ''investors'' through glossy magazine advertisements, newspaper supplements, prime-time television spots and slick websites.
The reality is the courts are teeming with bankruptcy applications from providers against clients. Weekend Business can reveal Australia's largest provider, IG Markets, has been racking up an average of one bankruptcy application a month against its investors since 2007. Add the other big player, CMC Markets, and its debt collection efforts, not easily
traced in the courts, would lift the rate of investors threatened with bankruptcy substantially.
Weekend Business can reveal the aggressive recovery actions are the unadvertised flip side of some providers' business models, part of which is based on profits made from investor losses (see breakout).
In the case of the country's second biggest CFD provider, CMC, internal company documents and extensive interviews show that until recently it operated like an unscrupulous casino: identifying the least savvy investors; acting to capture their losses and using mechanisms to manipulate win rates.
As a sign of just how badly stacked the odds are, these unsophisticated investors are referred to as ''cat's meat'' by some industry participants. The providers make their money luring the unsophistic-ated to trade products that are banned in the US and are considered by the corporate regulator as ''much riskier than a flutter on the horses or a night at the casino'' because potential losses are unlimited.
Within the industry, these unsophisticated investors have an average financial survival rate of two months. They are then churned for the next batch of investors willing to use their credit card to leverage their investments to the hilt. Players are sucked in using prime-time television spots and Chinese-language marketing material. Little
wonder at least one burned investor has branded them ''contracts for dickheads''.
Comparisons between providers and casinos are not made lightly. In Britain, the products are known as ''spread betting'' as recognition it is nothing more than gambling.
Threatened bankruptcies arise because investors lose more money than they put in. CFDs are sophisticated derivatives that bet on future movements of stock prices, markets or commodities. Using debt that magnifies initial investments by up to 100 times, a small move in underlying units can convert into big gains - or big losses - for an investor.
In the case of IG Markets, in the Federal Magistrates court alone there have been 29 bankruptcy proceedings filed against clients since 2007, and another four in the county court in Victoria. There are other CFD providers that use similar threats but instead of using in-house lawyers they outsource it, making it more difficult to track in the courts.
The IG Markets in-house lawyer and director Peter Richards played down the technique as a way to make clients pay back owed money. Of all the applications, only four or five resulted in bankruptcy, he said. ''Of those four or five, without exception they had other debts - we were not the only creditor,'' Mr Richards said.
He said the average debt was about $8000, but he confirmed there were some ''big'' debts. ''We have to [issue these proceedings] in some cases. It isn't pleasant and we have systems in place now so these debts will never arise.''
IG has more than 20,000 clients in Australia, with less than 10,000 described as ''active'' traders. Mr Richards said over the years there had been no threats of suicide or a move by IG to sell up somebody's home.
Sources close to another CFD provider said over the years there have been cases of attempted suicide, including a 21-year-old Chinese student who invested in CFDs thinking they were shares. When he found out he owed tens of thousands of dollars to the CFD provider, his parents agreed to sell their house to cover his losses. The guilt and shame of what he had done to his elderly parents resulted in a suicide attempt.
CMC Markets Group's Australian annual report for 2010 released this week showed $2.6 million was more than 90 days overdue from CFD traders. It's not a small amount in a business that reported an overall annual loss of $4.6 million.
There is at least one case of threats of physical violence, with CMC taking out an apprehended violence order against one client after numerous phone calls, which were followed by two visits to CMC's offices and threats to staff.
Hard luck stories abound. Simon Bond, a principal at RBS Morgans, said CFDs were an accident waiting to happen. ''The investment landscape is littered with the carcasses of get-rich individuals who think there is a short cut to wealth. I have been a stockbroker for 24 years and I don't understand the risks, so how is the average punter supposed to?''
Mr Bond said he had a number of clients who went off and invested in CFDs only to get blown up. ''One guy rang me up and he wanted to buy CFDs in BHP. He was in the food business and wanted to make extra money. I told him it was a bad idea but he didn't listen. A week later he rang me and said he put money into CFDs and now they kept ringing him to put more money in. He didn't and he ended up losing all his money. He said CFDs are 'contracts for dickheads.' ''
Jim Taig, the managing director of a business called Seismo which provides training for CFD traders with an emphasis on risk management, is critical of an industry practice of opening accounts on credit cards.
''These CFD account practices have attracted people with too few funds and expose them to risks far beyond their level of understanding or the amount of investment capital they have available,'' Taig says.
''CFD traders should not be allowed to open a CFD account on their credit card. Leverage on credit has been a recipe for disaster for thousands already.''
He remains a fan of CFDs, describing them as a ''fantastic product'', but he also raises questions about the ability of some providers to profit from investors' losses.
Profit from investors' losses has been achieved in the past by detailed customer profiling among some providers. At its crudest, the profiling determined how much customers would lose and the provider could win.
It is a well-kept industry secret that Australia's second largest provider, CMC Markets, profiled its customers and placed them into several different groups, including the A-book, the B-book and the C-book.
According to a document previously used within CMC, the C-book was a ''classification for clients with a past history of excessive loss on their account and the propensity to churn their Australian equity-only positions''.
People with knowledge of CMC's Australian operations said CMC did not hedge the C-book, which meant every time a C-book customer lost money, CMC made money.
''Hedging'' is a fancy way of saying a company attempts to lay off its risk from individual trades. What CMC was doing was identifying a C-book risk that it wanted to take, because it was pretty sure investors would lose their money.
In response to Weekend Business questions about customer profiling, CMC Markets referred to its latest British annual report showing it had decided to ''transition'' its hedging strategies last year.
The report said CMC had previously operated with ''minimal customer hedging'' up to June 30 last year - meaning it was prepared to bet more customers in this unhedged portion would lose than win.
(The fact CMC was substantially unhedged until recently raises another concern about the providers. Many providers use a similar model to that of the collapsed stockbroker Opes Prime, which leaves its clients as unsecured creditors if the business fails. Investors in CFDs were caught out by the collapses of Sonray and Geelong firm Chartwell. An unhedged provider is inherently more risky than a hedged provider.)
Now CMC has a target of hedging 90 per cent of its book, meaning it cannot profit from investor losses in the hedged portion.
A spokeswoman said there was no client profiling to determine the 10 per cent that is unhedged. ''This process is completely client neutral and all of our clients receive the same quality of pricing, liquidity and service.''
But it remains a fact that net customer losses in the unhedged 10 per cent (or more) accrue directly to the benefit of CMC Markets. Profits are also harvested through clauses in providers' product disclosure statements that give them opportunities to change the goalposts at will.
CMC Markets has the discretion to change a bid price or offer price; withhold any payments; close accounts, change margins and requote prices. This can result in clients feeling that if they are making too much money, the CFD provider has the discretion to change the price to reduce the win.
In CMC's product disclosure statement, it says: ''You expressly agree that we are not under any obligation to exercise any discretion in your interests or for your benefit.''
Not even stop-loss orders protect clients. They are supposed to put a floor on how much an investor can lose. But buried deep in some disclosure statements are clauses that say that a stop-loss is not guaranteed unless it is paid for - and the cost is exorbitant.
The traditional stop-loss on an account may not be triggered if there is too much volatility or the stock is illiquid. The upshot is clients might think they are protected but can end up losing their shirt. And many have.
After the collapse of CFD provider Sonray in June, ASIC released a regulatory guide relating to CFDs and called for better disclosure in product disclosure statements. It threatened harsh new regulation if the industry failed to improve standards.
The ASIC commissioner, Greg Medcraft, says it would be immoral and unethical if providers were relying on dumb or inexperienced customers to deliberately profit from their misfortunes.
But - given net unhedged customer losses translate directly to some providers' gains - this is part and parcel of some providers' business models.
And Weekend Business's investigations reveal, to the surprise of ASIC, the pre-meditated nature of how CMC Markets profited from the least able by using the C-Book category.
CMC went to some lengths to hide its profiling from its customers, stating in the document obtained by Weekend Business: ''IT IS ESPECIALLY IMPORTANT THAT NONE OF THE INFORMATION IN THIS SECTION IS RELAYED TO CLIENTS.''
Mr Medcraft said he was unaware profiling practices existed within providers.
''I have no problem with people buying complex products who know what they are buying, but I have a real problem with selling to, if you want, dumb investors. I consider that immoral and unethical,'' he says.
But he does not agree with the proposition that a provider driven by profits based on customer losses has an extra incentive to dud its customers. Instead he says the answers currently being pursued by ASIC include better screening tests before providers accept clients and better disclosure.
ASIC recently put out a regulatory guide on client money relating to over-the-counter securities, including CFDs, and another report found deficiencies in providers' product disclosure statements.
But it is yet to crack down on their opaque financial structures and models based on client money being co-mingled with other client money under the one account.
IG Markets stands with CMC Markets as the two biggest providers using a ''market maker'' model that allows them to profit from investor losses.
The chief executive of IG Markets, Tamas Szabo, said it was unlikely his business would be 100 per cent hedged, because some clients' trades would be set off against each other, creating what is known as a ''natural hedge''.
He said his business profiled clients to the extent high net worth clients were identified, but he denied IG Markets deliberately set hedging policies to profit from customer losses. ''Quite frankly, it's unethical. No company should aim to see clients lose money to their [the company's] advantage,'' he said.
''It's an unsustainable business model … no provider should do that. I have heard rumours of people doing that.''
They are not just rumours any more.
What ASIC and the broader investment community has failed to understand is that some providers are profiting from losses.
Those losses translate into debts owed to those providers, leading to swift recovery actions and the previously-mentioned bankruptcy applications.
In the past some providers have deliberately structured their business to capture those losses. And the ability (and the imperative) to profit from those losses still remains inside some providers' business models.
Don't expect to see that in a provider's product disclosure statement any time soon.
ANCAPS: ANARCHO-CAPITALISTS |
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