Two German researchers recently held a press conference in Frankfurt to announce that the notional value of an entire branch of Germany’s retail derivatives sector had risen 49% in a single year on a 116% surge in volume.
Just over a year ago, those numbers might have gotten lost in the flurry of reports from exchanges posting new record highs surpassing earlier record highs, but Jens Kleine and Markus Venzin of the Steinbeis Research Center for Financial Services announced the numbers in March.
The instruments in question are “Contracts for Difference” (CFDs), which are over-the-counter (OTC), futures-like instruments that originated in the UK nearly a decade ago and spread to Germany in 2005, but have been deemed too risky for retail in the United States (see “Forbidden Fruits,” Futures, December 2007).
Like futures, CFDs offer high leverage and deep liquidity. Unlike futures, they offer flexibility in size but no central clearinghouse and very little in the way of formal regulation. More importantly, they have grown in popularity since last year’s financial implosion, but at the expense of an even more popular instrument called Zertificaten (Certificates), which, like CFDs, offer retail traders leveraged exposure to market risk but without the counterparty guarantees of central clearing.
Issuers of both instruments say the past year has made them stronger, faster, and safer than ever before; and some issuers are even beginning to work with established clearinghouses to offer more counterparty certainty.
THE BIG THREE
Kleine and Venzin analyzed the CFD market on behalf of the CFD Verband (CFD Association), a German trade association launched by three CFD issuers who the researchers say brokered more than 10 million CFD transactions in Germany alone last year and issued CFDs with a notional value just shy of €500 billion, roughly 90% of the German market.
The three issuers — MarketIndex (which was launched by ABN Amro and became a subsidiary of the Royal Bank of Scotland after last year’s restructuring), IG Markets, and CMC Markets — all hail from the United Kingdom. That prompted other CFD issuers active in Germany to question the numbers. Even Harald Patt of Cefdex, another UK broker that has set up shop in Germany, dismissed the Verband as the “Association of British CFD issuers in Germany.”
No one, however, denies that the Big Three dominate CFD trading, not only in Germany but across the Continent and even in Australia.
CFDs vs. CERTIFICATES
Tellingly, CFD volume rose throughout 2008 and surged after the Lehman Brothers implosion, in part because investors were sheltering themselves from volatility, but also because they were fleeing Certificates.
There is no formal definition of either CFDs or Certificates that applies across all regulatory regimes, and neither faces consistent regulatory oversight beyond that which covers the underlying instruments. As a general rule, however, CFDs are more liquid and tradable than are Certificates, which are structured products issued in specific tranches, often offering pay-outs triggered by specific events or price breaches.
CFDs tend to be more flexible and smaller than Certificates, but also tend to have higher fees. Niche players such as CMC-Markets Deutschland dominate the CFD trade, while old guard companies like Goldman Sachs and Dresdner Kleinwort dominate the Certificates markets.
CFD providers contend, or at least imply, that their instruments are safer than are Certificates because CFDs are hedged while Certificates are not.
Specifically, CFD providers act as market-makers and live off of the bid/offer spread, financing charges, and commissions or a combination of all three. In this sense, they are analogous to OTC currency platforms in the United States: their aim is not to be long or short, but to be flat. If their positions don’t balance out, they fix that by hedging themselves in the underlying market or in futures. They also claim to keep customer funds in segregated accounts not commingled with their own money, and mark account balances to market in real time, but neither of these are required by law.
Certificates, on the other hand, are issued in the form of bearer bonds. A company like the dearly departed Lehman Brothers structures a certificate on some underlying risk, and then sells it off in pieces to individuals who are then exposed to the same default risk as any other bond-holder, a fact that many of the 60,000 who bought Certificates issued by Lehman learned the hard way last year.
While volume and open interest in CFDs surged in 2008, volume in Certificates dropped more than 40%. Still, the number of people trading Certificates dwarfs the number who trade CFDs: the Big Three together had just over 36,000 customer accounts in Germany by the end of last year — a 66% increase over the same period in 2007, but little more than half the number of Certificate customers at Lehman alone.
CFDs and Certificates can be offered on anything — from individual shares, to commodities, to currencies — but stock indexes represent the most popular underlying instrument by far, accounting for more than 70% of all CFD volume in 2008.
CLEARING AND SETTLING
The Australian Stock Exchange has been offering exchange-traded CFDs for over a year, but does not provide a central counterparty. As investors become more aware of counterparty risk, however, providers are looking for ways to reassure them and that means looking to clearing and settlement houses to stand behind their products.
The London Stock Exchange (LSE) had announced plans to list CFDs on its platform, with LCH.Clearnet acting as a central counterparty. That plan, however, was shelved in April after LSE decided the costs would not justify the income.
LCH.Clearnet still believes there’s money in the service, and says the platform it developed to support the LSE venture can be used to provide clearing and settling of CFDs to other interested partners. A spokesman says that negotiations with several providers are underway, but would not name names.
Meanwhile, on the Certificates front, Germany’s financial services regulator, the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), in November green-lighted a project launched by Clearstream and Commerzbank called “Secured Certificates” (SCs), with Commerzbank acting as an issuer and Clearstream acting as an independent fiduciary.
Under the scheme, Commerzbank transfers collateral to Clearstream but keeps the economic benefits of the collateral. Clearstream backs the Certificates in case Commerzbank goes under, and that raises the price of the Certificates, whose value generally fluctuates not only with the underlying market, but with the issuer’s credit rating. Commerzbank pays a clearing fee, but hopes to recoup that by selling its Certificates at a higher price, or at the very least winning greater market share.
The initial pilot phase was limited to 25 Certificates and three collateral pools, but other issuers quickly began lining up to offer similar products. Clearstream says it can add an issuer a month through mid-year, with that pace picking up in the second half. At press time, four companies are offering SCs.
Because Certificates are bonds, they are generally overseen by regulatory agencies, but CFDs are barely regulated outside Australia and the United Kingdom.
The Australian Securities and Investments Commission (ASIC) mandates that all sellers of CFDs receive an Australian Financial Services License, and London’s Financial Services Authority (FSA) keeps an eye on the sales practices of CFD issuers, but most Continental regulators take the view that CFDs only fall under their mandate when the underlying instrument is a security. This leaves commodity CFDs virtually unregulated in most of Europe, except by fraud provisions.
In cases where regulators have acted, the focus is usually on suspicion that someone has used CFDs on stocks to manipulate underlying share prices by taking large CFD positions in small companies.
The Sydney newspaper, The Australian, uncovered a pattern of trades last year that sparked an ongoing ASIC investigation into the sector. According to the paper, a CFD dealer called First Prudential bought CFDs through Merrill Lynch in at least 20 small companies on Sept. 30, the last day of the first quarter of the new financial year. This triggered Merrill’s hedging algorithm to buy underlying shares, nearly doubling some prices.
In March of this year, the FSA announced that investors will have to disclose their CFD holdings when their value reaches 3% of a company’s outstanding stock as of June 1.
Issuers, not surprisingly, enjoy the lack of regulation, and want to keep things that way. One method embraced by issuers of both CFDs and Certificates is the formation of national and international trade associations that do double duty as self-regulatory entities.
Only time will tell if such a combination of self-promotion and self-policing can work in this field, or whether the associations will eventually split into trade associations akin to the Futures Industry Association and self-regulatory organizations akin to the National Futures Association.
In Germany, on the CFD front, the Big Three have the CFD Verband, and similar entities are proliferating across the continent. So far, they have been big on promotion but demonstrated little in the way of self-regulation.
On the Certificate side, the Deutscher Derivate Verband (German Derivatives Association, or DDV) has at least set up a certification program for salespeople, and also set up a rating system for Certificates based on each issuer’s credit rating.
The DDV, together with Italy’s Associazione Italiana Certificati e Prodotti di Investimento, Switzerland’s Schweizer Verband für Strukturierte Produkte, and Austria’s Zertifikate Forum Austria formed the European Structured Investment Products Association (ESIPA) last July to lobby for them in Brussels. The Finnish Structured Products Association has observer status in the group and is expected to become a full member later this year, as is France’s Association Francaise des Produits Dérivés de Bourse.
ESIPA aims to create a pan-European code of conduct that will ensure common governing structures and standardization of products, promote transparency, and ultimately lead to a common certification process across the Continent.
TECHNOLOGY MARCHES ON
While Certificate providers continue to court the long-term investor, CFD providers are wooing — and winning — the business of short-term traders, largely by offering more and more tradability.
The latest development is “Direct Market Access,” which more closely mimics the underlying market on which the CFD is based and guarantees users the same spread they would get in the underlying in exchange for a higher commission. Some direct market access programs give users the ability to see buyers and sellers on either side of the execution price.
All providers claim to be working on new products, but are keeping mum on the details. MarketIndex boss Önder Ciftci believes the most productive innovation that Certificate providers can make is to begin offering CFDs, something that even the bland and boring PostBank says it will begin doing soon.