Competition among financial spread betting companies grows ever more intense. But some firms' willingness to take on more proprietary risk worries established players, and the threat of tighter regulation looms over the industry. By Navroz Patel
In 1974, Stuart Wheeler, a former barrister, launched Investors Gold, the first financial bookmaker, from his home, with just £30,000. Thirty years on, IG Group, as the firm is now known, is a constituent of the FTSE 250 index and has a market capitalisation of nearly £655 million.
"We now offer products that allow you to bet on almost anything you can think of," says Will Armitage, senior quoting dealer at IG Index, IG's financial spread betting bookmaker. "And to think, it all began with a somewhat eccentric old Etonian who wanted to allow punters to bet on the price of gold."
Volumes have surged on the back of growth in financial gambling alongside the use of spread betting as a bona fide hedging tool among sophisticated retail investors. Larger firms such as IG can handle hundreds of thousands of transactions during a single month.
Keen for a slice of the action, a number of cash and derivatives brokers have also set up financial spread betting desks over the past few years. For example, London-based financial services firm Man Group launched Man Spread Trading (MST) in September 2003. MST is a division of Man Financial, the brokerage arm of Man. A steady profit stream can be had from financial bookmaking, while using similar infrastructure and expertise to that which you find at a brokerage, making it a good complement to more profitable, but potentially volatile, revenues such as those associated with alternative asset management, says David Morrison, head of desk at MST.
Meanwhile, London-based GFT Global Markets UK launched spread betting, contracts for difference (CFDs) and spot forex trading services at the end of June. "We will quote in all markets," says Martin Slaney, head of spread betting at GFT in London. "Obviously, during the past 12 months, spread betting on currencies has thrived given the volatility in many pairs," he says, pointing to foreign exchange as an asset class where the firm will have a particular strength. GFT is a subsidiary of Global Futures & Forex, a US-based dealer.
Alongside the new and sophisticated players, smaller independent companies have sprung up too. "It seems almost every week a new rival - a new bucket shop, some might say - enters the market-place," says IG's Armitage.
A common gripe about some firms is that it is not uncommon for a punter on a prolonged winning streak to have their account closed down after a while. Some bookies are also wary of clients who use automated day-trading computer programmes. And even bookies who gamble in their spare time are not immune to such treatment. "I had an account closed at another firm after just two weeks because I was winning," says IG's Armitage.
With the benefit of hindsight, the firm in question, which Armitage declined to name, might have made a different decision regarding whether or not to maintain the IG bookie's account. "I lost a fortune last month after being stopped out of a bet," admits Armitage.
Stop losses are the typical way punters limit their downside risk on spread bets. Many firms strongly encourage their customers to use stop losses; the two most commonplace forms are the classic stop order, which closes out a position if a price drops or rises beyond a specified level, and a trailing stop order, where the stop is defined more dynamically. Armitage says around 90% of IG Index's clients have stop losses in place.
Competition among firms has led to severe margin compression. Currency trades, for example, now often have a bid-offer spread of just three points, while the spread on FTSE-related bets might be just two points. Firms are therefore trying to differentiate themselves from their competitors by other means - by improving their electronic platforms, or by offering a wider range of instruments.
For example, many firms have traditionally refused to make markets in the shares of companies with small market capitalisations, as it can be difficult for them to lay off the risk. Lower limits have typically been anywhere between £50 million and £200 million. Man is one of the firms carving out a niche in the small-cap space. "We can go down to much lower capitalisations as we are able to hedge client business quickly and efficiently with our in-house CFD provider, which offers CFDs on stocks down to £6 million market cap," says Man's Morrison.
IG, meanwhile, is seeing some client demand in another area where competition is less intense - namely derivatives. "We have seen some activity in spread betting on options - outright punts and also hedging and some call-overwriting," says Armitage. By way of example, a UK-based professional footballer who has an account with IG recently put on what Armitage describes as a fairly complex trade involving spread bets on eurodollar interest rate futures and options. He declined to name the football player, citing client confidentiality. "What I can say is that he's Scandinavian - it would be hard to imagine one of the England players doing something similar, wouldn't it?"
Although clients are increasingly trading different underlyings, most continue to focus on equities, currencies and to a lesser extent, interest rates. Firms are loath to disclose spread betting volume figures, but one of the leading bookies says that on a very busy day - for example, around the time of a major US economic release, such as the monthly payroll figures - it can turn over 500 bets per minute during peak activity.
"Spreads have been driven down and down in the most actively bet-on markets - it's difficult to see how they can get much lower," says Man's Morrison. "Some newer firms have entered the market quite aggressively with tighter spreads and lower margin. One way some of these firms cut costs is by hedging less and taking a lot more proprietary risk." MST's business model, according to Morrison, is to take very little proprietary risk - the firm hedges "almost everything", he says.
IG doesn't hedge everything, but "doesn't sit back and do nothing" either, says Armitage. It runs limits in every market it quotes - typically in terms of volumes and volatility - and has a risk committee. When other firms undercut its spreads, IG Index will often match them, to "try and squeeze them out", as Armitage puts it. "By cutting spreads and not hedging, other firms are playing a dangerous game. When times are good it can be fine, but when the herd (of punters) gets it right, as they occasionally do, it can be very painful," he cautions.
However, since the release of a regulatory discussion paper in May, a challenge beyond their own control has been causing firms great worry. The culprit comes in the unlikely form of the UK Financial Conduct Authority (FCA) and its efforts surrounding the European Union's Markets in Financial Instruments Directive (Mifid), due to go into effect on November 1, 2007. Separately, the FCA has also recently been involved in another spread betting controversy regarding allegations of market abuse (see box).
An important part of new legislation relates to best execution and the use of benchmarking to achieve it. UK spread betting firms currently have a waiver from best execution rules, but according to the FCA this won't continue post-Mifid. "As things stand, there's not any debate on whether spread betting firms will be subject to best execution," an FCA spokesman told Risk. "The only question is about how that should be delivered ahead of the release of our October paper on Mifid."
The bottom line of the FCA's suggested benchmarking method for spread betting firms is that clients "should not receive a price that is in any way less favourable than if the firm were to acquire the underlying financial instruments seeking to obtain the best possible result on a consistent basis", the FCA says.
According to GFT's Slaney, it would be difficult in practice to implement a benchmarking approach, and any attempt to do so will stifle the industry's creativity. "Someone could come to us today and request a spread bet on a one-week FTSE future and we could start to offer that pretty quickly," he says. "If we were subject to a benchmarking requirement, we wouldn't be able to offer such a product."
IG Index's Armitage is similarly peeved. "When the FTSE is out-of-hours, we make prices to enable clients to close out whenever they want," he says. "How are we supposed to go about our traditional business against the background of the new best execution rules?" According to GFT's Slaney, some of the industry's most popular products - such as bets on the cash market of an index where there is no two-way underlying market - would have their continued existence threatened by the implementation of Mifid.
Clients appreciate that firms make their own prices, says Slaney. "I would hope Mifid eventually recognises too that spread betting firms are a separate kind of entity."
I have just finished reading a report recently that Hargreaves Lansdown have decided to enter the spread betting and CFD world after signing an agreement with IG.
The two media reports I have read have lamented over how such a responsible investment house such as Hargreaves Lansdown could compromise their clients by offering them leveraged trading.
"What baffles me is the underlying assumption that spread betting is some kind of poison seeping in the gutters of the investment industry."
One chap commented thus on a story carried in Money Marketing, "so Hargreaves Lansdown don't like structured products but they are willing to take a financial 'cut' and let people lose money with IG off CFDs and spread betting (gambling with a fancy name)."
Simon English in the London Evening Standard reports, "How long will it be before Hargreaves clients that were avid investors in simple ISAS and SIPPs decide to dabble in something they don't understand and lose a fortune? How long before one of those cases ends up in the personal finances pages accompanied by a picture of the victim's tearful grandchildren."
What a load of tripe.
What baffles me is the underlying assumption that spread betting is some kind of poison seeping in the gutters of the investment industry.
What also baffles me is how English calls Hargreaves clients 'avid investors' in one breath, and yet in his next, suggests they will lose their fortunes in a new and ill-understood investment!
If these people are so well informed then I am sure they will have heard of, or even experienced, spread betting and CFD trading as a form of investment.
I believe we should give the good clients at Hargreaves Lansdown more credit than they are currently being afforded.
Anyone willing to invest their fortunes in ISAS and SIPPs are already showing a certain form of risk profile, and it is exactly because of that that I believe they will take a sober approach to this spread betting offer.
Spread betting, when done properly, is highly rewarding. Give the Hargreaves investors a chance - they could yet prove spread betting is not gambling with a fancy name.
Spread betting firms are also attracting a lot of foreign interest, particularly from Europe, and also from Australia, which in turn is becoming the base of choice for establishing offices to spearhead expansion into the Far East, with its time zone fit, and lack of language barrier. Another hot spot is Dubai where the property and equity markets have boomed. Overseas investors show signs of following the UK pattern, still predominately trading indices and main markets like the US.
Chris Spark at Finspreads, said: "The internet has really made it easier for expats. It cuts down on paperwork and saves time. The international market is really in its infancy but its growth is a formality rather than a possibility."
But is it possible for expatriates to use a British spread-betting company?
The rules are pretty murky for those outside the UK. Spread-betting within the UK is exempt from capital gains tax or stamp duty, like other forms of betting. Abroad, the rules governing spread-betting differ depending on which country you live in and which country you pay tax in.
Vincent Stanzione, a spread-betting expert, said: "There's no problem in opening an account from abroad, but expats have to check with their local authorities as to what taxes will apply to them."
The brief answer is no, but real events some time ago involving the Spaniard and the Plumber have raised the question.
The story in brief: The Spaniard (a broker by the name of Nigel Howe) put a £5 million spread bet on a company on behalf of an associate the Plumber who happened to be a major shareholder in the company the bet was placed on. The company, Cyprotex, was a private company which was just about to float on AIM, and was trying to raise £11 million.
The bet was so large the risk had to be laid off under the contract CityIndex would have had to pay the Plumber £170,000 for every penny the price rose above the 29p floatation price. City Index laid off the risk with a contract for difference (which is in essence a spread bet), the counterparty to which was a German owned investment bank. The bank, in turn, used its cash to buy shares outright in Cyprotex 80% of the company for some £5.16 million the aim of which was to hedge their own exposure to the Contract for Difference. Thus, if the share price of Cyprotex went up the money that the bank pays to City Index would have been matched by a corresponding profit that the bank would have made on the increase of share price. Oh, and just to complicate matters further, the Spaniard was Cyprotex's broker.
Sounds dodgy? Well, whether it was or it wasn't and the noms de guerre, The Spaniard and The Plumber hardly helped the impression that it was got the spread betting industry worried. Here they are spending fortunes on advertising and marketing campaigns designed to project them as respectable alternative to the City's more traditional markets and then along comes a story that creates precisely the opposite impression. Should retail traders be concerned? Specifically, is there anything about the story that should concern them about spread betting specifically? There are a number of reasons for thinking not.
First, the issues raised by what the Spaniard and the Plumber were or were not up to are in City terms age old. And they're not confined to the spread betting market. Second, although there have been claims that events show that somehow financial spread betting is under-regulated, in fact the FCA picked up on the whole affair very quickly and, at the time of writing, investigations are ongoing.
The story got big for two reasons it seems. First, the relatively large sums of money involved (although in City terms they're not that large) but, most importantly because of the use of a spread bet to try and achieve whatever the Spaniard and the Plumber were trying to achieve. Why should this be?
Subconsciously there seems to be a feeling that whilst buying and selling shares is ethically acceptable, betting is somehow morally reprehensible. But how true is this? You buy a share because you believe that the price will rise and you will make a profit. You bet on a share price for exactly the same reason - except, of course, with spread betting you need less ready cash to get your exposure to price movements, the costs are lower (for example, there's no stamp duty to pay), and you can profit from a share price falling too.
Unfortunately, the very word "bet" has connotations - connotations which seemed to be confirmed by the Cyprotex affair. The Oxford English Dictionary definition of a bet is: to "Risk one's money etc. against another's on result of doubtful event". The use of the word doubtful gives the game away. A more apposite word is, uncertain. But even in the Oxford English Dictionary you can't escape a hint of censoriousness. This is not to say spread betting isn't risky. It is, and what's more, because of the dangers inherent in geared investments, it's, undeniably more risky than simply buying shares. But what it isn't in any way suspect or morally dubious.
In May, a UK Financial Services and Markets Tribunal decision held that two people the Financial Conduct Authority (FCA) had claimed engaged in market abuse, and subsequently fined, were not guilty of violating FCA regulations. At the heart of the case was a large spread bet placed by Paul Davidson, a majority (35%) shareowner of Cyprotex - a UK-based drugs research company - prior to the company's listing on the UK Alternative Investment Market in February 2002.
The FCA had alleged that Davidson, who goes by the sobriquet 'The Plumber', used a £5 million spread bet on Cyprotex with City Index to help support the issue's placing, and that amounted to market abuse. The regulator had argued that Davidson knew that the size of the bet would require City Index to hedge itself with a dealer via a contract for difference (CFD) transacted with a dealer, and that the dealer would have to hedge the CFD with a purchase of Cyprotex's shares - therefore ensuring the offering would do well.
On October 23, 2003, the FCA had fined Davidson £750,000, alongside two others, claiming the spread bet and related transactions amounted to arrangements that "gave a false and misleading impression as to the demand for, or the value of, the shares in Cyprotex". According to recent press reports in the UK, Davidson is planning to sue the FCA to recover legal costs, and perhaps damages.
Spread betting firms say they now steer clear of sizeable trades on pre-initial public offering stocks. Man Spread Trading's head of desk, David Morrison, says the best course of action is for firms to avoid any potential problems by ensuring there is never a situation where someone has a spread bet on an issue that is still to come to market. "The whole affair has not made our industry look terribly good," says Will Armitage, senior quoting dealer at IG Index in London.
