Derivatives, securities whose values are derived from other assets, have been used for hundreds of years by companies and the wealthy to invest and manage their risks. Their use is so commonplace that they exist for everything from wheat and sugar to the price of gold or the level of rainfall. Spread betting and Contracts for Difference (CFD) are close relations of the most basic derivatives (we already reviewed the history of spread betting here). These retail derivatives make international markets accessible to normal investors and can reduce their tax liabilities. The retail derivatives industry faces a number of challenges. To grow it must expand its constituency to include female, ethnic minority, international and older customers while considering product development and how best to represent the industry and all its customers.
In the late 19th century the American satirist Ambrose Bierce wrote that, "the gambling known as business looks with austere disfavour upon the business known as gambling". What was true in the 19th century is just as true today. It provides the spread betting industry with perhaps one of its most significant challenges - how to convince the consumer that essentially there is no difference between traditional trading and spread betting. The word gambling is defined by one dictionary as:
n 1: money that is risked for possible monetary gainWith the possible exception of those who invest in companies for the sake of the company itself, and leave their money with that company, the definition adequately covers most trading activity.
Understanding that it is not the product that carries inherently more or less risk but the person and mindset using that product would help not only the individual consumer but also the industry, the legislators and the regulators. Such an understanding would, for example, have produced an entirely different ruling by the House of Lords in the Hammersmith & Fulham `swaps' case of the late 80s. In 1991 the HoL ruled that local authority interest rate swaps were illegal. Their lordships ruled in this way not because the swaps were used as hedging instruments but because they were used illegally in this particular instance. The reality was that it was the performance of the councillors that was at fault and not the financial products or the concept of hedging. Covering risk on behalf of the rates-payers seems an eminently sensible activity. The real issue that led to such a poor ruling by their lordships was that the process smacked of gambling in the traditional usage of word and was, therefore, considered as being overly risky. In fact, the informed professional gambler is the same animal as the fund manager, someone who is paid to be more knowledgeable about investment/betting than the individual placing money with that expert.
Almost any transaction can be adjusted to suit the particular risk characteristics of the individual consumer. And, in fact, products can start with one intention and are utilised for another. Indeed, financial derivatives originally appeared in the early 1970s as a counter to the volatility introduced into the markets by the breakdown of the Bretton Woods system of fixed exchange rates. Another example is the development of credit derivatives that were originally intended to reduce the risk and exposure of organisational finances by building in stability and predictability and consequently insuring against volatility.
However, gamblers immediately recognised that you did not actually need to own a commodity in order to be able to trade its derivatives, you could very simply bet on how the market would move. Thus a product designed to increase stability could be used in a manner that would actually act as a volatility force multiplier. One of the JP Morgan team that originally developed the credit derivative remarked, when asked how she got into the business, "I had read Liar's Poker and thought that trading derivatives sounded sexy and fun". That's gambler-speak.
Historically, financial institutions had an advantage over individual traders. The institutional traders had instant access to international markets, commodities and currencies from their desks in the City. They could balance a multitude of risks and grasp opportunities not easily available to individual investors or even to their brokers. Perceived economic threats from abroad, such as the rise of the Japanese economy, posed less of a problem for institutions because they could easily diversify into foreign stock markets. Similarly, the gathering competition from emerging economies today has provided a similar opportunity, rather than a threat. Because of this lack of individual access the impact of geopolitics on oil, gold and other commodities threatened the lone investor, while for the banks it provided opportunities which were available at the end of a phone or, more recently, a mouse click.
The cutting edge of globalisation and technology gave banks easier access to very traditional financial products. Ironically, despite all the new technology, the instruments used by the banks were the same familiar products. Assets such as commodities or entire national stock markets were traded through old-fashioned futures contracts. A futures contract being an agreement where parties agree a price for something now and then exchange the goods at an agreed fixed future date.
A futures contract is the simplest form of a derivative product, a security where the price is derived from the price of something else. The earliest examples of futures contracts date back 3,800 years to Babylonian farmers' sales of grain. The farmer and his client could manage their risks because they knew in advance what their cash-flows would be. Both parties could calmly plan ahead, safe in the knowledge that the price they agreed many months before would be adhered to. Unforeseen events such as price slumps from bumper harvests or profiteering during droughts could be avoided.
Rather than the individual deals of the ancient world, modern futures contracts are usually traded on exchanges. However, this particular aspect of modernity probably started back in Japan in the 1600s. A market developed there to redistribute (spread) the risk related to the production and distribution of rice. By the mid-1700s the Dojima and Sakata rice exchanges were so important that songs were composed about the rice market. Leading figures from the exchanges were even granted the honorary title of Samurai to become financial consultants to the government.
During the initial 3,500 year period of futures contracts every contract tended to be different. Each contract would be based on the amount of grain that a specific farmer was selling to their customer. By 1865 the fifteen year old Chicago Board of Trade (CBOT) was serving the needs of most Midwestern grain farmers and purchasers. They decided to standardise their contracts' quality, quantity, delivery times and location - price was, therefore, determined by market forces within the exchange. For example, the CBOT contract size for wheat is 5,000 bushels and the delivery months are March, May, July, September and December. Each contract is for the same physical amount of grain and you would trade as many contracts as required. Rather than a bespoke 50,000 bushel wheat contract to be delivered in September, the executed trade would be for ten September wheat contracts.
Prior to this standardisation, it was difficult to compare deals. By making pricing more transparent traders are able to see clearly what the market price is for the wheat that will be delivered in September. By the late 1960s the exchanges began offering futures contracts on non-agricultural commodities. For the first time there was a market for trading gold and silver futures - the right to receive or deliver the metals at a later date. Over the last century exchange trading in futures contracts has extended to many of the commodities we take for granted in our daily lives. Corn, soyabeans, cattle, pork, cocoa, sugar, coffee, copper and platinum, to name but a few. Trading in futures also dominates how we view the energy markets. The oil and natural gas prices we read about in the news are determined by trading in the energy futures markets of London and New York. Nearly every primary raw material that we consume is traded as a futures contract. If evidence were needed of the significance of this to the average citizen it can be found in the recent 20%-plus rises in domestic gas prices which were directly linked to the futures purchasing model.
The risk management tools initially used by farmers were so simple they were applied to other markets. It was realised that the commodity itself is actually irrelevant, it is unimportant as to whether the underlying asset is wheat, cattle or gold. It was only a matter of time before the simplicity of futures would lead to a whole new breed of financial products for banks and investment funds - traded financial derivatives. In 1971 the Bretton Woods system of pegging international currencies to each other, based on gold, collapsed. Currencies were left to "float" in the market and became a risk or investment like any other. The Chicago Mercantile Exchange (CME) launched the International Monetary Market (IMM) where parties could agree on an exchange rate months in advance of the transaction.
Exchange traded futures contracts on financial instruments had not existed prior to this - the genie was out of the bottle. Only the imagination restricted what could be traded in this way.
Over the next decade several important futures contracts were launched by the Chicago exchanges. CBOT launched a futures contract on 30 year US Treasury Bonds in 1977. In 1982 the CME offered a futures contract on the Standard and Poors 500 index of the American stock market. Whilst agricultural futures contracts tend to be settled with the delivery of the wheat or cocoa, for example, most financial futures are settled in cash. This way the buyer of a profitable Standard and Poors 500 index contract does not wait for receipt of the 500 stocks at the agreed price when the contract expires. Instead the seller would hand over the buyer's profit in cash, had the buyer sold all the stocks instantly at the higher market price. The parties square up the difference in value since the deal was struck, rather than handing over the securities on the settlement date. Hence the umbrella terminology for swaps and futures as 'Contracts for Difference'. Without cash settlement the buyer would have to await the transfer of the 500 stocks to his account at the agreed price so as to sell them for a profit in the market.
The American markets were not alone in embracing financial futures. Competition between the international futures exchanges has led to futures contracts on wide range of financial products since the 1970s. The Swiss and German owned Eurex has grown to be world's largest futures exchange and LIFFE in London, now owned by Euronext, is home to British futures trading. Between them they compete to cover short and long term government bonds from the United States, Japan, the Eurozone and Britain. Single stock futures exist for most of popular shares in Britain and the continent and there are even futures contracts on macroeconomic production, inflation and GDP.
The simple idea behind futures contracts is so useful that they are now used in a spectacular number of areas. For example, the growth in global trade has increased the volatility in the shipping markets. Units of freight space on the ships are traded, allowing manufacturers and shipping firms to manage risks from fluctuations in the market. Futures contracts are also traded on the right to buy or sell the ships themselves at a future date. The industrialisation that fuels this trade also drives pollution fears and international regulation of emissions from companies. Now companies can trade their emissions quotas. The increasingly volatile weather of recent years has become an increased risk to companies. As a consequence those companies are increasingly turning to futures contracts on rainfall, snowfall, frost and the temperature. Weather risks are important to any companies for whom rapid seasonal turnaround is crucial to margins such as re-insurers, soft drinks companies, energy companies and even fashion retailers. The CME saw a 170% surge in the number of opened weather derivatives last year. Even rubbish has value and there are now growing futures exchanges dedicated to trading recyclables such as paper and plastics.
The nineteenth century grain farmers would be amazed at how accepted derivatives have become. The number of markets and asset classes they now cover are impressive and their commercial usage is commonplace. Everyday corporations use them to manage the risks affecting their businesses, such as foreign exchange or interest rate risks. 92% of the 500 largest corporations use derivatives to manage their risks according to the International Swaps and Derivatives Association. Of these 500, the 35 British companies all make use of derivatives. The usage of derivatives is increasing by 22% per annum and by July 2005 the value of the assets underlying these derivatives amounted to $201.4 trillion, around four times the value of global GDP.
Innovation is, of course, never-ending and did not stop when applying futures contracts to new markets and assets. The banks have developed more complicated "exotic" derivatives from plain vanilla derivatives such as futures contracts. These non-standard contracts serve the specific needs of a bank or large company to shift risk and plan for the future. The banks employ quantitative analysts to design and price these products - the "rocket scientists" of the finance world. The value of an exotic derivative could be based on any number of conditions and often using more than one underlying asset, perhaps a mix or basket of stocks or commodities.
An example of an exotic contract might be a security that pays interest, similar to a bond; however, this interest payment is instead determined by returns on an index of traded commodities; this interest payment will continue until the expiry of the contract unless one of five specified stocks rises 10% above its price at the start of the contact. It is perhaps clear (or unclear) from this example why these are described as exotic contracts.
Banks have had easy access to all these markets for so long and moved on so far from the farmer's humble starting point. However, as financial products have become more and more complex and more and more derivative in a recursive, Russian-doll type relationship, it is only a matter of time before there are derivatives of credit derivatives, a sort of `derivatives cubed'. As a consequence such products become ever more distanced from individual investors who have ended up without easy access to even the simplest derivatives. Even plain vanilla futures contracts are not as easily available to the individual investor as other financial products due to the additional requirements when opening a futures account. Wealthier investors might have enough capital to open their own futures trading accounts but even they would still face several restrictions. Restricted to their domestic market only, they would still be isolated from trading or managing the risks from international stock markets. Commodities not traded at home or trading foreign currencies to hedge risks or speculate would still be a problem. To get around this they could open accounts with foreign brokers or pay exorbitant fees. Notwithstanding this, however they manage to trade foreign markets, their overseas investments would still be vulnerable to a plunge in value of the foreign currency of their investment. And these are the problems that just the wealthier investors faced - everyone else simply never got a look in. They could only miss out on opportunities and watch quietly, at the mercy of international shifts in wealth. Individual investors had been left behind. What was needed was a single trading account that allowed exposure to many different types of assets, in many countries and with the ability to manage currency risks from any foreign investments.
Today, of the £1.2 trillion traded annually on the London Stock Exchange, it is estimated that 40% is equity derivative related. It is estimated that 10% of the total figure relates to spread betting, making the annual UK spread bet consideration about 120 billion per annum, a figure a far cry from the take up of the Babylonian farmers.
It was this inequity in access to the complete range of trading opportunities that a new breed of firm saw as an opportunity. They have offered new ways for investors to trade the markets and manage their risks. Financial spread betting and contracts for difference (CFDs) give normal investors the opportunity to trade a wide range of assets from a single account. They can trade British or foreign shares, indices, commodities, bonds, currencies or even hedge funds.
Spread betting permits investors to bet on price movements in the markets, and not just metaphorically. Legally, spread betting is defined as gambling. The investor only bets on moves in market price without any of the benefits, or encumbrances, of ownership or the opportunity to take actual delivery of the real asset. It allows individual investors to take control of their own investments without the need to rely on a middle-man to make the trade and/or offer `expert' advice. Unlike a fixed-odds bookmaker or casino, not all companies offering spread bets or CFDs benefit from your losses. If you use a traditional bookmaker to gamble on a sporting event it is certain that they hope and require that you lose. Spreads and CFDs do not represent the same risk for the company and can be managed. The firms hedge their risks by taking positions in the underlying market and make their money from the transaction costs for each trade - the spreads or CFD commissions.
They could take the same position as you in Microsoft shares, instead of your Microsoft spread trade, and if you make money it is paid for by their equivalent trade. This way they look forward to customer success. It is also in their interests to encourage responsible trading which they do, at least in part, by offering training courses and risk management orders.
Spread betting works by being quoted two prices for a trade that are around the current market price, known as `the spread'. The higher price is what you "buy" at and the lower price is what you can "sell". It is important to note here, that you can sell without owning the asset i.e. you can "short" the market. An investor would stake a certain amount of money for each unit the price changes from the price traded. For UK shares these units would be pennies. The objective is the same as for traditional investment, making money by predicting how share prices will behave. The spread is analogous to the commission you pay to trade. If you buy and sell before prices change you would lose the value of the spread. The final profit or loss is a multiple of the stake multiplied by the amount that the price has moved in the specified direction. If you had staked £1 per point on a spread around the quote on the FTSE 100 at 5900:5902, this would mean you 'bought' it at 5902. If the spread then moved to 5922:5924 you could 'sell' it to close out the position at 5922 - a profit of £20 on this trade.
The definition of a CFD appears similar to spread betting. The investor does not own the real asset and benefits from a change in its value. The difference is that CFDs are intended to replicate all the financial benefits of share ownership bar voting rights. Dividends and rights issues are replicated by crediting the account as if each CFD were an actual share. For example, if one owned a CFD on Marks and Spencer you would receive any profit or loss from the movements in the actual share price. However you would also receive any dividend payments from Marks and Spencer that you would have received had you owned the actual stock instead.
One of the main attractions of spread betting and contracts for difference are the various tax benefits compared to conventional investments. CFDs and spread bets do not grant ownership of the underlying asset or related voting rights and so are not subject to stamp duty. At 0.5 per cent, Stamp Duty Reserve Tax on share transactions in the UK is the highest in Europe. Even for wealthy investors with access to their own futures accounts there are further benefits from trading spreads or CFDs. Because spread betting falls within gaming laws, it is also exempt from capital gains tax and so spread betting is completely tax free. CFDs incur capital gains tax but unlike spread bets and futures contracts, investors in CFDs are not just hoping for a change in the traded share price. CFDs are intended to replicate all the dividend benefits of share ownership. CFDs have no settlement date, because the intention is replication of share cash-flows, unlike futures contracts and spread bets which must be "rolled over" to the next contract on expiry.
Whilst financial spread betting has the tax benefits of gambling, the dominant industry players are not part of the traditional gambling industry. They are owned by financial firms whose businesses specialise in currencies, commodities and financial derivative products. When a futures contract is traded the exchange matches the two parties to the trade; the farmer and the food producer or the gold buyer and seller. In the case of CFD trading and spread betting the counterparty will always be the company issuing the spread bet or CFD. There is no exchange needed to match parties hence they have entered into an OTC (over the counter) contract.
This allows orders in particular to take on forms that would not be possible on an exchange, such as guaranteed stop-loss orders. Precisely the same as when investors trade shares or futures, it is sensible for them to place stop-loss orders when opening new positions in case prices move against them. Some markets can have their stop-losses guaranteed, even if the underlying price moves through your stop-loss level. This eliminates the risk of slippage or market gaps.
Another important consideration is that spread bets on foreign securities are based on the numerical value of the traded price rather than the currency value. Put otherwise, there is no currency risk when trading international markets with spread bets. For example, buying a share at $10 and selling at $15 is a 50% return. If you owned the share itself you would instead own it in dollars. Any return from that trade would be more or less than 50% depending on what happens to the value of the dollar during the same period. Your equivalent spread bet profit would be 50%, giving the investor no currency risk.
 |
Both spread betting and CFDs are very similar to futures contracts, as summarised in figure 1 above. The trades are settled in cash like the majority of financial futures, with your profits or losses accounted for on the balance of your account. Like a futures contract trading before expiry, a spread-bet or CFD position does not require you to buy or sell the real underlying asset. This has several benefits. If you believe that a company's mismanagement will translate into a falling share price or that the price of oil will fall due to the discovery of new oil fields you can benefit from the fall in price. To make money on the way down you can take "short" positions, and more easily and cheaply than in spot markets such as normal shares. Alternatively, a short spread bet or CFD position could be used to hedge against losses in a real share already owned, locking in a profit without incurring a tax liability. The other appeal of CFDs and spread betting is that they are margin products, giving the investors the option of leveraging up their trades. This is the same as making trades on credit, giving the option of retaining ready cash for other things. Because leverage increases risk not all investors make use of this ability.
The futures exchanges know that only 20% of traders make money. The same is true for spread betting and CFD traders. There are several reasons for this. If you are trading for profit you need to earn at least the spread or commission you have paid to make the trade. If you are using spread bets or CFDs to hedge an existing position the intention is to lock in any gains just in case the holding goes against you, or equalise a loss made in the underlying. As an example, an investor may need to lock in the current profit from a Vodafone trade but cannot cash in the profit because the shares serve as collateral for other personal obligations. Instead of selling his Vodafone shares he could 'short' a Vodafone CFD to benefit from any fall in price to compensate for any reduction in the share value.
The content of this site is copyright 2016 Financial Spread Betting Ltd. Please contact us if you wish to reproduce any of it.
