The UK's spread betting firms have been attracting growing numbers of private investors, primarily because of the tax advantages of spread betting over buying shares. But traditional brokers are starting to fight back.
From its birth in the 1970s, when its customers were predominantly off-duty City traders, the spread betting industry has come a long way. It is difficult to determine the exact size of the UK's spread betting market, but the few statistics that are available paint a picture of rapid growth. One spread betting operator, London-based Capital Spreads, now sees over 27,000 trades a day (August 2009) compared to 16,456 in mid-2008. The oldest and largest, London Stock Exchange-listed IG Index, saw revenues from financial bets for the six months of 2009 amounting to a healthy £80 million similar to that of last year despite tougher comparisons. Meanwhile, Martin Slaney, head of spread betting at GFT Global Markets UK, a subsidiary of Michigan-based forex and futures dealing firm Global Futures & Forex, says introducing online betting at his firm meant an increase from 'hundreds to tens of thousands of trades a day'.
The original financial spread betters in the 1970s focused on the price of gold. However, the business expanded rapidly in the 1980s and 1990s with the introduction of foreign exchange dealing, contracts for differences (CFDs) and sports spread betting. But most attention - from investors, spread betting companies and traditional brokers - is on the equity sector.
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Spread betting offers UK investors two significant financial advantages over cash equity trades. First, it falls within the UK gaming laws, so winnings are exempt from capital gains tax - anywhere between 10% and 40% of the profits made on selling the asset. What's more, spread bets aren't subject to the 0.5% stamp duty on share transactions.
"It's not the tax-free basis, it's the stamp duty basis for equities that is very important," says Simon Denham, managing director of Capital Spreads. "For equities, stamp duty is 0.5%. On a share of £16, that's 8-10 pence on the share price. To make money is hard enough, but when you are 8-10 pence down on the trade, plus commissions, and you could do the same trade with a spread betting company with no commission, no broking costs, and you can trade on margin, it makes it far more cost-effective than trading the real shares."
Spread betting companies are treated like other bookmakers by the UK Inland Revenue, and so pay corporate tax. A betting tax, which levied 9% of winnings on punters, was abolished in 2001 as part of a successful UK government effort to draw the sports bookmakers back from overseas. Most spread betting firms are confident this situation is not going to change any time soon.
"The current UK government has been very encouraging of gambling," says Slaney. "They shifted the tax on to the bookmakers and the higher volumes made everyone happy. They are more likely to raise the tax on bookmakers to increase revenue than shift back (to a tax on winnings)."
Moreover, Denham adds: "UK chancellor Gordon Brown and everybody else know that most people lose money. If spread betting became taxable, they would be able to offset their losses. And as they lose more than they gain, the Inland Revenue would actually lose revenue."
The other advantage, shared by spread betting and CFDs, is the ability to trade on margin: for investors with limited capital resources, this is particularly important. Will Armitage, senior quoting dealer at IG Index, points out: "Why put down £100,000 to get £100,000 of exposure to Vodafone shares when you could put down a spread bet and get the same exposure for a twentieth of the outlay?"
In the past, spread betting has suffered from the conservative tendencies of some private investors - unlike buying a stock, where losses are limited to the price paid for the share, spread betting losses are, in theory, unlimited until an investor closes out the trade. To some extent, the industry has also suffered from its association with gambling. "Because of the name, there is a misconception that it is an inferior product to trading," says Slaney.
But growing expertise in the retail sector means this is no longer the case. "Retail investors are much more sophisticated - we will see them getting much more involved in the market," says one broker. The growth in spread betting volumes backs this up - and traditional brokers are becoming increasingly nervous.
Kevin Sloane, of the Association of Private Client Investment Managers and Stockbrokers (APCIMS), a UK industry association, says its members are both uncertain and worried. "Clients are moving over to spread betting firms - typically with simple bets, where there are benefits. Nobody seems to know how many and there is no certainty on volume. Unfortunately, there are so many other factors that bear on the volume of business they do - the time of year, the popularity of the markets, whether buy-to-let is still a more popular form of investment - so you can't say 'well, our volumes are going down, it must be spread betting'. You can't single out one thing. But I think there is recognition that spread betters are 'eating their lunch' to some extent."
Undeniably, the rise of spread betting companies represents a threat to the traditional stockbrokers and in turn we are seeing these fight back by also offering a spread betting service alongside the traditional stock broking service. Traditional private-client brokers still have two things on their side - existing client relationships and their advisory arms. Spread betting companies are execution-only, prohibited by the UK regulator, the Financial Services Authority, from offering investment advice. But there seems to be no legal or regulatory barrier to an existing broker offering spread bets, either by forming a dedicated subsidiary and developing their own software - for instance, MF Global Spreads, the UK broking subsidiary of MF Global, set up MFGlobalSpreads in 2004 - or by operating a white-label service, passing the custom through to an established spread-betting bookmaker. "We will continue to see more and more brokers setting up their own spread betting operations, either white-label or in-house," notes IG Index's Armitage.
As an example of a white-label service we can take Barclays City Index. The biggest worry with white-label deals from a broker's perspective in such deals revolves as to which party actually owns the client since investors are in practice opening the account with the spread betting firm. However, spread betting providers understand this and typically they have strong commercial partnerships in place. In terms of the provision of the service, it is technically City Index's client, but commercially they understand that in practice this is a client of the house brokerage manager such as Barclays, and they would not deal with them outside the terms of the white-label service. Brokerages which have adopted the white-label site model include Barclays Stockbrokers, Halifax, TD Waterhouse, Self Trade and Hargreaves Lansdown.
Spread betting volumes are huge. There is a sizable - and often underestimated - segment of the UK wealth market that likes to take a more proactive approach to managing their wealth. These are often investors who self-manage their portfolios and have a high level of knowledge about financial markets.
It would be a mistake, however, to expect spread betting to take over completely from traditional investments. Spread betting is still largely the domain of private investors, with two minor exceptions. "We do have some omnibus accounts, which have one individual placing bets on behalf of others - more or less fund management," says GFT's Slaney. Share Clubs have also started adding spread bets on individual equities to their traditional equity investments.
Some firms have also noticed that a small number of corporates are using spread bets to hedge foreign exchange exposure. "Some companies find it is actually cheaper to hedge their foreign exchange with us than it is to go through their banks. These companies are below FTSE 250, but they want to do several million pounds a shot," says Capital Spreads' Denham. "When a smaller company does a foreign exchange hedge deal, they normally won't get a particularly good rate from a bank in the first place, and the bank will also expect them to put up 20% of the margin. We only ask them to put up 2-3% initially. Of course, they don't get the tax advantage that private investors do - from their point of view, it is simply a known risk in a foreign contract, so they declare it to the Inland Revenue as a hedge position."
Corporate and institutional investors are more likely to use CFDs than spread bets - although most corporates are still not aware of CFDs as a potential hedging tool, says Slaney. He adds that CFDs offer advantages over futures as a method of hedging forex or commodity risk: "CFDs are not closed and reopened every day, so it is easier to track profit." CFDs are not legally classed as bets, so trades are subject to capital gains tax, although the contracts are still exempt from stamp duty.
The bulk of the CFD volume is still coming from hedge funds, although retail investors are also now entering the market. "Over the past 18-24 months, demand has been rising as more retail investors become more advanced and are able to take advantage of gearing and being able to short stocks," says Chris Cheverall, head of CFDs at SP Angel, a London-based investment management company owned by brokerage firm Tradition.
However, while spread bets have advantages over traditional investments in the short term, the situation is reversed for buy-to-hold investments. To roll over a long spread bet entails a carrying charge, so "in the long run, for a rolling bet the cost of the deal will work against you", says Denham. With a fee of 0.3-0.5% for each six-month rollover, holding for more than one rollover could wipe out any gains made from the bet, despite its tax-free status. CFDs, however, do not involve carrying charges.
Even with the growth in spread betting accounts, the industry is unlikely to affect volumes in the underlying markets. For one thing, although there are no official figures on the size of the spread betting market, nobody believes it to be significant compared with the trading volume in the underlying markets.
Sam Dibb, a consultant at the UK hedge betting consultancy Certain Risk Management, gives another reason: "It's not a question of competition, because if I place a spread bet on a single stock, the spread betting firm will almost certainly hedge it using a CFD, and the firm offering the CFD will hedge it on the underlying. While it is an alternative from the investor's point of view, ultimately that transaction will end up with a stockbroker one way or another."
1975: Investors' Gold Index (later IG Index) founded, offering spread betting on gold prices.
1976: Spread betting takes off as the price of gold soars from $100 to more than $800.
1983: City Index founded as financial spread betting specialist.
1985: Sports spread betting offered by Ladbrokes and others.
1997: The single largest spread-betting win: a London punter makes £5 million with a bet on the sterling-franc foreign exchange rate.
2002: Spread betting hits the headlines when the Financial Services Authority names investor Paul Davidson and City Index broker Ashley Tatham in an insider-dealing case involving a spread bet on a single stock. They are cleared four years later by a tribunal.
Financial spread betting is predominantly a UK phenomenon, but spread betting companies have started to expand overseas. IG Index opened its Australian branch in 2002, the first financial spread betting operator in the country, and GFT Global Markets UK is set to follow, with branches in Australia and Japan due to open shortly, according to spread betting head Martin Slaney.
Ireland also has a growing sports and financial spread betting sector.
Ireland and Australia are both familiar markets to UK companies. Slaney comments: "Australian regulations are very similar to those of the UK Financial Services Authority. You can't really get stricter than the FSA. All the same, we have to be careful in Australia - the public are prone to betting, so the Australian Securities Industry Commission is more careful about licensing."
Further on, the Cass Business School predicts India and China are likely to become important markets: "There is also an undeniably deep gaming culture among the Chinese," write Chris Brady and Richard Ramyar, the authors of a recent Cass Business School report, adding that the Indian and Chinese fondness for commodity speculation and the prospect of a free-floating rupee could produce profitable new betting markets.
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