Contracts for Difference: Playing with Fire

Increased regulatory scrutiny of CFDs highlights the need for a renewed focus on financial literacy and investor education, says Emma Parry.

In April 2022, the Australian Securities and Investments Commission (ASIC) extended its Contracts for Difference (CFD) product intervention for a further 5 years.

The rationale? During the order’s first six months, ASIC observed a staggering 91% reduction in aggregate net losses by retail clients (from $372 million to $33 million per quarter on average). The announcement concluded that the order “will ensure that the leverage ratio limits, and other protections can continue to reduce the size and speed of retail clients’ CFD losses.”

Regulatory asymmetry is nothing new, but if there’s one thing regulators around the world agree on, it’s the risk to retail investors posed by CFDs. As a result, product intervention orders have been imposed by various regulators, implementing a range of restrictions including:

  • leverage ratio limits
  • standardisation of margin-close out rules
  • negative balance protection
  • prohibitions on offering or giving of certain inducements (e.g. rebates)

What’s the big deal?

CFDs are leveraged derivatives contracts that enable investors to speculate in the change in value of an underlying asset. The assets can be FX rates, stock market indices, single equities, commodities and now, even crypto.

Additionally, because the products are leveraged, clients are essentially trading with borrowed money, with the leverage significantly amplifying returns and losses.

Various websites I visited as part of the research for this article accept credit cards as a payment method to fund CFD trading accounts. This included sites in Australia, Singapore, Hong Kong, and the UK.  One website I visited stated that clients can have ‘up to 5 active cards’ on an account at a time.

Research undertaken by the UK Financial Conduct Authority (FCA) has highlighted that some investment apps have as much as 10% of their total payments coming from credit cards.

Overlay the ability to fund CFD trading via a credit card (or five), market volatility and the current cost of living crisis – and it is little wonder that some retail investors are finding their debts spiralling out of control.

The game’s afoot

Worryingly, the risks to retail investors don’t stop there!

According to a consultation paper published by IOSCO (March 2022), “various apps and online trading platforms are using gamification techniques to attract retail investors and influence their trading behaviour and decisions.”

In the CFD industry, techniques include benefits such as bonuses, rebates, or reduced costs.

Executed well, IOSCO notes “gamification techniques can help to convey complex information in a simple and rewarding way”.  However, executed badly, and what regulators are seeing is, “inexperienced investors trading more and taking on risk outside their tolerance and beyond their financial capacity”.

This became particularly problematic during the pandemic, with regulators noting an increase in self-directed trading via online platforms and mobile apps, alongside a greater appetite for trading in higher-risk products – CFDs, crypto-assets, FX.

The behaviour was driven by a combination of factors – lockdown boredom, financial issues (e.g. job losses), alongside an increase in promotions on social media platforms (including dating apps).

Influencers were actively promoting ‘investment opportunities’, often accompanied by photos of the cars or holidays they had apparently gained through their trading activity.  This became another area of focus of regulators, who were rightly concerned about investment advice being offered by those with no licence to do so.

The key concern? That easier access to trading platforms, coupled with behavioural effects of gamification, haven’t been accompanied by proportionate increases in consumer education. Financial inclusion must be partnered with financial literacy.

Conduct unbecoming

Some jurisdictions allow retail clients to be reclassified (or to ‘opt-up’) from retail to a more sophisticated client classification.  In Australia, this is a reclassification to ‘wholesale client’ or ‘pro-account’ status; in MiFID II terms, the client becomes ‘elective professional’.

The process (and criteria) to reclassify may differ depending on the jurisdiction, but the implications are broadly the same – the loss of significant retail client protections which can include:

  • losing negative balance protection
  • losing margin close-out protection
  • losing access to external dispute resolution mechanisms (e.g. Australian Financial Complaints Authority, UK Financial Ombudsman Service)
  • loss of certain risk warnings or product disclosure documents

Whilst the ability to reclassify isn’t an issue in itself, there have been cases where the processes followed have not adhered to the regulatory requirements.

Online and mobile apps undoubtedly provide a convenient and immediate ability to trade when the market moves.  However, some retail investors who have been through a reclassification (or opt-up) have complained that the process (often via a digital channel with a series of click through dialogue boxes) provided insufficient warnings of the protections they would lose.

Align this with high pressure sales tactics and inducements (e.g. rebates, higher leverage) as a ‘reward’ for the upgraded status, and it’s not surprising that regulators continue to raise grave concerns about the potential harm.

Catch me if you can

Where industry misconduct is detected, enforcement actions are sure to follow.

Some of actions are relatively straightforward.  For example, in 2020, the Monetary Authority of Singapore (MAS) blocked the website of an unregulated trading platform known as Arotrade, after police received complaints from Singapore residents.  Registered in Belize, the platform offered trading in CFDs, FX, and cryptocurrencies.

However, authorities are increasingly investigating far more complex cases. In July 2019, MAS successfully prosecuted three individuals for front-running and insider trading with the activity linked to CFDs.

And, in November 2021, Japanese authorities tackled a market manipulation case involving CFD trading which resulted in a monetary penalty payment being levied against Evolution Trading Ltd, a company incorporated in the British Virgin Islands. Investigators were able to link the trading of CFDs to market manipulation of underlying Japanese stocks.

Some enforcement actions have related to high pressure sales tactics, which was the case in 2021 when ASIC banned the sole director and four former employees of Forex Capital Trading Pty Ltd from providing financial services for periods ranging from three to ten years. ASIC found the account managers were pressured to:

  • offer incentives to clients to encourage deposits
  • recommend trading strategies that would increase a client’s exposure to the market
  • pressure clients to deposit funds into their trading accounts
  • pressure clients to delay or cancel withdrawal requests

Mission impossible?

Much of this article has focused on structural issues within the CFD industry alongside a backwards looking view of some enforcement actions, the aim of which has been to raise awareness of how harm specific to retail investors is manifesting.

There is increasingly a focus on how the industry ‘predicts and prevents’ future misconduct, including, for example, the use of AI to achieve ‘predictive alignment’ between values and operations. However, until the industry reaches this next stage of maturity, continued regulatory scrutiny will be critical. The foreseeable harm to retail investors is already taking place.

Finally, with the availability, and ease of access to self-directed trading via online platforms and mobile apps, there must be a renewed focus on financial literacy – be that via formal education or credible industry voices.  Financial inclusion, without the requisite financial literacy, will ensure that we perpetuate the harm.

Emma Parry is a Senior Advisor at Change Gap and specialises in conduct risk and culture.

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