Traders are better at managing risk than the regulators
UNEASE about the information provided to some Contracts for Difference (CFD) customers has caused concern to the financial authorities in Ireland. This has no direct implication for UK traders, but it is worth revisiting the current regulations and risks of CFD trading. Ultimately, all good traders must take responsibility for their own risk exposures.
Last Thursday, the Central Bank of Ireland raised concerns about the compliance of a small number of CFD providers with the EU’s Markets in Financial Instruments Directive (MiFID). The bank’s head of consumer protection Sharon Donnery criticised a few firms for “failing to fully inform and provide adequate warnings to consumers of the risks that CFD and financial spread betting carries before they begin trading.” It is not yet clear what, if any consequences, will be faced by the companies involved.
THE UK REGULATORY ENVIRONMENT
In the UK, CFDs are regulated by the Financial Services Authority (FSA), which has incorporated MiFID regulations on the organisational requirements and operating conditions for investment firms into its rules and guidance. The aim of MiFID is to increase competition and to establish better rules for investor protection, requiring CFD providers to pass on the best execution and best executable prices to customers. David Norman in CFDs: The Definitive Guide to Contracts for Difference writes: “CFD providers are required to establish a formal best execution policy and provide regular reports as to the effectiveness and performance of that policy.”
Most participants appear content with the current state of regulation. In an FSA consultation paper undertaken in November 2007, leading investment banks and CFD market participants asserted that they “were not in favour of a new regime being introduced specifically for Contracts for Differences (CFDs), and did not agree that it would improve transparency or bring any benefit to the market.” It also found that the majority “also thought that, should such a regime be introduced, it would increase confusion in interpretation of market movements, would lead to double counting, would not solve the initial problem and would increase costs and complexity without clear benefits.”
MANAGE YOUR OWN RISK
Of course, regulators shouldn’t be the only people worried about risk – traders should too. Risk management is arguably the most important skill for success. Malcolm Pryor of www.spreadbettingcentral.co.uk identifies three categories of risks. Firstly, he says there is “the predefined risk of the trade” – the difference between the stop and entry. Associated with this is the double-edged nature of any leveraged product. As such, traders need to manage the risk of both individual trades, as well as the total risk of all trades. The second category of risk according to Pryor is “additional market risk – the risk of a market event causing a larger loss than the predefined risk to occur.” This can impact upon any asset class, but can be easily mitigated against if CFD traders always set stops. Finally, there is the danger of counterparty risk. However, on this front it should be pointed out that over-the-counter (OTC) CFD providers are required by law to segregate client funds, thus protecting client balances in the event of a company default.
Despite the concern from the Central Bank of Ireland, it would already be impossible for a potential trader to open a CFD account in either country without being aware that there are risks associated with trading. Also, given the plethora of information available on the internet – both on CFD providers’ websites and external to them – there certainly isn’t the need for any additional legislation. Caveat emptor should be the order of day. Regulation is a growth industry, but authorities in the UK and EU need to hold back. Due to the concealed nature of the unintended consequences of trying to control risks outside of the market process, it is impossible to understand the negative impacts of most regulations. Yet the financial crisis makes it clear that bad regulations can, as if guided by an unseen hand, homogenise the actions of market participants, increase moral hazard and contribute to overall market instability.