No tears shed for CFD Firms.

Monday, 8th October 2018 09:07 - by Ranjeet Singh

There is a saying in the City that the ‘market is always right’. Even when it’s wrong, it’s right, if you know what I mean? That’s because it’s the value that investors place on it at that moment in time. Therefore, and following this logic, the market can never be undervalued or overvalued, it’s always absolutely right; for the budding economists in you, this is otherwise referred to as ‘Efficient Market Hypothesis’ theory.

It is an interesting theory and I can see the argument very clearly, partly because I have a background in Economics but mainly because it just makes a lot of sense. However, whether it makes sense or not doesn’t really concern me or my clients.

After all what I am interested in is how to profit from the market and take advantage of its future movement. If EMH is to be believed then the only way to make money in the stock market is to accurately predict the future value of businesses. In other words, and contrary to the way 99% of investors think, one is buying a company not because it’s undervalued or selling it because it’s over-valued. If the markets are absolutely efficient then the price is the price. That’s it. What they are doing is trying to see into their crystal ball and work out what will happen next month or next year.

Whether you fancy yourself being a Mystic Meg and being able to predict the future or you regard yourself as an opportunist being able to spot a bargain, the end result is the same, so what does it really matter? What is more important is that the market moves!

The reason that I mention this in today’s blog is because a lot is being made of market movement (volatility) and for some reason there is a very divided opinion in this area. There are some segments of the financial world which seem to be suggesting that market volatility has slowed down in recent years and that there are fewer trading opportunities now than there were before. Others including myself, would argue the opposite.

There is of course an arbitrary way in which we can measure volatility and so I am sure we can find out quite quickly who is right and who is wrong, but let’s park that discussion to one side for now.

What is of greater interest to me is the types of companies that appear to be suggesting that market volatility is dying when clearly it isn’t. It’s no coincidence that the firms now spouting this argument are the very ones that make their money from market volatility.

For example, take CMC Markets and IG Group, two of the largest Contracts For Difference (CFD) and Spread-betting firms in the UK today. They both recently reported some pretty appalling results, citing a reduction in client activity due in part to lower market volatility and in part to increased regulatory restrictions.

I think that they are only half right. We all know that the FCA has been on an absolute tear with CFD brokerage firms over the past few years and with good reason, and so it would follow that business from CFD firms would drop off due to the stricter regulations. That has nothing to do with a lack of price movement however.

The market volatility argument is nonsense and nothing more than a smoke screen of what is really going on. The truth is that the market is as volatile as it has ever been, and some could sensibly argue more volatile than it’s ever been. Therefore, clients not being able to find enough suitable trading opportunities due to a lack of market volatility is definitely not the problem. Clients are trading less because of regulatory change.

In other words, the problem actually sits squarely with the CFD firms themselves.

You see, for many years nearly all of the major CFD brokerage firms in the City that I have had the misfortune to know or deal with have run amok and made a fool of the system. That’s because they have openly promoted a product which they have long known has a success ratio of around 1 in 10.

That’s crazy! Imagine that. How can you possibly not just allow but actively encourage an unsuspecting retail investor with little or no experience in a high-risk product like a CFD or spread-bet, with ridiculous leverage, to speculate their money on something which has a statistical winning chance of just 10%? The 430 at Ascot would be a better bet!

I realised this in my own business several years ago, long before this position became popular. For me it was as clear as day and I knew that this was always a disaster waiting to happen. Finally, I have been proven right.

That’s why I made the financially painful decision to move away from CFDs when everybody around me thought that I was mad. For me it just didn’t work. It didn’t matter how much money I could have made, if the clients lost money and I knew that there was a 90% chance that was likely happen, I just couldn’t do it.

It was clear from my own experience that the odds were stacked so unfavourably against the client, that there could only ever be two winners, either the CFD firm that we were clearing our trades through or us. Never the client. That didn’t work for me and so I changed things around.

Instead of using CFDs for speculation I began to use them for hedging purposes. In other words, I was one of the few firms that I know of that actually was able to finally turn a profit for clients using CFDs. When client accounts were ‘blowing up’ every day in every CFD firm all over the City my clients were actually within the ‘1 in 10’ group that were actually making money. This isn’t because I am particularly intelligent or gifted, but absolutely because I believed in doing the right thing.

At the time I even wrote an article about the CFD market but rebranding it ‘Created For Dealers’. That’s what it was back then and for many firms it still is.

Of course, having a big conscience also came with a big cost to my business. Whilst I watched my competitors push CFDs harder and harder and reap the financial rewards from doing so, I was doing the opposite. I was using CFDs very sparingly, with minimal volume, with minimum leverage and primarily to make money in a falling market to protect against an existing equity position.

It wasn’t long before I got a phone call from the firm that I was clearing my CFDs through at the time. I remember it well, it was Saxobank and I was called in for an emergency meeting to the Head Office to discuss why there had been a significant drop in business being done. When I explained my concerns about clients losing money and therefore changing the strategy which would mean more success for clients but a significant slash in income, my account manager looked at me as if I had two heads.

You have to remember that this was at a time when the FCA had not yet seen the full impact of CFDs and it would not be for at least another two full years until there would be a ‘thematic’ review on this product, and several years before any real regulatory change.

Shortly after the meeting I received a letter from Saxobank stating that they had decided to terminate our business agreement stating that they needed a minimum amount of business in order to make the relationship viable. It was pretty clear that it didn’t matter to them whether my clients were going to lose money, as long as we were doing the volume.

Fair enough I thought and so I took my (small amount) of business to another clearing firm and yep, you guessed it, after a few months they also terminated the relationship. And so, I moved again, and again….and again.

We ended up joining and then having our contracts terminated by SaxoBank, IG Index, CMC Markets and Gain Capital (which later became City Index). I don’t know any other firm that had to endure what we had do. What a joke and what for? Simply because greed came over service. Sure, short term profitability is important but longevity is more important. It’s a shame that some of these bigger firms didn’t take my advice when they had the chance.

Forgive me then if I don’t shed a tear when I now see that Peel Hunt is downgrading its 2019 forecasts for CMC by 20% to £34.9m or that IG Group is reporting a significant global fall across their leveraged trading products and a big reduction in overall client trading. It’s long overdue.

Now please don’t get me wrong. I’m not suggesting that there is not a place to speculate and indeed I still do for my clients when it is the right time to do so. The point that I am making is that the intention has to be with the client’s best interests in mind.

The truth is that the regulations have only just finally caught up with this out of control product. The margins have been squeezed, the controls are tighter and firms are being forced to put the client first which is a great thing.

This has nothing to do with a fall in market volatility and everything to do with unadulterated greed that got out of control. What we are seeing now is just a return to sensible levels of CFD trading that should always have been the norm and with that will evolve more sensible valuations of the CFD firms behind them.

Ranjeet Singh

www.londonstonesecurities.co.uk

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.