Wednesday, 19 September 2018

Which way forward for CfDs?

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It remains unclear if a new disclosure regime for contracts for difference will come together in Germany as has happened in the UK. Some industry officials continue to argue that if Germany had had in place a CfD disclosure regime similar to the one about to take hold in the UK, last autumn’s Volkswagen and Porsche incident might not have happened. Jean Haggerty reports.

During the past six months, expectations that new EU-wide disclosure rules for CfDs might be in the pipeline have faded. After Porsche Automobil Holding set in motion plans to raise its stake in Volkswagen and triggered a massive squeeze on short-sellers, industry officials were sure that CfDs would come under greater scrutiny in Germany and elsewhere in Europe.

On October 26 2008, Porsche disclosed the extent of its position in VW equity, due to a belief that short positions in the market were greater than assumed. At that point, Porsche held 42.6% of VW ordinary shares and 31.5% through cash-settled options akin to CfDs. This meant the effective free-float had shrunk to single percentage figures. The company reacted by saying that it would seek to take its total exposure above 75% in 2009.

Short-sellers reacted quickly and this led to extreme trading as they desperately tried to cover their positions despite the lack of stock. The stock had closed on Friday October 24 at €210.85; by the close on the following Monday, it had reached €520. One day later, it topped €1,000.

Then, on October 29, VW declared that it would be taking profits on positions representing 5% of VW to help increase liquidity in the stock. By the end of that tumultuous week, VW shares had eased to about €500.

Among EU member states, the UK has taken the lead in introducing a new disclosure regime for CfDs. Just a few weeks before the Volkswagen and Porsche incident, the UK Financial Services Authority published draft rules that, under certain circumstances, require investors to disclose their holdings when they use CfDs to build a position in a company.

As a large portion of the UK CFD market involves far smaller stakes, the new rule is not expected to inflict damage on the market. Crafted amid growing concern that CfDs could be used to improperly gain stakes in large companies, the UK’s new rules are intended to reassure the boards of publicly-owned companies of who is trading their shares.

The initial disclosure threshold for CfDs is set at just 3% of a company's outstanding stock, the same as the existing disclosure rules for direct equity stakes. The new rules also include an exemption for CfD writers acting in a client-serving capacity, to prevent unnecessary disclosures to the market.

In March 2009, the FSA announced that its new disclosure regime for CfDs would take effect on June 1, three months earlier than the planned launch in September. The FSA's move was not entirely unexpected and those active in the CfD market have said that the volatility in the market has had a far greater impact on the CfD market than the prospect of the new disclosure regime, but industry officials will feel under pressure to meet the new deadline due to adjustments required for systems.

"A significant shortening of the implementation period as has recently been indicated would severely impact on our members’ ability to meet important planned commitments,” said the International Swaps and Derivatives Association and the London Investment Banking Association, in a comment letter in late January.

“As a result of the current crisis, our members are struggling with numerous systems projects which are required to meet regulatory requirements and business exigencies. Thus, meaningful accommodation will be required to ensure that compliance with any new regulations will be a practical possibility," the institutions added.

According to the FSA, its new disclosure regime represents a very significant step in improving market transparency and the regulator has brought the implementation date forward to reflect that.

"The new rules will resolve some of the concerns raised about the risks of market players devising ways to avoid disclosure or over-disclosing," said Alexander Justham, director of markets at the FSA said when the regulator announced its plan to bring the compliance deadline forward.

Upsurge in Germany

The Committee of European Regulators flagged CfD disclosure as an area for future regulatory consideration as far back as July 2007. Since that time, the EU’s Markets in Financial Instruments Directive (MiFID) directive has helped fuel an upsurge in CfD trading in Germany. MIFID allows EU firms to passport certain investment products approved in one member state to other member states.

“We looked at the UK, Switzerland, Italy, France, Spain and Germany,” said Chris Curran, head of international development at Dublin-based CfD firm Delta Index, which launched its online XDeal platform in Germany almost two months ago.

Germany is often perceived to have a conservative investment culture. This is in part because its large pension segment invests heavily in bonds, while the country is also renowned for having a high savings rate. But what is sometimes forgotten is that Germany also has a sizeable leveraged trader niche. Germany consistently ranks among Europe’s largest warrants and certificate markets, for example.

This, and the fact that CfDs are more transparent than warrants and certificates, helps explain the German market’s recent growth trajectory.

“Germany has enormous growth prospects because there is a pent-up leveraged trading demand,” Curran said. “[We are trying to provide traders with] a competitive alternative to the UK-based companies that currently dominate the German CFD market. With trading volumes increasing monthly by 6%, Germany is an extremely attractive market.”

Delta Index transacted €840m in leveraged trading in 2008, and sees itself as on a firm footing as it enters the German market. “If you get it right there, you can go anywhere. They are a loyal and discerning group of customers,” said Curran.

Many other CfD firms have also targeting Germany as a potential new market for these same reasons. And although the German CfD market is competitive, research conducted by the Steinbeis Research Center for Financial Services suggests that it is still growing (see accompanying chart).

Market participants note that the number of traders participating in the German CfD market during the past year has grown by 10,000 to reach 40,000. Additionally, during the past three years, CfD trading volumes have doubled each year. By some estimates, about 80% of all CfD trades are on DAX-related products.

According to Curran, demographic changes within Germany and the current elevated market volatility both suggest continued growth in the German CfD market. “There is just less trust in the financial market complex. Private investors are eager to take responsibility of their own investment decisions,” he said, adding that the current heightened volatility also helps because when markets are in the news investors have opinions on them.

That said, the current difficult market conditions have already claimed one victim on the CfD front. The London Stock Exchange, which hoped to launch the world's first combined cash equity and CfD market later this year, has abandoned its plan.

After extensive consultation with the market, the LSE decided to suspend its project indefinitely. The feedback from the market was that it simply could not digest the development required at the moment given market conditions.

The exchange worked in close co-operation with LCH.Clearnet, its customers and the wider market on its listed CfD project, but few details were ever made public, and so market participants were never entirely clear what impact it would have had.

In May 2008, during a presentation on the LSE's preliminary results, chief executive Clara Furse said that the exchange could make the over-the-counter CfD market more efficient. "The LSE's service will offer customers a way of trading CfDs on the same order book as the underlying equity,” she said at the time. “For investors, it will cut the cost of economic exposure to UK equities and unlock latent demand."

In order to launch listed CfDs, the LSE would have had to standardise all CfD terms and that might have dented the instrument’s appeal to investors, according to some market participants, who also highlight that the UK CfD market tends to be bespoke.

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