Following the recent volatility of the Swiss Franc, the spotlight is back on over-the-counter (OTC) trading versus exchange traded products (ETPs), most notably contracts for difference (CFD) and spread betting.

The fallout by the Swiss central bank’s decision to remove its Euro hedge in January took the market by surprise and saw the Swiss franc appreciate by circa 30% within 30 minutes. Any investor holding a leveraged CHF-EUR position experienced extreme losses or gains. CFD and spread betting firms had to absorb these gains and losses, many of which were against unhedged positions.

Contracts for difference and spread bet providers offer OTC trading. This means a trader or investor has a contract with a third party - in this case the CFD or spread bet provider - who relies on the third parties’ good faith to honour that arrangement. If the company gets into difficulty it may not be able to repay the money to its customers. This is called counterparty risk, i.e. the risk of default.

In a default scenario, a creditor (such as an investor) will be treated as an unsecured creditor and placed in a queue with other creditors. These providers are required to segregate client monies to minimise the risk. Unfortunately some clients have previously lost their deposits, as well as any unpaid profits owed to them, because this has not been done. If a company declares bankruptcy but an investor owes money on a losing trade, that investor is still required to pay that money to the bankrupt company.

Product difference

Exchange traded-products differ from CFD and spread-betting products as the investor’s risk is mitigated through the exchange, clearing house and settlement system which manage counterparty risk. ETPs also tend to own physical assets or are collateralised. This means that the trader or investor’s risk is against the product and the exchange and not with the provider.

The reasons why the CFD and spread betting firms occurred major losses as a result of the Swiss franc volatility was due to two fundamental factors. First, investors' losses weren’t limited to their original investment. Second, providers hedged their exposure based on their internal risk management systems and processes. If the systems and processes fail, investors are fully exposed to the credit worthiness of their provider.

Investors who use CFDs or spread betting firms are able to access extremely high leverage factors, with reports of leverage amounts of up to over 50x, using very small capital amounts. When the Swiss Franc went up by about 30%, anyone who was on the ‘wrong side’ of that move, and who was leveraged up to 50x, the losses would have led to bankruptcy, even on a very low initial investment / outlay. For example, a few thousand pounds invested could have resulted in hundreds of thousands of pounds in losses.

Knockout

With ETPs using a leverage product, the investor would have lost no more than their original investment. For example, a 5x leveraged (typically the maximum size) product would have been ‘knocked out’. As the market move was over 20% and the leverage was 5x then the product would become worthless and would cease to exist. This occurred when the ETF Securities 5x leverage CHF/EUR product was ‘knocked out’ and was delisted as a result.

When an investor trades OTC they are effectively happy to take the credit risk of their CFD or spread betting provider. Clients have to rely on how good or bad the provider is at managing its business. The money paid by clients is not secured against any assets. There are some protections around segregating ‘client’ and ‘firm’ monies.

With ETPs, the product is either physically replicated and holds all the constituents it is tracking; or synthetically replicated where it usually has high quality collateral backing. This collateral is held at arms-length in custody banks.

We believe that leveraged trading will increasingly move from OTC trading, to be on exchange. The robustness and protections that ETPs provide to an end investor are significant in terms of risk management, and events such as the Swiss franc move really does prove their worth in times of severe market stress.

It should always be noted that any form of trading, and especially leveraged trading, does have significant risks and investors should ensure they understand what they are trading before they trade or invest.

Hector McNeil

Co-CEO of WisdomTree, Europe