The UK could soon see stricter rules around CFDs
One path to profit in financial markets is to understand the cognitive biases that can make investors behave irrationally, and take advantage of their mistakes. For example, when prices are pushed out of alignment by panic selling or euphoric buying, a measured investor can try to benefit by taking the other side of the trade.
However, while reasonable among consenting adults, this idea has some moral limits attaching to it. At some point, taking advantage of a poorly-informed or unskilled counterpart begins to look unseemly.
It is with this in mind that the Financial Conduct Authority (FCA) in the UK has taken a look at, and proposed stricter rules for, firms offering contracts for difference (CFDs) to retail consumers. (CFDs are a form of derivative trading that enable you to attempt to net a potential profit by speculating on the rising or falling price of shares, indices, commodities, currencies and treasuries.)
CFDs have an entirely legitimate place in financial markets, but they are complex products that are often traded with high rates of leverage, thereby allowing investors to trade large volumes (and assume large risks) with limited capital.
Often, a CFD provider will provide helpful trade ideas and strategies to encourage clients to be more active. It is no doubt tempting for clients to follow the recommendations of someone who claims to have trading expertise, and who can back this claim up with anecdotes of successful past trades.
This is clearly an attractive setup for the CFD providers who profit from the volume traded by their clients. For the retail clients who may not have a firm grip on the markets or instruments they are trading, however, the benefits are a little less clear. Human bias being what it is, these clients will often assume that they have the skill, judgement and dynamism to make easy money by aggressively trading these instruments.
And this, it turns out, is their undoing. The FSC has analysed a sample of client accounts for CFD firms to work out how well those clients have been doing. They found that 82% of clients lost money: a remarkably poor success rate that few informed investors would consider attractive.
Improved regulation and disclosure will no doubt help protect these investors from themselves, but one suspects the FSC has a big job ahead of it if it wishes to eliminate irrationality from this part of the market.