On 7 November Rule 8 of the Takeover Code was amended to require certain dealings in options and derivatives related to target shares to be disclosed to the market in the same way as dealings in actual shares.

Under the revised Rule 8.3 of the Code, a person who is directly or indirectly “interested” in 1% or more of any class of relevant securities of the target company or, if appropriate, the bidder (or who will be interested in 1% or more as a result of a transaction) must disclose publicly all “dealings” in such relevant securities of that company carried out during an offer period. A new definition of “interests in securities” provides that a person who has long economic exposure to changes in the price of securities (ie. essentially, he will benefit if the price rises) is treated as interested in them. Such an interest will be held by a person who owns or controls the actual shares, who has a call option or written put option in respect of them, or who has a long derivative referenced to them. But a person with only a short position will not be treated as interested.

A new definition of “dealings” captures any transaction which results in an increase or decrease in the number of securities in which the person is interested or in respect of which he has a short position, including buying and selling securities, granting or exercising an option, subscribing for securities, and entering into, closing out or varying a derivative referenced to securities.

At the same time, the Panel amended various other Rules of the Code to require disclosure of derivatives and options in (particularly) Rule 2.5 announcements, offer documents, defence documents, and announcements of levels of acceptances.

Proposed further changes to the Code

(1) Dealings in derivatives and options: control issues

On 2 November the Panel published a further consultation paper (PCP 2005/3) containing its detailed proposals to amend various Rules which deal with obtaining control of a target.

In general terms, the Panel again proposes to treat long exposure under derivatives or options as equivalent to interests in actual shares for the purposes of the thresholds in Rules 5 (Timing restrictions on acquisitions) and 9 (mandatory offers). However, derivatives and options will not count towards a bidder’s acceptance condition under Rule 10.

(2) Proposed abolition of the Substantial Acquisitions Rules (SARs).

On the same day, the Panel issued a separate consultation paper (PCP 2005/4) in which it proposes to abolish the majority of the SARs. Only those parts of the SARs that relate to tender offers will be retained (re-located as a new Appendix to the Code).

With both sets of proposals, if they are supported by the majority of market-users, they are likely to come into effect towards the end of February or in March next year.

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Full Article

On 7 November Rule 8 of the Takeover Code was amended to require certain dealings in options and derivatives related to target shares to be disclosed to the market in the same way as dealings in actual shares.

Under the revised Rule 8.3 of the Code, a person who is directly or indirectly “interested” in 1% or more of any class of relevant securities of the target company or, if appropriate, the bidder (or who will be interested in 1% or more as a result of a transaction) must disclose publicly all “dealings” in such relevant securities of that company carried out during an offer period. A new definition of “interests in securities” provides that a person who has long economic exposure to changes in the price of securities (ie. essentially, he will benefit if the price rises) is treated as interested in them. Such an interest will be held by a person who owns or controls the actual shares, who has a call option or written put option in respect of them, or who has a long derivative referenced to them. But a person with only a short position will not be treated as interested.

A new definition of “dealings” captures any transaction which results in an increase or decrease in the number of securities in which the person is interested or in respect of which he has a short position, including buying and selling securities, granting or exercising an option, subscribing for securities, and entering into, closing out or varying a derivative referenced to securities.

Previously, persons whose only interests were in the form of derivatives referenced to or options in respect of shares of a target company (or, if appropriate a bidder), no matter how large, had no obligation to disclose their dealings under Rule 8 as long as they were not also associates of the bidder or target. Further, while a counterparty to a derivative or option could acquire more than 1% of a company’s shares as a hedge, if the counterparty was a principal trader who was a recognised market-maker, it may have been exempt from the disclosure obligation by virtue of Rule 8.3(d).

For over a year the Panel has been concerned that investors may be able to take advantage of the economic rights conferred by options and derivatives that are referenced to company shares without having to comply with the obligations that would apply if the underlying shares were actually purchased.

For example, entering into a contract for difference (CFD) or spread bet referenced to the price of a share in Company X, multiplied by a specific number of shares, replicates to a large extent the economic exposure attached to actual ownership of the shares, particularly if the counterparty agrees to pass on to the investor the benefit of any dividends that are paid. Whilst the counterparty will usually hedge its exposure under the CFD, often by going out into the market and buying actual shares in Company X, unless the counterparty cedes control of those shares to the investor (e.g. under a voting rights agreement), the investor will not usually be obliged to notify Company X of its “interest” in the shares under section 198ff of the Companies Act (obligation to notify interests of 3% or more).

This lack of transparency provides scope for a potential bidder to build a stake without having to reveal its hand, and also for investors to assist one of the parties to an offer without being identified as a concert party. It also makes it difficult for other market-users to understand why the price of a company’s shares may be moving in a particular direction.

In addition, because the investor invariably knows that the counterparty will usually buy actual shares in the market in order to hedge its exposure, and because the counterparty will often (although not always) deal with those shares in a manner that suits its client’s intentions (even if there is no express agreement to do so), the investor may exercise a significant degree of de facto control over the shares. If the counterparty is exempt from the disclosure obligations because it is a principal trader acting in that capacity, an investor may even be able to ‘surprise’ a company by closing out his position and acquiring the hedging shares from the counterparty at a single stroke.

For example, only a couple of weeks ago it was reported that Polygon, a London hedge fund, had secretly entered into CFDs in respect of 13.9% of the Peacock Group, which is subject to an offer by its management team. The existence of the ‘stake’ was only revealed when Polygon closed out its CFDs and acquired the actual shares previously held by the counterparty. Under the new Rule 8, entering into or varying any CFD referenced to Peacock shares once the company was in an offer period would be a ‘dealing’ that would have to be disclosed.

A contract for difference is a type of derivative. For further information see the note at the end of this article.

Changes to Rule 8

Calculating the size of a person’s interest

To establish whether a person is interested in 1% or more of any class of relevant securities, and therefore whether he is required to disclose his dealings, he must evaluate his holdings at midnight (London time) on the day of the dealing and on the previous business day. Any interests held by virtue of derivatives or options will have to be aggregated with any holdings of actual shares and with interests under other derivatives and options. Generally, a person’s percentage interest is taken to be his aggregate gross long exposure; but long positions can be netted off against short ones where the positions are in respect of the same security, the same investment product is used, and each is on the same terms and with the same counterparty.

Where the number of securities in which a person in interested is variable, he will normally be treated as interested in the maximum possible number of securities concerned. Where a person enters into a derivative by reference to the price of a number of securities, but subject to a multiplying factor, the Panel will have regard to the person’s gross economic exposure – ie. he will be taken to be interested in the number of reference securities multiplied by the relevant factor. If a derivative is not referenced to a particular number of securities, the investor will normally be treated as interested in the gross number of securities to changes in the price of which he has economic exposure.

Timing of disclosure and information required

Such dealings must be notified to the market by 3.30pm (London time) on the following business day using the Panel’s Rule 8.3 disclosure form. (By contrast, disclosures under Rules 8.1, 8.2 and 8.4 must be made no later than 12 noon on the business day following the date of the transaction.)

The obligation to disclose falls upon the investor, rather than the counterparty. However, the counterparty may have a separate obligation to disclose if, for example, it acquires actual shares as a hedge.

In the case of a derivative, the investor should disclose the number of securities to which the derivative is referenced, the maturity date or closing out date and the reference price, together with a description of the derivative instrument itself. In the case of an option, disclosure should include the number of shares under option, the exercise period or exercise date, the exercise price, any option money paid and a description of the option instrument. But in both cases, the identity of the counterparty need not be disclosed.

Any arrangement giving the investor control of the voting rights attached to the hedging shares, and any option for the investor to acquire those shares, must also be disclosed. If there is no such arrangement, this fact must be stated. Where such an arrangement is entered into after the derivative or option has been opened, this will be treated as a ‘dealing’ and must be disclosed.

Other changes into effect on 7 November

At the same time, the Panel amended various other Rules of the Code to require disclosure of derivatives and options in (particularly) Rule 2.5 announcements, offer documents, defence documents, and announcements of levels of acceptances.

PROPOSED FURTHER CHANGES TO THE CODE

Dealings in derivatives and options: control issues

When the Panel first proposed in January this year making changes to the Code to deal with derivatives and options, it divided the issues into ‘disclosure’ and ‘control’ issues. The disclosure issues have now resulted in the changes described above, which took effect on 7 November.

On 2 November the Panel published a further consultation paper (PCP 2005/3) containing its detailed proposals to amend various Rules which deal with obtaining control of a target. If these proposals are supported by the majority of market-users, they will come into effect as soon as the Panel publishes its Response Statement – which is likely to be towards the end of February or in March next year.

In general terms, the Panel proposes to adopt the same approach as for the disclosure issues – ie. as far as possible to treat long exposure under derivatives or options as equivalent to interests in actual shares. However, derivatives and options will not count towards a bidder’s acceptance condition under Rule 10.

Specifically, the main changes proposed are:

• Amend Rule 5.1 (Timing restrictions on acquisitions) to apply also to dealings in long derivatives referenced to shares carrying voting rights in a company, regardless of whether, or how, the counterparty hedges its position, by regarding a derivative referenced to such shares as equivalent to a “right over shares”. Irrevocable undertakings will continue to be taken into account for the purposes of Rule 5, but not for Rule 9.
• The exemption in Rule 5.2(a) for purchases from a single shareholder should continue to be construed narrowly. It should therefore not be available where an interest in shares is acquired by virtue of a derivative. (In any event, a derivative will often be entered into with a principal trader and Note 1 on Rule 5.2 states that a principal trader will not normally be considered to be a single shareholder for the purpose of that Rule).
• Amend Rule 9.1 (Mandatory offers) to provide that if a person (together with his concert parties) acquires shares carrying voting rights, call options and written put options in respect of such shares, and long derivatives referenced to such shares, which in aggregate amount to 30% or more of a company’s voting rights, he will trigger an obligation to make a mandatory cash offer. Similarly, a person who, together with his concert parties, has an aggregate long position determined on this basis in respect of between 30% and 50% of a company’s voting rights will be required to make a mandatory cash offer if he increases that long position. In each case, a bid obligation will be triggered regardless of whether the derivative or option is cash or stock settled, whether it is in or out of the money, and whether (or how) the counterparty hedges its position.
• Various references to “shares” or “securities” will be changed to refer to “interests in shares” or “interests in securities” (which include derivatives and options), and various references to “purchases” will be changed to “acquisitions”. A large number of consequential changes will also be made.
• Acceptance condition: Although interests under derivatives and options will count towards the thresholds in Rules 5 and 9, they will not count towards an offeror’s acceptance condition under Rule 10 (or Rule 9.3). This is because the Panel considers that offers should only become or be declared unconditional as to acceptances in circumstances where statutory control has passed. As at present, a person will only become free of the restrictions in Rules 5 and 10 on acquiring further shares once he has statutory control of the target.
• Price at which an offer is required to be made (Rules 6, 9.5 and 11): where the offeror, or a person acting in concert with it, has entered into long derivatives referenced to, or options in respect of, shares in the offeree company during the offer period or in the 12 months prior to its commencement, it will be treated as having purchased shares at the highest derivative reference price or option exercise price (plus any option money paid), whichever is appropriate. (The Panel does not favour an alternative proposal under which the offeror would have to offer the highest price at which the counterparty has acquired hedge shares during this period).
• The introduction of a new status for certain trading desks, to be known as “recognised intermediary” status, under which interests in shares by virtue of derivatives or options held by a desk which is acting in that capacity will not be taken into account in determining the overall interests, for the purpose of Rule 9.1, of the group of which the desk forms part. The Panel proposes that recognised intermediary status should be used as the status for determining the applicability of the exception from disclosure in Rule 8.3(d).
• Amendment of the dealing disclosure requirements under Rule 38.5 for trading desks of connected exempt principal traders which do not benefit from recognised intermediary status.

Proposed abolition of the Substantial Acquisitions Rules (SARs)

On the same day, the Panel issued a separate consultation paper (PCP 2005/4) in which it proposes to abolish the majority of the SARs. Although this proposal is independent of those relating to derivatives and options, it was prompted by responses to the Panel’s previous consultations. Only those parts of the SARs that relate to tender offers will be retained (re-located as a new Appendix to the Code).

Background and purpose of the SARs

The SARs were introduced in December 1980 following a series of market raids on the shares of listed companies without any offer having been made. At the time, the Panel was principally concerned that:

Specifically, the main changes proposed are:

• the premium paid by the potential acquirer in the market raid was made available only to a limited group of shareholders who were normally institutional investors; and
• the fact that the stake was acquired over a very short period of time meant that the board of the target company had no opportunity to respond to the development and to advise the company’s shareholders on how to proceed.

The SARs were therefore introduced in order to slow down the speed with which a person who has not announced a firm intention to make an offer can acquire shares or rights over shares that take his stake to between 15% and 30% of the voting rights of a company.

Panel’s reasons for abolishing the SARs

Originally, in its consultations on dealings in derivatives and options, the Panel proposed to extend the scope of the SARs to dealings in derivatives referenced to, and options in respect of, shares carrying voting rights. However, for the following reasons (amongst others) the Panel has concluded that the SARs no longer serve a useful function:

• A person acquiring a stake is already required by s.198ff Companies Act 1985 to disclose details of his interest to the target within 2 business days. Where a person’s aggregate interests are 1% or more, all ‘dealings’ during an offer period must be disclosed to the market under Rule 8. Rule 5 of the Code also restricts a person acquiring shares or rights over shares which take his and his concert party’s aggregate holding to 30% or more, and Rule 6 sets a floor on the price at which any offer must be made.
• Shareholders have the option not to sell their shares in a market raid and instead to hold out for a better price in subsequent purchases or in an offer.
• When SAR 3 was introduced, the period within which significant shareholdings in listed companies had to be disclosed to the market under the Companies Act 1985 was 5 days. With the reduction of the statutory limit to two business days, part of the rationale for this rule has disappeared.
• In general, the Panel’s approach to share dealings is permissive rather than restrictive, focusing on the consequences which should flow from particular dealings rather than seeking to prohibit them altogether, unless there is some overriding policy concern.

Tender offers

The Panel does, however, intend to retain those provisions of the Code and the SARs that relate to tender offers (principally SAR 4, which sets out the requirements for the conduct of a tender offer) and include them in a new Appendix 5 to the Code. The draft Appendix will largely replicate existing SAR 4 and Note 3 on Code Rule 36.3, although some amendments are proposed, including:

• a new provision under which the Panel’s consent will be required for a tender offer;
• changes to take account of the amendments proposed in PCP 2005/3 (described above); and
• clarification that where a tender offer is for the shares of a company quoted on the London Stock Exchange, AIM or OFEX, it must be made by advertisement, although the buyer may also send a copy of the announcement to the target’s shareholders. In all other cases, the tender offer must be made by circular and be open for at least 21 days.

Timing of changes

This consultation closes on 27 January 2006 and, if the Panel’s proposals are broadly supported, they are likely to come into effect towards the end of February or in March next year.

If, following consultation, the Panel decides to retain the SARs, it proposes to publish a further consultation paper on amendments so that they apply to dealings in derivatives referenced to, and options in respect of, shares carrying voting rights.

Derivatives and contracts for difference (CFDs)

Derivatives are financial instruments whose price and value derive from the value of the underlying assets or other variables; these could an index such as the FTSE 100, individual shares or interest rates.

CFDs

A CFD is a type of derivative whose value is determined by reference to the price of an underlying security. In its simplest form, a CFD is an agreement where two parties agree to exchange the difference between the opening and closing prices of a particular share, multiplied by a specific number of shares, on pre-determined dates. Although a counterparty will often hedge its exposure by acquiring actual shares, sometimes it may do so by purchasing a balancing derivative.

Sometimes the counterparty may be prepared to enter into a voting rights agreement (or similar), under which the investor is given the right to control the exercise of votes attaching to the shares bought by the counterparty to hedge its exposure under the CFD and/or an option for the investor to purchase those shares.

Spread bets

A spread bet is a type of contract for difference. The glossary to the FCA Handbook defines a spread bet as:

“a contract for differences that is a gaming contract, whether or not section 412 of the Act (Gaming contracts) applies to the contract;

In this definition, “gaming” has the meaning given in the Gaming Act 1968, which is in summary: the playing of a game of chance for winnings in money or money’s worth, whether any person playing the game is at risk of losing any money or money’s worth or not.”

The Code definition of derivative is deliberately wide and catches spread bets.

Other types of derivative

These include swaps (bilateral contracts where the parties agree for a period to exchange cash flows on future dates); options contracts (bilateral contracts between an option holder and an option writer who, in return for a premium, grants the option holder the right, but not the obligation, to buy or sell an agreed amount of an underlying asset at a fixed price on a future date); and forwards and futures (where the parties agree to buy and sell an underlying asset at a future date at an agreed price).

Derivatives can be traded on an exchange or over the counter (OTC) (ie. sold directly by seller to buyer). OTC derivatives have the advantage that they can be tailored to meet the requirements of a particular investor.

Futures and covered warrants

For the purposes of Rule 8.3, futures contracts and covered warrants that include the possibility of delivery of the underlying shares are treated as options; but if the terms do not provide for the underlying shares to be delivered, they are treated as derivatives.

Warrants to subscribe

A holding of warrants to subscribe for new shares will not amount to an interest in those shares for the purposes of Rule 8. But the holder will have an interest in the warrants as a class of security: if his aggregate interest in that class of securities amounts to 1% or more, he will have to disclose all dealings in relevant securities.

In the past the UK regime required any direct or indirect holding of 3% or more of the voting rights and every 1% change thereafter to be disclosed. By themselves, CFDs confer no rights to acquire the underlying shares, nor to control the voting rights of those shares, and as a result did not require public disclosure under the UK’s Disclosure and Transparency Rules (‘DTR’). Similarly, the earlier disclosure provisions under the Companies Act 1985 only caught “interests in shares”, which focused on legal rather than economic relationships.

The new rules aim to enhance transparency of synthetic long positions in UK shares and give companies and investors a clearer picture of who has significant economic control over listed shares. The new regime requires investors who hold 3% or more of a company’s voting equity through either shares, CFDs, or other relevant derivatives, or an aggregation of shares, CFDs, and other relevant derivatives, to disclose their stakes. Further disclosures will be made at increments of 1 per cent (in the same way as shares currently are). The disclosure requirements, explained below, refer to gross long CFD positions. This means that in determining whether the disclosure thresholds have been triggered, the CFD holder must disregard any short positions held in the referenced shares.

The amendments apply in respect of UK incorporated companies whose shares are admitted to the Main Market, AIM or PLUS. Overseas companies whose shares are admitted to the Main Market, AIM or PLUS will therefore not be subject to the CFD disclosure requirements, but non-EEA companies whose shares are admitted to the Main Market will continue to be subject to the major shareholder notification regime apart from these requirements.

How Disclosure will Work

The new system will require aggregation of all voting rights in specific UK issuers which a person holds (or is deemed to hold) as the owner of:

• shares;
• so-called ‘qualifying financial instruments’. Broadly, this means instruments giving the owner an unconditional right to acquire shares to which voting rights attach; or
• long CFDs or similar derivative products which are not qualifying financial instruments but are referenced to shares and have a similar economic effect to qualifying financial instruments. This will be the case if the holder has, in effect, a long position on the economic performance of the shares.

Why has the FCA made the changes?

In the past CFD holders were not required to disclose their positions during the life of the contract. This allowed CFD holders to build stakes through CFDs anonymously.

Also, previously CFDs and related derivative products fell outside of the scope of DTR 5, unless the instrument explicitly gave a right to acquire, or gave access to the voting rights attached to, shares held as a hedge by a CFD writer.

The FCA has decided to bring forward the implementation of the new rules due to ongoing market turmoil, also claiming that the new rules are a very significant step in improving market transparency as it addresses certain ‘market failures’ by bringing long CFDs within the disclosure regime. Whilst CFDs are not a substitute for direct share ownership, the FCA concludes that in certain circumstances they can be used in ways ‘the intention of which the regulatory regime is designed to catch’.

Specifically, a survey of market participants found that CFDs are sometimes used by CFD holders to seek to influence voting and other corporate governance matters on an undisclosed basis. In such cases the CFD holder would control access to the shares or exert influence over the shares indirectly through its counterparty, usually an investment bank. For example, on termination of the CFD, the investor may wish to acquire the shares underlying the CFD, at which point the investment bank would be a natural seller of such shares. The investor may therefore be able to acquire the shares more quickly than would have been possible if the CFD had not been entered into (even though it has no contractual entitlement to do so). Also, the FCA has followed a number of recently reported cases where CFDs have been used to build up significant stakes in companies without prior disclosure. Under the UK Takeover Code, CFDs become disclosable during a takeover ‘offer period’. The inclusion of CFDs in the major shareholder notification regime would also complement the Takeover Code requirements.

Which Issuers

The new elements of the disclosure regime only apply to UK-incorporated issuers whose shares are admitted to trading on:

• a regulated market in the EU (e.g. the London Stock Exchange’s main market); or
• a prescribed market (e.g. AIM).

Which Products

The FCA has deliberately adopted a principles-based approach in shaping the new requirements to discourage the creation of innovative products in a bid to avoid disclosure. Amongst other things, this catches contracts for difference and other derivative products such as cash-settled options and convertibles over unissued shares. This applies to long positions held through contracts for difference, swaps, options or forward sale contracts, even if cash-settled, whether or not the investor has the ability to control voting rights or obtain physical delivery of the underlying shares. Exchange-traded derivatives are covered. Short positions are not covered by this regime.

Instruments which give a legal right to acquire shares which are not yet issued (such as convertible bonds and warrants) are also caught. The FCA’s view is that they allow for the acquisition of voting rights in an issuer and as such could be used to build stakes in companies. On the other hand, where an instrument gives rise to a conditional right to acquire a CFD or similar derivative product, provided the transaction is subject to conditions beyond the control of both parties, the FCA expects a notification to be made only when the relevant conditions are fulfilled. This would cover, for example, nil paid rights and placee rights which are subject to shareholder approval. It would not cover the choice of whether to exercise an option as that is within the control of at least one party.

Aggregation

In determining whether a relevant threshold has been reached or crossed (with respect to a UK issuer) holders must aggregate their direct and indirect holdings in shares, qualifying financial instruments and CFDs. Aggregation was deemed necessary not only to prevent a ‘loophole’ which would have allowed an investor to build up a covert stake of up to 8% through a combination of shares and CFDs, but also to avoid a costly parallel disclosure regime. These new rules will bring the DTR much more in line with the disclosure obligations imposed by the UK Takeover Code in respect of CFDs written on shares subject to a takeover offer.

Denominators

The denominator to be used for determining whether a disclosure is required is (as now) the issuer’s total voting rights in issue based upon that issuer’s most recent total voting rights disclosure. This is the case even if the disclosure relates to convertibles over unissued shares.

Gross or net positions?

The FCA has confirmed that the Rules are intended to catch gross long positions held through CFDs without netting any offsetting short positions. This is because it is only the long position that is relevant to the control of voting rights. So (as with the existing DTR 5 rules), a person may have a disclosed long 15 per cent position but may also have a non-disclosed offsetting short position.

How this Differs from the Past

Save in relation to companies subject to a takeover offer, and save as required by the new short selling rules, there was previously no requirement in the FCA’s Disclosure Rules and Transparency Rules to disclose holdings of CFDs, provided they were cash settled and did not confer voting rights. The FCA is concerned that, without disclosure, companies cannot identify who has significant economic exposure to their shares which could result in inefficient pricing in the market.

The nature of a CFD means that a holder can gain economic exposure to a particular share without being required to pay the full market value of that share. The holder gains no voting rights, but can usually switch the contracts into holdings of the underlying shares. This has meant that CFDs have been used for many years to build positions in public companies without the need for any public disclosure.

The new rules significantly tighten the UK disclosure regime and make it more difficult for investors to build significant economic stakes in UK listed companies using cash-settled derivatives without disclosure. The Rules also go beyond the requirements of the EU Transparency Directive, implemented in the UK in January 2007, and make the UK regime tighter than many other EU Member States with regard to disclosure of synthetic positions. The new rules are in line with stricter rules already introduced by the UK Takeover Panel (Panel) in 2005, under which dealings in cash-settled derivatives became disclosable during takeover offer periods.

What are the requirements that will apply?

This is a single threshold for both shares and CFDs requiring disclosure once a holding reaches 3%, and subsequent disclosures being required where holdings increase or decrease above or below the 1% steps set out in the Disclosure and Transparency Rules.

An exemption for CFD writers is in place to reduce unnecessary disclosures and reduce the cost of implementing the systems for disclosure. This will be similar to the Takeover Panel’s disclosure exemption for banks and securities houses with Recognised Intermediary status. So basically CFD writers are exempted from disclosure where they are only acting as intermediaries and providing liquidity.

Whilst most proposals have not changed, the March 2009 paper does set out two areas where the FCA is changing its approach:

First, in relation to the basis on which disclosures should be calculated, the FCA has decided that disclosures should be made on a delta-adjusted basis, save that reporting on either a nominal or a delta adjusted basis will be allowed for a transitional period of 7 months from implementation. The delta-adjusted basis is explained below.

Second, the FCA confirms that the new disclosure rules will be effective from 1 June 2009.

What is a Delta-Adjusted basis?

Disclosures must be made on a ‘delta-adjusted basis’. The delta of an equity derivative represents how the change in the pay-off of that derivative changes in relation to the change in price of the underlying equity. A CFD, for example, would normally have a delta of one, as it perfectly mirrors a change in the underlying share price. The advantage of a delta-adjusted disclosure obligation is that it more accurately affects the holder’s real economic exposure to the underlying shares. This approach has the effect of differentiating between a call option which is out-of-the-money by a significant margin (and therefore has little real economic value) with a call option over the same number of shares which is in-the-money. The latter has a real economic value and is likely to be hedged by the writer of the option acquiring the shares to hedge its exposure. The holder of a call option in such instances is under an obligation to recalculate its delta-adjusted holding on a daily basis (at the close of business).

Disclosure on a delta-adjusted basis can be illustrated as follows:

Company A has one million shares.

A CFD for 100,000 share in Company A has a delta of 1. Therefore the appropriate calculation would be (100,000 x 1) / 1,000,000 which gives a disclosure of 10% of Company A’s shares.

A cash settled call option for a notional 100,000 shares in Company A has (at transaction date) a delta of 0.2. Therefore the calculation (100,000 x 0.2) / 1,000,000 gives an answer of 2% of the company’s shares and no disclosure is required.

To determine the delta value, the FCA is of the view that standard option pricing models are readily available.

Other Points to Note

The new rules catch derivatives in addition to CFDs. The precise wording of the new instrument states that in addition to disclosing interests in ‘qualifying financial instruments’, a person must make a notification in respect of any financial instruments held directly or indirectly which are referenced to the shares of an issuer and have similar economic effects to (but which are not) qualifying financial instruments. The effect is that although the focus is on CFDs, the FCA intends that all similar economic interests are disclosed.

Relationship with Takeover Code

The new DTR requirement to disclose CFD positions will apply alongside the disclosure regime under the Takeover Code during an offer period, so separate notifications will be required.

Disclosure of Short Selling

The FCA is in the process of consulting separately on long-term proposals for disclosure of short positions, which it views as an issue of market conduct, rather than transparency and voting rights. Its proposal, as set out in its February 2009 Discussion Paper, is that individual net short positions held in all equities and their related instruments of UK incorporated issuers should be publicly disclosed on reaching a threshold of 0.5 per cent. An FCA feedback statement is expected to be published in the third quarter of 2009.

The current position is that net short positions of 0.25 per cent or more in companies undertaking a rights issue and certain financial sector companies are disclosable. These disclosure requirements must be complied with separately and in addition to the DTR 5 requirements.

Europe (updated for 2012)

The major shareholder notification requirements were substantively harmonised across Europe in early 2007 when most member states adopted the Transparency Directive6. Under the Transparency Directive, member states are required to ensure that, where a shareholder directly or indirectly acquires or disposes of shares of a company whose shares are admitted to trading on an EEA regulated market, and such shareholding exceeds or falls below certain prescribed thresholds, the shareholder will be required to notify to the issuer the proportion of voting rights that it holds. The Transparency Directive imposes minimum standards which must be incorporated into national law by members states. By focusing holdings of voting rights, CFDs are not covered in the major shareholder notification regime in the Transparency Directive and, to the extent that they wish to bring CFDs within the scope of their national regimes, member states will have to impose more stringent national requirements. The disclosure regimes for CFDs and other derivatives differs in each member state.

CFDs and similar derivative instruments have drawn the attention of securities regulators in a number of jurisdictions. In Europe, even though the Transparency Directive has provided harmonised minimum requirements, CFDs are excluded from those requirements and individual member states will need to take specific legislative steps if they are to impose more stringent national requirements to provide for the disclosure of CFDs.

References: Mayer Brown Capital Markets Alert Newsletter, Orrick Research and Ashurst London

Background

CFDs have attracted considerable attention internationally in the last few years. When the Porsche car manufacturer revealed in October 2008 that, in addition to the 42.6% equity stake that it already held in Volkswagen, it also held cash-settled options in respect to the 31.5% of the total issued Volkswagen stock capital (thereby in practice having an economic interest in Volkswagen of 73.1%), investors and speculators fought each other in a short squeeze and Volkswagen’s stock price rose sharply from around € 200 to € 1,000 in a few days. The German’s financial regulator, BaFin, made an enquiry and reached a conclusion that Porsche did not breach any stock exchange laws by doing so.

In addition, during the takeover battle regarding ABN AMRO, it emerged that members of the consortium (ie RBS, Santander and Fortis) had built-up a holding in ABN AMRO of about 4% of the entire issued share capital via derivative structures, in addition to the 4% already held by them directly.

Also, in the case of Continental/Schaeffler, Schaeffler was denounced of having effectively increased its shareholding to a controlling stake of about 36% without notifying the market. Schaeffler had done this via a swap transaction for 4.95% of Continental stock (under which the swap counterparty had to to sell the stocks to Schaeffler) and a number of other cash-settled transactions for another estimated 28% of Continental shares.

These incidents led to outcry from market participants regarding the exemption of contracts for differences and similar instruments under the respective disclosure rules in Europe countries. The basis of the argument was that although holders of CFDs do not own the assets in question and thus weren’t entitled to voting rights, there is a risk that their counterparties (most of the times holding the Underlying stock to hedge their exposure under the relevant contract for difference) would utilise the voting rights attached to the Underlying Shares in parallel with the interests of the CFD holders, creating a non transparent scenario (for example in general meetings of stock holders). Disclosure of such positions should reduce this risk.

Another argument arises as to the financial ambiguities created by a non-transparent market. We have witnessed Volkswagen’s stock price spiralling up when Porsche finally made known its percentage of cash-settled options. In takeover situations, stake building by the offeror is usually considered as sensitive data that is important to other stock holders in the company. If an offeror can increase its economic stake in the target company in a concealed manner, this will create a situation where the stock price of the target company remains generally unmoved. If and when such a suitor decides to make its bid for the target company known to the public (assuming the bid will be at a higher stock price level than the price the offeror paid to acquire its economic stake in the target company), the offeror will gain from the fact that it has economically acquired a part of the target company’s stock against a lower price, thereby making its entire bid for the target enterprise less expensive.

References: Clifford Chance paper: Disclosure of contracts for differences and other cash-settled equity derivatives.

Past Articles (also of interest)

FCA imposes disclosure to block covert stakes

The UK Financial Conduct Authority’s (FCA) is demanding that contracts for difference, which give exposure to a company more cheaply than by buying shares outright, be disclosed to the stockmarket if they are worth more than 3% of the value of the relevant company, to avoid stealthy stake building in the previously unregulated areas.

CFDs provide exposure to a share at a cost of about 10% of the actual share and avoid stamp duty. The holder is also able to convert the contract into stock, which means companies can suddenly find themselves with a large shareholder.

The new disclosure rules which are mainly targeted at hedge funds will make it easier for private investors to see what is going on behind the screens as big holdings through contracts for difference will be disclosed as if they were shares.

The FCA had not originally intended to require such a strict level of disclosure and had wanted to keep the need to report trading positions in CFDs, which drive up to 40% of daily trading volume on the stockmarket, to a minimum.

The regulator appears to have been swayed, however, by the views of major institutional investors, which were concerned that CFDs could be used to gain an economic exposure to a company without market participants knowing and could affect the way the voting rights attached to the shares were used.

As well as setting 3% as a threshold regardless of whether voting rights are used, the regulator is requiring that contracts for difference positions are added to existing shareholdings in companies. The FCA said: “We originally proposed that there should be no aggregation of CFD holdings with share-holdings, with CFD holdings becoming disclosable at a threshold of 5% … There was significant support from respondents for aggregation, principally because otherwise it would allow a potential interest of nearly 8% to be built up without disclosure (that is up to 3% in shares and 5% in CFDs)”. The 3% limit is currently used for conventional share-holdings.’

An exemption will be made for CFD writers who act as intermediaries, similar to the Takeover Panel’s Recognised Intermediary exemption to reduce unnecessary disclosures.

The rules will not be in place for 14 months. The FCA will publish the policy statement with feedback on the consultation, with the final rules released in February 2009. These will come into force in September 2009 latest. However, the FCA may try to advance that date.

The FCA has also introduced surprise rules recently demanding short positions greater than 0.25% to declare bets against the shares of companies involved in rights issues. Derivatives, particularly CFDs, have become increasingly important as hedge funds seek to avoid public declarations of their holdings to gain easy access to leverage and, in the UK, avoid stamp duty. The FCA estimates CFDs account for almost a third of equity trading.
Reporting Levels

While CFDs don’t currently need to be disclosed, investors must reveal their shares if they hold more than 3 percent of a publicly traded company’s total stock. If the investor is regulated by the FCA, this position rises to 5 percent. If a company is in the middle of a takeover bid, any trade over 1 percent of its stock must be disclosed. A number of Disclosure-faqs

Barnett Alexander now hopes to increase his £120,000 pension fund to £1m over three years without making any new contributions. His huge gains have been made possible through the use of the sophisticated market instruments known as contracts for difference (CFDs), which now enable individual investors to gear up their stakes (multiply through borrowing) and go short as well as long (bet on shares going down as well as up). Along with their counterpart spread betting, CFDs come buzzing with health warnings for all but the most savvy online traders.

But for Alexander, 40, after a 15-year career as a stockbroker, the new freedoms presented an opportunity to make a fortune. Alexander said: “In the old days you would have to pay for everything upfront. If you had got £10,000 in your Isa, you could only buy £10,000 of shares. With CFDs, all of a sudden your £10,000 has jumped up to £30,000 or £40,000. If you trade a FTSE share some firms will give you 10 times your stake.”

Alexander, who might make 20 trades a day, says the secrets of his success are “money management and risk control”. His £20,000 Pep was inflated by the technology boom to £200,000, by April 2003 it had hit £750,000, and early this year it hit £1.2m.

But he warns: “This is only suitable for the person who is interested in trading and in the old days would have gone to a conventional stockbroker. Leverage means risk, and if you can double your money you can also lose a lot.” Spread betting and the closely related CFDs have exploded in five years and now account for 30% to 40% of all trades on the London Stock Exchange.

They are ways of betting on the rise or fall in the price of individual shares or in the market indices, such as the FTSE-100. In neither case do you actually own the shares. So there is no stamp duty to pay, and there may be no commission or brokers’ fees. And because spread betting is gambling, there is no capital gains tax. You also only need 5% to 10% of your stake in cash but if you lose the gamble you have to pay the full amount. This is why the Financial Services Authority is concerned at how they are promoted. For CFDs, though, private traders have to deposit about £10,000 to cover potential losses.

Prolific day-trader with a theory of relativity ; City CFD Trader;

Those Northern industrialists who used to complain in the 1980s about City ” shorttermism” might choke on their Tetley’s if they heard about [Nick Sparkes], who says most of his trades last less than one day.

“I sit here all day and watch stocks,” he says. “I get an idea of where they are relatively. Lloyds might be up 3p and Barclays up 3p, but suddenly you might find that Lloyds was up 15p and Barclays up only 3p.” At that point, he might decide to go short of the first or long of the second.

Sparkes’s chosen instrument for his trading is the contract for difference (CFD), a derivative that allows experienced investors to go long or short of a large number of shares without taking delivery of the stock. It is also a margin product, so a pounds 100,000 trade on a share with GNI, Sparkes’ CFD provider, could be made using just pounds 10,000 initial capital.

IN THE attic of Mitch Mosley’s country cottage, in amongst the pictures of and drawings by his two young daughters, there are a dozen Dunhill butts in the ashtray by 10.30am. “They’re fucking about with the Barclays share price,” he’ll be fulminating, or “GUS shares are too high, I’m not having that.”

In David Eaton’s Fulham loft, piano music playing softly in the background, he may be on to his second glass of water by 10.30am. On a computer screen to his right, the winnings from his bet against the Wyevale Garden Centres share price will be gently ticking higher.

The pair maybe poles apart temperamentally, but they are the new faces of retail investment. The myth is that day traders and other short-term private investors were wiped out by the bursting of the technology bubble.

True, many have drifted off nursing horrible losses. But the growing popularity of contracts for difference (CFDs) – an easy-to- use derivative product which allows investors to profit from both rises and falls in share prices – means that those who remain are often making a tidy sum from the market.

Mr Eaton is even going to start investing his pension through CFDs, cocking a snook at those who have seen the bear market maul their long-term savings.

A former oil trader, he makes his living from CFDs, heading up to the office in time for the market opening at 8am and leaving it decisively behind at 4.30pm in time for an early dinner with his young family. He’s been doing it full time since “finding ourselves in Somerset and unable to get a job that pays more than pounds 20,000”.

Temporarily back in London, Mr Eaton makes maybe 20 trades a day, and pays income tax rather than capital gains on his earnings.

“The first thing I think is not how much I could win on a trade, but how much I could lose,” he says. “I have a very high stop-loss. If I’m wrong, I’m wrong and I cut my losses before they get past pounds 300.

“All the small winners and losers cancel themselves out. You make the money on the one in eight, the pounds 1,000-plus winners.”

A CFD gives traders an exposure to the stock market that is many times the value of the money that needs to be deposited with the CFD broker. Their popularity has ballooned because it is a way of playing the market without having to pay stamp duty.

Some estimates suggest more than 20 per cent of the volume of shares going through the London Stock Exchange is from brokers hedging CFDs.

Mr Eaton argues CFDs are the best method of short-term trading. “There is no stamp duty to pay, you can go short, and you get leverage because someone is lending you the money. It is also just a lot easier. There is no paperwork. I have more trouble getting together the certificates and dividend paperwork for the three or four shares I own than for 2,000 CFD trades.”

Where Mr Eaton’s trading is actually his livelihood, Mr Mosley’s is more in the manner of a hobby, albeit an occasionally lucrative and often addictive one. And in stark contract to Mr Eaton’s spartan loft overlooking west London, activity in Mr Mosley’s corner of his cluttered attic is about as frenetic as sitting at a desk can get.

There is the clicking of share price graphs, the coloured flickering of the London Stock Exchange trading screens, the white noise of Bloomberg TV, and the man himself on the phone ordering his broker to “get two of Aviva at 34” or some such.

Mr Mosley has also now put in a high-speed telephone link at work – he runs the family flooring firm and a motorcycle shop – so he can keep an eye on his positions and make sure he is not losing money while he is out. He has long been able to make money while he is out. His biggest coup was a pounds 6,000 gain on Colt Telecom in 2001, through a CFD set up while he was on the phone to his broker from a Blockbuster video shop.

“The first share I bought was Reuters in 1999 – I had never touched a share in my life – and it went up 40 per cent,” he said. “Then I bought Harrier, a tip that was on the telly, and made a stupid amount of money in a week. I wasn’t really trading, just buying stocks. Once I’d lost all the money I had won, I went to see a guy who knew about charts, and the rest, as they say….”

The charts he speaks of are not astrological. They are share price charts from which technical analysts can divine levels at which share price moves might reverse, based on previous peaks and troughs, when investors may be tempted to buy or sell. They can guide investment decisions for the medium term as well as the very short term. Mr Mosley is often in and out of a share two or three times in a morning, banking several hundred pounds on a penny or two move in the share price.

Mr Eaton often trades shares of companies despite having a hazy or even no knowledge of what they do. “I don’t know anything,” he said. “I don’t ever have the news on and I don’t read the Financial Times. If something is going on, 1,000 people will always know it before I do anyway,” he says. “Leave that sort of trading to the boys at Goldman Sachs.” There are as many different strategies as there are traders. Fundamental analysis of company accounts has served the ubiquitous Simon Cawkwell – the bear raider known as Evil Knievil – well over many years.

Others chase the latest bar-room gossip, seeking and repeating rumours of takeovers or profit warnings, spending their day in an endless round of phone calls that will almost certainly include one from “Jimmy from Glasgow”, another of the great characters unbowed by the bear market.

And there are the computer geeks who can spot the automated trading strategies set up for the computers of the big hedge funds, which may buy small parcels of shares at given intervals. The best geeks of all can make money by studying the Stock Exchange order book and beating the computers at their own game.

When we visited Mr Mosley last week, he was having a mixed morning. He was betting on falls by shares in Reuters and WPP, which weren’t going down, and Barclays and Aviva, which mostly were.

At different points he was variously up pounds 1,500 and down pounds 200 before closing the day with a whopping pounds 1,900 profit from the pounds 10,000 deposit with his broker, GNI. Since then, the gains have grown further, as his bearish outlook stood him in good stead this week.

“I’ve missed trains for this,” he says. “It is addictive because where else can you make this sort of money so quickly? There is lap dancing, I suppose, but I’m not too well qualified for that.”

In the old days you would have to pay for everything upfront. If you had got £10,000 in your Isa, you could only buy £10,000 of shares. With CFDs, all of a sudden your £10,000 has jumped up to £30,000 or £40,000. If you trade a FTSE share some firms will give you 10 times your stake.”

There are now an increasing number of brokers offering these platforms. So it’s more easy than ever to trade long or short (to profit from falls in share prices), avoid stamp duty, trade on margin, and trade directly with other market participants in the underlying market.

But be warned: “This is only suitable for the person who is interested in trading and in the old days would have gone to a conventional stockbroker. Leverage means risk, and if you can double your money you can also lose a lot.

CONTRACTS for difference are so called because they are a legal contract with a broker. He agrees to pay you the difference between the price at which he buys shares on your behalf and the price at which you tell him to sell them. If there is a loss, you agree to pay him the difference. At no point do you own the shares, just an interest in the gains or losses from those the broker has bought in the market.

You do not have to put up all the cost of the shares, as you would if you were buying or borrowing them directly. Deposits can be as low as 10 per cent, so a pounds 10,000 account with a CFD broker could allow you to speculate on pounds 100,000 worth of shares.

CFDs enable individual investors to gear up their stakes (multiply through borrowing) and go short as well as long (bet on shares going down as well as up).

If you were trading shares directly, you would need to be a short seller to profit from stocks going down. Direct short selling involves borrowing shares to sell and returning them with shares bought at what you hope will be a lower price. Selling and buying back a CFDs is as simple as buying and selling one. The explosion of short selling during the bear market has mainly been done using contracts for difference.

CFDs allow all of this as they are ‘synthetic’ derivatives – created out of other securities. They are an agreement between two parties – an investor and a provider (usually a broker) – to pay the difference between the opening price and the closing price of an underlying security (usually a share). That means, as an investor, you can profit – or lose out – from share price movements, without ever taking delivery of the actual shares. Since you never own the shares, there’s no stamp duty to pay. Providers also allow margin trades, which means you only have pay a ‘margin’ or deposit of as little as 10 per cent of the contract value. This allows you to take larger positions than you could afford to in the underlying shares – which translate into much higher profits if you invest the right way, or losses if you invest the wrong way.

Trading can be near instantaneous via the internet and, now, some CFD providers are giving investors direct access to the Stock Exchange’s electronically-traded market (SETs). This means investors have the ability to place orders and deal inside the existing bid-offer spread – as well as access to the SETs pre- and post-market auctions, where the trading day’s best prices often occur. Other important features shared by the new CFD platforms include the ability to create several watch lists and view detailed Level 2 (L2) dealing screens. Access to Level 2 screens is also provided by sites such as www.advfn.com and www.moneyam.com. But here we review the CFD brokers that provide both access and trading facilities.

All three platforms offer an impressive level of functionality and sophistication, and seem certain to appear at the top of any active trader’s list of preferred dealing applications.

Although many firms do not advertise the fact, commission levels are often negotiable based on trade size and activity, so headline rates are not always representative – don’t be afraid to cut a deal.

Germany’s Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) announced new rules Thursday designed to protect retail investors, becoming the latest European regulator to move to limit the expansion on the fast-growing industry in which many retail investors end up losing money.

Shares in CMC Markets, IG Group, Plus500 and other listed brokers traded down after Germany’s Federal Financial Supervisory Authority (BaFin) announced it planned to restrict the marketing, distribution and sale of CFDs to private investors. The industry watchdog Bafin stated that the sale of CFDs will not be permitted unless providers offered ‘limited risk accounts’ where clients’ maximum exposure is limited to their account balance.

“In the case of CFDs with an additional payments obligation, the risk of loss for the investor is incalculable,” Bafin Chief Executive Director Elisabeth Roegele said. “For consumer protection reasons, we cannot accept that,” she added.

Germany’s measure is arguably one of the most effective as far as consumer protection is concerned. The terms can’t be clearer – providers that want to provide their services to German residents can do so, as long as they protect clients from negative balances.

The regulator considers that leveraged trading is akin to trading with borrowed money. Financial CFDs with no downside protection may lead to price gaps and in some cases require the trader to end up paying much more than the amount they initially invested. BaFin doesn’t consider stop loss orders and margin calls as effective protection in limiting client losses in such instances. In fact, they could lead to incremental losses since investors’ positions could be forcibly closed at highly unfavorable prices.

The regulator lists several main risks associated with CFD trading – the complexity of performance calculation, speculation on credit, lack of transparency when it comes to calculation of underlyings where there are price gaps, no limitation on the risk of loss through the margin call procedure, and no limitation of the risk of loss by stop-loss orders, among others.

The regulator noted that CFDs do have some advantages compared to direct investments but CFD providers mainly targeted retail clients. Currently the CFD trading industry enjoys relative freedom in the European Union with no caps on leverage. That means retail investors can take out bets that are far bigger than their initial deposit, offering much larger potential returns but also running the risk of amplified losses. In the past German clients were held personally liable for losses if these happened to exceed the balance of their CFD brokerage accounts.

BaFin published on Thursday a draft General Administrative Act concerning the issue. Once the rules are approved, they will come into effect within three months of that date. Thursday’s move came after three UK-listed spread betting companies saw their share prices plunge by more than a third on Tuesday after Britain’s Financial Conduct Authority said it planned to bring in new rules for the sector.

Some providers already offer limited risk accounts that are meant to prevent client from incurring losses in excess of the amount deposited in their account, however in future this will be a requirement.

The main participants in the German CFD market will be meeting Bafin representatives, who have allowed until January 20, 2017 for consultations on the new ban. The ruling may result in some changes for high net individuals who may have to be reclassified as professional investors in order to continue receiving STP access to the market without the negative balance protection.

Last week, the financial regulator in Cyprus, where a number of CFD providers are registered, also sounded a warning to companies about the bonuses they offer to customers.

FCA Proposals

The FCA has published a consultation paper proposing a range of measures designed to enhance protection for retail CFD customers. The new measures aim to reduce the risks posed by CFDs and ensure that firms provide better information to customers. The proposals include:

• Enhanced disclosure requirements – the FCA is proposing that retail CFD firms must provide a standardised risk warning to their customers. In addition, the FCA plans to impose a requirement for firms to provide a disclosure stating the percentage of client accounts that made a net profit or loss in the previous calendar quarter and over the last 12 months.
• Leverage limits – the FCA will require firms to apply leverage limits for CFDs. The limits will be set according to both the volatility of the underlying asset and the experience of the customer, as follows

To count as ‘experienced’, clients will be required to evidence that they have conducted at least 10 trades per quarter in four of the previous 12 quarters (or entered into at least 40 trades over the previous 12 months with at least two trades in each quarter); otherwise they will be treated as ‘inexperienced’.

Ban on bonus promotions – the FCA will prohibit firms from using any form of trading or account opening ‘bonuses’ or benefits to promote their retail CFD products and platforms.

The leverage limits and enhanced disclosure requirements will not apply directly to firms offering CFDs to retail clients in the UK under a cross-border services passport from another EU member state. However, the FCA proposes to restrict financial promotions for incoming firms that do not seek to comply.

Background

The FCA’s proposals are the latest in a line of regulatory interventions in the sector by the FCA and other EU regulators:

• In February, the FCA published a ‘Dear CEO’ letter reminding firms to look closely at their on-boarding procedures, including the quality of appropriateness tests and the adequacy of anti-money laundering checks.
• On a European level, the European Securities and Markets Authority has published and repeatedly updated a series of questions and answers on retail CFDs intended to foster better supervisory convergence among EU member states.
• In July and August, regulators in Belgium and France took aggressive measures to restrict the marketing or distribution of CFDs to retail investors.
• On 30 November, the Cypriot regulator, CySEC, announced its own restrictions.

CySEC Restrictions

CySEC’s measures are of particular interest as many firms that operate in the EU are authorised in Cyprus. Typically, these firms then use a MiFID services passport to offer CFDs to clients in other member states on a cross-border basis.

CySEC has introduced similar restrictions on bonus promotions and is also targeting the use of leverage, although its leverage restrictions are less severe than the FCA’s proposals. CySEC states that firms should offer retail clients a default leverage limit that does not exceed a cap of 50:1, but firms will still be able to give clients the option to change the default to a higher leverage.

Binary Options

The FCA consultation paper also addresses the FCA’s policy considerations in relation to binary options (which the FCA is terming ‘binary bets’). Binary options are currently treated as gambling products in the UK with providers licensed under the Gambling Commission, rather than being regulated by the FCA.

However, this is set to change as part of the UK’s transposition of MiFID II, when it is anticipated that binary options will be brought within the FCA’s regulatory perimeter. This will bring the UK into line with most other EU jurisdictions which already regulate binary options as regulated securities under MiFID. The FCA makes clear that it believes that binary options carry material consumer protection risks, on the basis that they:

• do not allow retail investors to make informed decisions and can lead to addictive behaviour akin to gambling;
• pose significant information asymmetries for clients; and
• lead to conflicts of interest for the firm which takes the other side of the client’s bet, there potentially being a strong commercial incentive for firms to manipulate expiry reference prices to avoid pay-outs to clients.

The FCA states that it is considering possible policy measures to address these risks, including a potential restriction on marketing binaries to certain retail clients and the future use of product intervention powers under MiFID II to address specific product features, marketing, distribution or sales techniques.

Consultation Details

The FCA is inviting feedback responses on its policy proposals set out in the consultation paper. The consultation will run until 7 March 2017. The FCA then aims to publish a Policy Statement confirming the final rules in spring 2017.

This is an area where there is considerable cross-border activity and where many providers use a MiFID passport to offer their services into the UK from elsewhere in the EU. Although the FCA proposes to restrict financial promotions for incoming firms that do not comply with its rules, it is difficult to see how the FCA will be able to police this in practice.

Since the FCA’s proposed leverage limits are more stringent than those of CySEC, there is a risk that the UK regulator is creating an uneven playing field which could drive operators to rely on authorisations from Cyprus or other member states – or to use entities regulated outside the EU, which typically do not offer the same level of client protections. Respondents to the consultation will likely focus on the consequent risk that the FCA’s measures may be counter-productive, in reality leaving UK retail customers more exposed.

As for binary options, the industry will welcome the opportunity to provide feedback to the FCA on a product that has languished in regulatory limbo over the past few years. However, it remains to be seen how far the FCA will go in imposing restrictions once binaries are finally brought within its purview.

by Berwin Leighton Paisner LLP – Matthew Baker and Anthony Williams

The report is heavy on the numbers, and compares the three trading spectrums of CFDs, spread betting, and Forex. It shows there is little doubt that IG has a strong hold on retail traders, with a slight decrease in market share on financial spread betting and FX, and a slight increase on contracts for difference. This is against a backdrop of a reduced number of active traders from 2012 to 2013.

The report puts the numbers at 93,000 traders for spread betting and CFDs, down from 104,000 in the previous year, and a smaller decrease from 74,000 down to 72,000 in Forex. This is the first time since report started in 2009 that the market has decreased, and it is thought to be mainly caused by a reduction in the number of people taking up online trading, with the number of traders ceasing activity each year remaining about the same.

The UK is by far the largest market examined by Investment Trends, which also reports on trading in Australia, France, Germany, and Singapore. As CFDs and spread betting are not permitted in the United States, this means that the UK clearly remains the leading market in the world for these financial instruments.

The report is based on a survey of 13,185 UK traders so is extrapolated from their answers, but as Investment Trends is experienced in research, I have no problem believing the numbers are correct. It’s interesting to note that IG rebranded itself last year, becoming simply IG rather than separate brands like IG Index and IG Markets. The company felt well enough off to spend several million dollars buying the website domain IG.com, so that bears out the optimistic report.

In fact, as a demonstration of the IG’s dominance in online trading, it was estimated to have 34% of the CFD market, 29% of the FX market, and 41% of the financial spread betting market, and no other provider had as much as 10% in any of those.

An interesting part of the survey is that the company Plus500, which was only founded in 2008, is rising up the charts and number five in the CFD market at 5% (Plus500 specializes in CFDs). Plus500 set itself the goal in 2012 of becoming the number one CFD provider, and it went public in 2013. While it still has a way to go to become number one, it put on a good showing in the last year.

It is great to see that many traders rated their brokers as good or very good, and this is consistent with 2012. It seems that the major players take customer satisfaction very seriously. On that note, 72% of spread betters use their smartphones or tablets for their trading, and this is up nearly 10% on the previous year. What is more, the report states that an additional 12% intend to start using their mobile devices in the coming year.

The providers have made sure that they are competitive in this market, according to Pawel Rockicki, the Senior Analyst at Investment Trends. ‘These days it is not enough to just let clients trade from their mobile or tablet. They want good functionality and all the bells and whistles available on the desktop platform. Brokers have been spending substantial amounts of money investing in mobile capabilities.’

He added that 90% of current “mobile traders” use their device to monitor their open positions, 60% open their positions and 70% close positions on their mobiles, as well as using them to keep up on the news and doing research.

CFDs are an important innovation in the design of futures contracts and their adoption by private investors has fuelled significant growth in the derivatives market and has also generated some controversy, but to-date there have been no detailed academic studies examining CFD markets. In 2007, the Australian Securities Exchange (ASX) introduced exchange-traded CFDs on individual stocks and other financial instruments.

Lee, Adrian D. a Post Doctoral Fellow and honours student Choy, Shan both from the University of Technology (Sydney) examined the performance of investors who utilised ASX-listed stock contracts for difference to see if we are being taken for a ride. The two scholars used the S&P/ASX 200 Accumulation Index as a performance measure to compare traders’ performance on long (i.e. buy) trades in relation to short (i.e. sell) trades and reached a conclusion that individual CFD trades net modest but ‘statistically significant’ positive returns over daily trade horizons (daily price against closing price and next day’s closing) and lose on average when holding positions from one week to one year.

The research is hypothetical, in that trades held for weekly, monthly, half-yearly and yearly periods are assumed based on the available data. Having said that, the better returns were noticed over the two shortest holding timeframes. The findings show that inclusive of the bid-off spread but before other costs such as financing fees, investor CFD buys outperformed sell CFDs by 5.85 basis points per day over a one day holding period, with no statistically significant performance for longer holder periods of up to one year. Investors who continue holding positions to extended periods are unlikely to come ahead because of the financing costs. A fee is charged for holding CFD positions overnight (typically RBA cash rate + 1.5%) which can add up in the long term. Sellers on the other hand earn interest at the cash rate – 1.5%.

Good stock picking was also observed as investors in aggregate turned into shares with a high beta (which is a measure of a stock’s volatility) before the stock market rose, so as to beat the risk-free rate. If the scenario materialised, they would have demonstrated themselves to be good market forecasters.

The traders who took sizable positions ($20,000 to $50,000) experienced short-term outperformance suggesting that such traders are more likely to be sophisticated. The short-term outperformance was noted in both small (less than $10,000) and large trades ($20,000 or more) – even after financing fees.

The study also found out that ‘buy positions’ outnumbered ‘sell position’ by 2.47 basis points (0.0247 percentage points) per day (intraday) and by 6.10 basis points per day over a one-day holding period (measured against the next day’s return). The bid-offer spread for trading contracts for difference was an extra 3.46 basis points than when directly trading the underlying shares, the authors observed.

The report examined 270,584 trades spread over 71 exchange listed shares on the Australian exchange between Nov 2007 and Jun 2010. The Australian exchange nominates price makers to help boost liquidity to ASX-listed CFDs in periods where prices move away from the underlying share values. The paper admits that volume on the exchange is small compared to the wider market; the aggregate value of shares traded is almost 380 times greater than the value of ASX-listed CFDs over those shares. The number of deals traded on the Australian exchange is also a miniscule of the amounts traded in relation to its wider over-the-counter market rivals. CFD trade sizes average $21,734 versus $13,277 for conventional share dealing which is logical given that minimal execution fees and margins provide extra incentive to trade in larger size.

For the entire sample, the average CFDs trading volume is aggregately $7.8 million per day while trading on the underlying stocks is 382 times larger at almost $3 billion per day. Lee appears to conclude that traders who deal in CFDs traded on the Australian Securities Exchange don’t necessarily perform badly. ‘It’s a surprise finding that if you suspect retail traders using these ASX-listed CFDs are stupid, they’re not. Overall, they have slight trading ability on the day and the next day.’

There isn’t substantial research about private investors’ performance with derivatives trading although one European study by Bauer, Cosemans and Eichholtz noted that most investors lose money in options trading due to mainly poor timing and costs although the authors also suggest gambling and entertainment value as motivators.

The full text of the academic study can be found here [pdf format].

“This initiative forms part of the JSE’s focus to be more responsive to the needs of the market rather than develop products simply because they seem like a good idea.”

A spokesman for the Johannesburg stock exchange noted that it regards CFDs as a compliment to single stock futures and that both financial products can exist side by side.  In a similar way to an over-the-counter CFD, the JSE eCFD will carry an overnight holding charge and in this respect the exchange proposed that it will be using the South Africa’s Benchmark Overnight Rate, published daily by the SA Reserve Bank.

Clifford Chance LLP has drafted a briefing detailing these measures and setting out an tentative timeline showing the path to mandatory clearing in the European Union.

The update from Clifford Chance LLP can be found here [PDF format]