What you need to know about trading derivatives

When the JSE partnered with Deutsche Bank to launch International Derivatives (IDX), an asset class allowing South African investors to trade single stock futures (SSFs) on internationally listed companies, investors revelled in the opportunity to participate in international markets.

Towards the end of 2008, the JSE was ranked the 10th largest derivatives exchange in the world, by number of contracts traded. This ranking was published by the Futures Industry Association (FIA).

Derivatives trading is big in South Africa – but it’s perhaps important to note that we’re not talking about opaque, non-exchange-traded credit derivatives, which were largely to blame for the United States credit crash in 2007. The credit default swaps that caused all the trouble are not traded on an exchange and there was no transparency surrounding the dark, unregulated pool of about a trillion dollars’ worth of swaps. But that is another story.

Derivatives are considered useful because investors can unbundle and transfer some financial risks, while some products like IDX can also provide additional diversification in a portfolio. Olatundun Janet Adelegan, who works for the International Monetary Fund (IMF), has noted that our derivatives market was developed to self-insure against volatile capital flows and manage risks associated with the high volatility of asset prices.

How are derivatives traded?
In South Africa, most derivatives traded can be divided into two classes of instruments: options and futures. They can be traded in two ways – through a broker, that is, on an exchange like the JSE, which is regulated. They can also be traded OTC (over-the-counter).

OTC trades are usually for big, professional investors who understand the markets and are aware enough of the risks involved not to need the protections of exchange trading. However, in South Africa, there is also a large retail OTC market in CFDs. A CFD (contract for difference) agreement is a bilateral contract between, say, a bank and a private individual, whereby the buyer must pay the seller the difference between the current value of an asset and its value at the time the contract is concluded.

You can’t enter into CFDs in the US because the US Securities and Exchange Commission has restricted over-the-counter (OTC) financial instruments to professional users. OTCs are not regulated in South Africa, but you can access the market in two ways: through online trading, or over the phone with a financial or other institution.

SSFs are the exchange-traded version of a CFD and offer transparency and effective regulation missing from CFD trading.

How does the IDX set of products work?
The JSE’s IDX (International Derivatives) allows investors the opportunity to trade and gain exposure to price movements of internationally listed equities or shares. The JSE’s Equity Derivatives Market (SAFEX) lists, regulates and margins these products daily in order to provide a safer investing framework for investors.

Depending on the kind of investor you are, you can use derivatives to hedge your portfolio (that is, reduce risk by protecting a particular share portfolio against a drop in price in the market). Or you can also try to make a profit on the short-term movements in the contract price of a derivative, but this is obviously a rather risky enterprise.

The advantage here is that the JSE regulates the trades. You therefore have some protection against fraud and undeserved financial losses. Pricing is also more transparent, you can see how the market is performing and whether you have received a fair market price. Through the JSE’s central clearing house your profits or losses are guaranteed to be paid even if the other side of the trade defaults. This minimises credit risk.

How does a CFD or an SSF work?
SSFs and CFDs give you much greater exposure to the market by affording you leverage. This means you can profit from the market without having to pay the full amount invested in cash upfront. Rather, you are borrowing funds to trade in the market. But this also means that you can lose a lot more, because if the market makes an abrupt correction you may have to pay significantly more than the cash you used to take the position.

“Instruments such as CFDs and SSFs do have a place and purpose in financial portfolios but the associated risks must be clearly understood and mitigated where possible,” says Allan Thomson, head of derivatives trading at the JSE. He recommends trading on a regulated formal platform. He cautioned that although CFDs may appear to be cheaper products, they do have a hidden interest-rate on which both the interest rate and the principal amount on which interest is charged, can fluctuate daily.

This is in contrast to a SSF, where the interest rate and principal are fixed for the period invested. “The net effect is that CFDs’ interest costs can fluctuate and for longer periods will often be more expensive than SSFs,” he says.

There is a large OTC trading market for derivatives in South Africa for large institutions and professional traders. These trades are regulated by the International Swaps and Derivatives Association Master Agreement. As a professional investor, you still need to check that these transactions don’t run contrary to South African regulations. Also, there’s less price transparency because these transactions are often performed privately and bilaterally. This means that unless you are a very experienced trader for a large institution, with good insights into the correct pricing of complex derivatives, you may want to avoid OTC trading.

The underlying market risk is the same for SSFs and CFDs
It’s important to note that the underlying market risk is the same, whether you’re investing with SSFs or by means of CFDs. But where you may be taking on more risk is entering into CFD trades with a small brokerage with small balance sheets.

This is naturally a credit risk for investors where the profits owed to them and their deposits at that firm may not be safe.

South African investors may remember Dealstream, the brokerage trading in unregulated CFDs, which defaulted on its payments to its clearing agent, Rand Merchant Bank, and subsequently went under. (Interestingly, Rand Merchant Bank started the first informal futures exchange, in 1987.)

But it’s not all plain sailing with SSFs, either – the Bourse had to tighten its rules on SSFs in early 2009 when client defaults forced Absa bank to buy stakes worth R1,4-billion in the four JSE-listed companies involved. (Absa is a clearing agent on the futures market.) Absa then announced it would take legal steps to recover these losses.

Note that you’re required to match your losses with cash if a price move works against you. If you can’t do so, the position you’ve taken will be closed by your broker and loss will be inevitable.

As long as the investor understands that derivatives are perhaps inherently risky trades, and proceed with caution, he or she can take advantage of the leverage offered. Derivatives are useful instruments – but they can also be dangerous, so make sure you’re well-informed before you dip your toe in the water.

Questions you need to ask:
Before you dip into derivatives, ask some pertinent questions.

  • Is the seller authorised to sell these instruments with the JSE and or the FSB?
  • Is the firm a member of the exchange?
  • Is the product traded on an exchange and does the exchange have a record of you as a registered client?
  • What interest rate will I be paying and will it be annualised? Is the interest rate sufficiently competitive?
  • How does a CFD provider manage risk? What are the clearing processes like?
  • Be careful when it comes to online products – websites may make false, misleading or deceptive claims or forecasts. This is an offence in terms of the Securities Services Act, so don’t take anything at face value: ask for more information and check with the JSE or the FSB.

It’s important to note that pension funds and long-term insurance companies allocate only a 15% foreign allowance in terms of futures; and asset managers and registered collective investment schemes have a limit of 25% foreign allocation.

 

 

 

 

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