Financial Derivatives

"The plans of the diligent lead to profit as surely as haste leads to poverty."(Proverbs 21:5)

The recent financial trouble of a major financial derivatives broker again throws light on the risks of commodities and derivatives products. In an environment where it has becoming very difficult to make money based on stubbornly current low interest rates lent to clients, more and more financial institutions are taking on excessive risk and over-leverage to carry out their own proprietary trading. Making big bets on European sovereign bonds is one of them. These companies relied heavily on overnight loans to finance their operations which can be pulled at any time.

The Contracts for Difference (CFDs) are basically betting on the movement of an asset without actually owning it. They were first introduced to retail traders in 1990s and were popularised by a number of UK companies with innovative online trading platforms. The ability to trade on leverage (as high as 10 times the leverage ratio), and one can trade both ways (long or short position) are the main selling points of this product.

There are a lot of talks held over last few years which just as any other kind of ‘investment talk’, unfortunately focus primarily on financial gain potentials rather than risks. Now it is apparent that the inherent risks are not just confined to the financial instrument itself, but also the CFD provider. The CFD is always a contract between the client and the provider. It can trade under two different models, i.e. the provider is a ‘market maker’, or by way of ‘direct market access’. The ease of opening such trading account with a small cash outlay has enticed many novice investors over the years. This financial turmoil may help to bring us back to reality – that there is no free lunch in this world.