In July 2024, the Australian Securities and Investments Commission (ASIC) issued a strong warning to derivative issuers offering Contracts for Difference (CFDs). ASIC's concern stems from some CFD issuers allegedly offering ‘margin discounts’ to retail clients holding opposing long and short positions, a practice that violates the ASIC Corporations (Product Intervention Order – Contract for Difference) Instrument 2020/986 (CFD PIO).
According to ASIC, these margin discount practices pose significant risks to retail investors and are in direct contravention of regulatory requirements aimed at ensuring market integrity and investor protection. As a result, ASIC has called for the immediate cessation of such practices, warning that failure to comply could lead to severe penalties.
Understanding the CFD PIO Regulations
The CFD PIO came into effect in October 2020 and applies to all CFD issuers providing these products to retail clients in Australia. The regulation was introduced as a product intervention measure designed to protect retail clients from excessive risk exposure inherent in highly leveraged CFD products.
The CFD PIO sets out clear conditions under which CFDs can be issued, particularly concerning margin requirements and close-out protection for retail clients. Two key sections of the regulation are particularly relevant to the current issue of margin discounts:
Initial Margin Requirement (Section 7(2))
Under this section, a CFD issuer must require retail clients to provide an initial margin that varies depending on the underlying asset. The required margin ranges from 3.33% to 50% of the notional value of the CFD. Crucially, the CFD PIO prohibits the netting off of opposing positions (long and short) in a client’s account when calculating the initial margin. This means that a client holding both a long and a short position cannot use one to offset the other, a practice often referred to as margin discounting.
Margin Close-Out Protection (Sections 7(3) and 7(4))
These sections require that CFD issuers provide close-out protection for retail clients, ensuring that the client’s losses do not exceed their initial margin. The protection amount is calculated based on the aggregate initial margin for all open positions. Similar to the initial margin requirement, issuers are prohibited from netting off opposing positions when calculating the close-out protection amount, which is designed to automatically close a client’s position before their account balance turns negative.
Risks of Margin Discounts
ASIC's investigation highlights several potential risks associated with the illegal practice of offering margin discounts. These practices can lead to financial instability for retail clients, who are often less experienced and more vulnerable to market volatility than institutional investors.
Here are the key risks outlined by ASIC:
Excessive Leverage:
Offering margin discounts can encourage retail clients to build highly leveraged positions, increasing their exposure to market fluctuations. High leverage amplifies both gains and losses, and in volatile markets, this can result in significant financial damage for retail investors.
Increased Funding Costs:
When clients are encouraged to take on larger positions through margin discounts, they may face higher overnight funding costs (also known as swap costs). These additional costs, which accumulate daily, can erode profits and increase the financial burden on clients over time.
Delayed Margin Close-Out:
One of the most dangerous outcomes of margin discounts is the potential delay in margin close-out protection. If the initial margin is artificially reduced through netting off opposing positions, the automatic closure of losing positions may not be triggered in time, leading to significant, unrealized losses for the client.
Sudden Margin Increases:
If one side of an opposing position is closed, the effect of the margin discount is removed, potentially causing a sudden margin call on the remaining open position. Retail clients, often unaware of the risks associated with margin discounts, may be unprepared to meet these margin requirements, resulting in forced liquidations and unexpected financial losses.
ASIC’s Response and Potential Penalties
ASIC has made it clear that contraventions of the CFD PIO will not be tolerated. The regulatory body has begun investigating firms that offer margin discounts and is ready to take civil and criminal actions against those in violation of the rules. ASIC has broad enforcement powers, which include imposing hefty fines, launching court procee