The Australian Government’s client money reforms will grow the sector


Tamas Szabo Pepperstone

One of the recent ‘hot topics’ in the Retail Forex world, we’re pleased to present a guest post by Tamas Szabo, Chief Executive Officer Australia and NZ of IG Group Holdings plc (LON:IGG) on the changes to retail client money handling rules recently proposed by Australia’s Government.

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For eight years I have been urging our industry, ASIC, the Treasury and various Federal Governments to take a closer look at the circumstances under which client money can be used as working capital by firms in the retail OTC space. This has not been done out of an anti-competitive or petty agenda. I believe reform is both necessary and beneficial to increasing investor confidence and growing the overall market, providing opportunities for all firms.

australiaWhen I refer to working capital, I reiterate the words from the ASIC release. When a firm offers OTC retail derivatives (typically referred to as CFD or FX trading) each one of these firms operates as a principal counterparty to each client. This simply means that there is an agreement between a firm and a client. When a firm trades with a client, it hedges its net exposures to its clients with a third-party broker or liquidity provider (LP). These hedging trades are initiated by the firm on behalf of the firm, NOT on behalf of clients.

Under the circumstances where client money is permitted to be used, a firm is essentially trading with broker or LP in its own name but with its clients’ money. Section 981D in the Corporations ACT which permits this practice was originally written with exchange-traded products only in mind. It was never meant to encompass retail OTC contracts – where there is no clearing house, no exchange and no compensation scheme in place. Client money should never be permitted to be used in these circumstances and history has shown there are many things that can go very wrong. In the eyes of the broker or LP, there is no connection between the client money and the firm using it. This becomes very pertinent in the event of insolvency, as the current BBY situation exemplifies. In the example of a client with a cash balance and no positions, they would not be able to recoup their funds as there is nothing in place to protect them and the broker would only release surplus funds to a liquidator once all losses are covered.

australia-asic-client-money-protectionThere has been some criticism of the reform drive, despite support from the broader financial services community and knowledgeable financial media, and extensive examination of the issue by the Treasury and ASIC. Critics argue that firms claiming to hedge every trade will not be able to continue to operate this model, often referred to as STP (straight-through processing). I find this argument bewildering. FX firms are unlikely to be affected given that most of the net positions of these firms are balanced – buyers and sellers tend to balance each other out so a firm only has to hedge its net positions, and these tend to be small compared to the overall gross exposures. Much the same can be said of index trading.

However, problems do arise when firms offer individual equities, as clients tend to go long equities, and many smaller shares cannot be shorted. Therefore, the majority of clients end up being long. This typical situation removes the balancing-out effect and means that greater capital requirements are required to adequately hedge client stock portfolios. The problem with equities is that they present the greatest risk of loss to clients and firms given they can easily gap overnight or go into suspension where no trading can take place.

The net result of this is that a firm would have to carry all client losses in these scenarios to avoid using the overall client money pot to essentially bankroll other losing clients that cannot pay losses on their leveraged positions. In this scenario, the only thing that would protect client money is an appropriately capitalised firm that has the pockets to put up the losses. However, many firms in the Australian industry are not listed and even if they are, it can be very hard for clients to ascertain the level of capitalisation a firm has to provide them with this comfort. Finally, very few firms offer individual equity CFDs as they are not supported by the popular platform MT4 which most firms use.

Not permitting the use of client money is the global standard, and with good reason as it simply provides better protection and less risk for clients. There have been some arguments made that client money can be used in the US. This is partly true, however, firms need to hold on reserve ring fenced assets equal to the client money pool – which effectively achieves the same things as segregating it fully. Yes, New Zealand is the only country other than Cyprus where client money is allowed to be used – not surprising given that the New Zealand regulator followed Australian rules relatively recently.

The industry has to get better. ASIC has had to closely monitor the retail OTC sector thanks to a long list of corrective actions. This is not a good look for the sector and if firms are unable to comply with basic financial requirements as highlighted in the ASIC health check, then allowing firms to put client money at risk is preposterous.

There is absolutely no evidence to show that costs to clients are any higher in jurisdictions  where client money cannot be used versus Australia. There are number of firms that operate in multiple jurisdictions including those that use client money in Australia. None of them seem to have any problems adhering to laws that does not permit them to use client money elsewhere and offer the same competitive pricing.

There are clear opportunities for all providers to grow their business. A better-regulated sector with the client money loophole closed will go a long way to increasing consumer confidence and improving the perception of the sector. It is a huge win for the industry and its clients, and gives us the right framework to grow investors’ use of OTC derivatives.

The last thing a client should have to worry about is the safety of their funds. They should focus on trading effectively and beating the market.

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The Australian Government’s client money reforms will grow the sector

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