There is a lot that can be said about the collapse of MF Global and I might have
several things to write over the next week or so, but the most eye opening
thing to me and I think to most Americans is just how much pure gambling is
done in financial markets overseas particularly in places like the United
Kingdom – activities that are illegal in America and products that Americans
are not even allowed to purchase even from foreign sellers. MF Global was
apparently knee deep in these activities known as contracts for difference and
spread betting. Yes that is what it is called in the UK —- spread betting. In
fact, spread betting in the UK on financial products is regulated by financial
regulators but any profit is considered gambling income for tax purposes there
and in the UK, gambling income is tax free.
It is not that in the US – institutional investors cannot create these types of
instruments through customised private derivatives contracts – they can. But
overseas they sell this stuff retail to small investors. In fact, there are
firms in the United Kingdom and Ireland that handle both financial spread bets
and sports spread bets. It would be like Merrill Lynch allowing you to bet on
IBM but also selling you a bet on the Packers game.
What are spread bets and contracts for difference (CFD)? The two are very similar in terms of types of
risks taken and type of “bet” and overseas they don’t shy away from the term
bet. There are some tax differences and differences in how margin costs are
imputed, but I won’t wade into those here and there are also important
differences in contract expiration or lack of them – but they are more similar
than different, so for now we will treat them as one.
Let’s use an NFL example to illustrate. The Steelers-Ravens game last Sunday has the Steelers as 3 point favourite, but the Ravens (Baltimore) won by three. So if you had picked the Steelers (Pittsburgh)
not only were you wrong, but the magnitude of your error was 6 points – your
team should have won by three instead it lost by three. Now in normal football
bets, you would typically wager $1.10 to win $1 and if you chose Pittsburgh the
Steelers would need to win by more than 3 points for you to win the bet. If
they won by exactly three – you would push or tie and get your money back. If
they lost the game of won the game by under 3 points – you would lose the bet.
Now with spread betting as is done in Europe – you could have wagered say $10 or
10 pounds or Euros per point favouring the Steelers. As you prediction was six
points off – you would have lost $10×6 or $60. If you had wagered $100 per
point, your loss would $600 and so on. Of course for this to work, you would
need to have an account that could be debited – this would not work with the
traditional sports book ticket issued in Las Vegas. If you had bet the Ravens, you would get the
opposite result – this is simplified because it does not use the real bid-ask
prices that would be used that have a built in commission or vig – but this is
the basic function.
Now run this same scenario with the S&P 500 – you can bet on the S&P moving
in either direction by so many points and wager any number of dollars per
point. Obviously the more dollars you bet per point, the more leveraged your
bet. But your leverage does not even end there. Overseas, they allow you to enter these contracts on margin to begin whether, so you get even more leverage and risk.
We don’t even know the details of MF Global’s bad bets – we know from press
reports they had losses in European sovereign debt. We know from a balance
sheet perspective they were leveraged around 44 to 1. But what we don’t know
yet is the extent if any that MF Global’s sovereign debt losses were
exacerbated by products like CFDs or spread bets.
With what the world just went through in 2008 and 2009, it is amazing that this type
of leveraged gambling in financial markets is allowed to go, but apparently it
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