24 March 2015

Should consumers be allowed to lose £250,000 in a few minutes?

James Daley

By James Daley LinkedIn

The removal of the Swiss Franc exchange rate controls in January left some investors nursing losses which may leave them bankrupt? Has the regulator taken its eye off the ball?

In the middle of January, the Swiss central bank shocked investors and policymakers alike when it unexpectedly announced it was removing its exchange rate controls against the Euro. It's an event that will have passed 90% of the British population by. But for those in the financial world, it caused a day of chaos, and left some hedge funds and investment banks nursing losses of hundreds of millions of pounds.

Followers of this blog will know that I don't spend an awful lot of time lamenting about the fortunes of investment banks and hedge funds - and I'm not about to start now. But on the edges of the Swiss Franc shock, a small number of consumers also made heavy losses - so heavy that in some cases the individuals may be left bankrupt.

These were people who were speculating on currency movements using a form of investing (or gambling, if you prefer) called "spread betting", which uses derivatives to allow you to leverage the positions you take - greatly increasing the potential gains as well as the potential losses you can make.

Spread betting 101

In the world of regular investing, if you were to buy £1,000 of shares in a company at £10 a share, you would make £10 if the share price rose by 1%, and you'd lose £10 if it fell by the same amount. Importantly, if the share price fell all the way to zero, you could never lose anymore than the £1,000 you started with.

But in the world of spread betting, it's common to bet on much smaller incremental movements of the asset price. So, for example, a spread better may bet £10 for every penny movement in the share price. At £10 a share, that means you'd make £100 if the share price rises 1%, and £1,000 if it rose 10%. On the downside, if the share price collapsed to zero, you'd lose £10,000.

In this high risk world, sharp movements in the price of the underlying asset that you're betting on can make or lose you enormous sums of money. And in the case of the Swiss Franc - where the price moved 30% in a matter of minutes after the Swiss Bank's announcement - a small number of people lost enough money to bankrupt them.

Indeed, one consumer in Ireland - a teacher earning just under £18,000 a year - is reputed to have lost £280,000 as a result of the Swiss Bank's move.

Protection for the gamblers

Depending on your views on consumer responsibility, you may not have a great deal of sympathy for people who lost money in this way. Spread betting is a bit like taking borrowing money from the bank to invest. And if you can't afford to take the risk, then you shouldn't play. In this case, spread betters built in a false assumption that the Swiss Franc exchange controls would remain in place indefinitely, a call that they got wrong. If they bet too much - then surely it's no different to someone betting their house on Balthazar King in the Grand National.

But just as we force people to wear seatbelts, and ban the use of drugs which can harm you, surely there should be some kind of consumer protection around this kind of high stakes gambling. Although spread betting firms are forced to check that their clients are aware of the risks and are suitable to be involved with such a high risk sport, it's really not that hard to set up an account.

I could perhaps live with this, if there were better controls once you got started. But once you've opened an account, you put yourself at risk of losing more than your their entire net worth on a single bet.

Spread betting accounts offer stop loss mechanisms, to cap the amount you can lose when a bet goes against you. However, in the event of market shocks, where prices move very quickly, the spead betting companies are often unable to close out the trades at the prices their customers requested. Somewhere in the small print, the firms warn you that they can't guarantee they will be able to get you out at exactly the price you ask for. But if that's the case, then they must surely be able to put other mechanisms in place to provide the protection that customers need. It's certainly not fair to leave customers potentially exposed to losses which could criple them.

I would have thought that spread betting firms have a responsibility to their shareholders as much as their customers in this regard. If they let their customers go bankrupt, it's in no one's interest.

If spread betting firms are to be allowed to have private individuals as their customers, they must be able to limit their losses. And if they can't shut out positions in a panicking market, it should be the companies not the customers who are left on the hook for the additional losses.

This may mean that spread betting firms need to spend some extra money hedging or insuring their clients' positions - a cost that will ultimately have to be passed onto their customers. But we can't have a market where individuals can be bankrupted in a heart beat.

I understand it's an area the FCA is looking at. And in light of what happened in January to a small number of investors, I hope there's a new urgency in their work.