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Published online by Cambridge University Press: 17 February 2009
It is a trite statement that the global investment markets have been transformed by the internet. The proliferation of on-line share broking services, the migration of investment transactions from proprietary electronic networks to the open architecture of the internet, the use of the internet to by-pass traditional “bricks and mortar” financial intermediaries, the creation of on-line markets for exotic commodities such as bandwidth and new types of derivatives such as credit and weather derivatives, and the electronic “day trader” phenomenon have all been widely publicised.
1 Equity swaps can also be used to exchange exposure to one parcel of shares or index for exposure to different shares or another index (called “equity call swaps” or “relative performance swaps”), or to create an exposure to the greater of the total returns on two or more different shares or indices (called “outperformance swaps”) or to the composite performance of a basket of different shares or indices (called “blended swaps” or “rainbow swaps”). For a discussion of the different types of equity swaps, see generally Marshall, J. F. and Yuyuenonwatana, R. P., “Equity Swaps: Structures, Uses and Pricing”, in: Francis, J. C., Toy, W. W. and Whittaker, J. G. (eds.), The Handbook of Equity Derivatives, revised ed. (New York: John Wiley & Sons 2000) pp. 344–347 and 352–357Google Scholar; Das, S., Structured Products and Hybrid Securities, 2nd ed. (New York: John Wiley & Sons 2001) pp. 561–579.Google Scholar
2 See generally Salomon Smith, Barney, Exotic Equity Derivatives Manual (June 1999) pp. 9–16Google Scholar; Marshall and Yuyuenonwatana, ibid., p. 343; Kat, H. M., Structured Equity Derivatives (New York: John Wiley & Sons 2001) pp. 110–128Google Scholar; Goldman, Sachs, “A Historical Perspective on Equity Derivatives” (June 1999) at 11–13.Google Scholar
3 See generally Partnoy, F., “Financial Derivatives and the Costs of Regulatory Arbitrage”, 22 Journal of Corporation Law (1997) 211.Google Scholar
4 See generally “CFD Strategies”, Applied Derivatives, Nov. 2001.
5 “Leveraging Equity Trades”, Applied Derivatives, Oct. 2001. This is also consistent with the information contained in the prospectus issued in July 2000 for the flotation of IG Group pic (the proprietor of IG Markets and IG Index).
6 The low costs faced by on-line providers of equity mini-derivatives have made it possible for them to service the entire spectrum of retail investors: they can offer micro-priced derivatives to more risk averse retail investors as well as competitively-priced credit to less risk averse investors. In addition, these low costs translate into low barriers of entry. Thus, many of the on-line providers of equity mini-derivatives are new or “greenfields” entrants to the financial markets. This is in stark contrast to the on-line trading of shares in Australia, the United Kingdom and continental Europe, and the United States where the leading on-line brokers are the subsidiaries of banks, insurance companies or well-established brokerage houses. For example, the leading on-line share brokers in Australia are Charles Schwab, ComSec (owned by Commonwealth Bank of Australia), E*Trade, Merrill Lynch HSBC and TD Waterhouse (owned by Toronto-Dominion Bank).
7 See generally “CFDs versus Single Stock Futures”, Applied Derivatives, Jan. 2002Google Scholar. The competition with equity mini-derivatives is made explicit in LIFFE's publications on its “Universal Stock Futures” product: LIFFE, “Universal Stock Futures – Why Trade Anything Else?” (2001)Google Scholar; LIFFE, “Trading Contracts for Differences? Thinking about it?” (2001)Google Scholar; LIFFE, “Trading Equity Spread Bets? Thinking about it?” (2001)Google Scholar. For a more detailed discussion of the LIFFE product, see generally LIFFE, A Guideto Universal Stock Futures (2001)Google Scholar. Single stock futures have, in contrast to the United Kingdom and the United States (see infra n. 8), been available to investors in Australia for several years. However, that product has languished, more as a result of the turf battles between the Sydney Futures Exchange and the Australian Stock Exchange than any defects in the design of the product.
8 The first low-value futures contract (the “E-mini S&P 500 Index Futures Contract”) was launched by the CME in September 1997. That product was, however, only thinly traded prior to the “day-trader” phenomenon, the same phenomenon that has provided much of the impetus for the on-line trading of shares and other equity instruments. For a more detailed discussion of CME's E-mini Index Futures products, see generally Lerman, D., Exchange Traded Funds and E-mini Stock Index Futures (New York: John Wiley & Sons 2001)Google Scholar Chapter 8. In addition, on 30 January 2002, the Australian Stock Exchange launched two low-value futures contracts (the “ASX Mini50” and the “ASX Mini200” futures contracts) modelled on the CME contracts.
9 In the case of the latter, an investor finances the purchase of shares or other investment securities by borrowing typically 50-70% of the purchase price. The balance of the purchase price is provided by the investor out of his or her own funds and the investor grants the lender a security interest over the purchased shares, to support the repayment of the loan. If the shares appreciate in value, the investor can borrow additional funds against them; if, however, they fall in value, the investor will be required to provide additional security (in the form of cash or other shares) to ensure that the loan-to-value ratio is maintained at 50-70%. Alternatively, the lender can force a sale of the purchased shares to maintain the loan-to-value ratio. On-line CFDs can be characterised as synthetic margin loans.
10 The leading on-line providers of equity CFDs are Cantor Index <www.cantorindex.com>, City Markets <www.citymarkets.net/cfds/>, CMC Spreadbet <www.dea14free.com/spreadbet>, GNI <www.gnitouch.com>, Halewood International Futures <www.hifutures.com/cfd.htm>, IG Markets <www.igshares.com>, ManDirect <www.mandirect.com/products/equities.cfm> and Sucden <www.equitycfd.co.uk>.
11 Alternatively, a retail investor who believes that ABC pic shares are over-valued can establish a “short” or “sold” position by selling a CFD.
12 CFDs are purchased at the offer price for the underlying shares, index or options, but are sold at the bid price. Thus, in the above example, a short position over an equivalent parcel of ABC pic shares would be established by selling a CFD to the on-line provider at £50.00 per share.
13 An up-front commission of 0.25% (of the value of the underlying shares, index or options) is generally charged for purchases and sales of CFDs.
14 This margin provides the on-line provider with security for the performance of the investor's obligations under the CFD. The lodgement of cash margin – called “cash collateralisation” – is one of the most important techniques used by dealers and other participants in the financial markets to manage credit risk: see further Benjamin, J., Interests in Securities: A Proprietary Law Analysis of the International Securities Markets (Oxford: Oxford University Press 2000) Chapters 4-6.Google Scholar
15 The financing charge is typically set at 2.5-3% above the relevant benchmark inter-bank interest rate (e.g. LIBOR). The amount payable by the investor will be reduced during the term of the CFD by the amount of any dividends declared in respect of the underlying shares (since a bought CFD is economically equivalent to purchasing the underlying shares).
16 In the case of a short CFD position, the investor will, instead, be credited with interest on the balance of the underlying assets (as if the investor had sold the underlying assets and was receiving interest on the sale proceeds). See further “Leveraging Equity Trades”, supra n. 5.
17 The lodgement of additional margin ensures that the ratio of the “loan” (that is the amount on which the investor is paying a financing charge) to the current value of shares underlying the CFD is maintained at the original 80-90%.
18 Many on-line providers permit investors to limit their losses by incorporating a stop-loss limit in the CFD. The investor specifies a threshold at which the CFD is to be automatically terminated. In the above example, the investor could specify a stop-loss limit of £49.00 so that if the bid price for ABC pic shares were to fall to that level, the CFD would be closed out with the investor incurring a maximum loss of £2,000.00. The incorporation of stop-loss limits is relatively expensive, with the charges for such contract features ranging from 0.25% to 1.5% of the total value of the underlying shares, index or options.
19 A further refinement is the MarketPlus product offered on-line by Invesdex <www.invesdex.com>. The funds invested in this product can be allocated by the investor to a long or short position in respect of a share market index, with the gain or loss on the investment being determined by the difference in the futures contract price for the index on the inception of the investment and the price on the closing-out of the investment or the re-allocation of funds by the investor. The MarketPlus product can be characterised as a capped CFD: in contrast to conventional on-line CFDs, the investor's loss is limited to the amount of his or her investment and, consequently, the investor does not need to post collateral to support the transaction. See further “Homemade Hedge Fund”, Forbes, 24 Dec. 2001.
20 The leading on-line providers of equity spread bets are Cantor Index <www.cantorindex.com>, City Index <www.cityindex.co.uk>, CMC Spreadbet <www.dea14free.com/spreadbet>, Financial Spreads <www.finspreads.com>, IFX Financial <www.ifxfinancial.com>, IG Index <www.igindex.co.uk>, Index Trade <www.indextrade.com> and Spreadex <www.spreadexfinancials.com>.
21 The majority of on-line providers permit investors to limit their losses by making a “controlled risk” or “barrier” spread bet: the investor specifies a threshold at which the bet is to be automatically closed out. This feature is typically used by investors to place a floor on their potential liability to the on-line provider. Thus, in the hypothetical example above, the investor could specify a threshold of US$ 109.50, thus limiting his or her loss to US$5,000.00. The cost to the investor in placing a controlled risk spread bet will be reflected in a widening of the spread quoted by the on-line provider.
22 In contrast to CFDs, the on-line provider's commission is, in the case of an equity spread bet, incorporated in the spread quoted by the on-line provider. This is usually the only transaction cost incurred by the investor. While the investor will also be required to lodge a cash margin of typically 10-20% of the value of the shares, index or options underlying the spread bet with the on-line provider to support the performance of the investor's obligations, the investor will not be subject to any financing charges.
23 This is achieved by the investor making a reverse bet, that is a Down Bet for US$100.00 per point at the sell figure then being quoted by the on-line provider for XYZ Corporation stock for March 2002.
24 The leading on-line providers of equity fixed odds bets are Blue Square <www.bluesq.com/bet>, Square Mile <www.squaremile.net> and Xodds <www.xodds.com>.
For a more detailed discussion of fixed odds equity bets, see Ali, P. U., “Betting on Shares On-Line: The Nature and Regulation of Internet Equity Bets”, 19 Company and Securities Law Journal (2001) 181.Google Scholar
25 For example, an investor will only receive a pay-out under a “quinella” fixed odds bet where he or she has selected the best and second-best performing index during the term of the bet from a group of indices.
26 The generalised preference of investors for spread bets as opposed to fixed odds bets may be attributable to the risk-averse nature of retail investors (see generally Woodland, B. M. and Woodland, L. M., “The Effects of Risk Aversion on Wagering: Point Spread versus Odds”, 99 Journal of Political Economy (1991) 638CrossRefGoogle Scholar) or simply because spread bets are “more fun” (see generally Bassett, G. W., “Point Spreads versus Odds”, 89 Journal of Political Economy (1981) 752).CrossRefGoogle Scholar
27 A fixed odds bet can be characterised as a digital European option: see further Zhang, P., Exotic Options: A Guide to Second Generation Options, 2nd ed. (Singapore: World Scientific 1998) paras. 15.2 and 15.4.CrossRefGoogle Scholar
28 This represents a substantial departure from the present, bifurcated approach towards the licensing of financial instruments, where separate licensing regimes apply to “securities” and “futures contracts”. Dealings in equity mini-derivatives or the conduct of a market for such derivatives will, as a general rule, only be subject to regulation where the derivatives in question fall within the statutory definition of “futures contract”. That definition, however, presents significant problems for the regulation of derivatives in Australia since it is predicated upon the concept of fungible, standardised instruments; such instruments are indigenous to the authorised futures exchanges but are not representative of the instruments transacted in the Over-the-Counter markets. The regulation of equity derivatives as futures contracts in Australia (and the unsatisfactory overlap with the securities licensing provisions) is discussed further in Ali, P. U., “Mimicking Shares: The Nature and Regulation of Equity Swaps”, 17 Company and Securities Law Journal (1999) 436Google Scholar. As regards the “futures contract” versus “securities” approach to derivatives regulation, see generally Gibson, W. E., “Are Swap Agreements Securities or Futures?: The Inadequacies of Applying the Traditional Regulatory Approach to OTC Derivatives Transactions”, 24 Journal of Corporation Law (1999) 379.Google Scholar
29 Section 762A(2), Corporations Act 2001 (Cth) (as amended by the Financial Services Reform Act 2001). Accordingly, the references are to sections that have been inserted by the FSR Act into the Corporations Act.
30 Sections 762A(1) and 763A(l)(a) and (b).
31 Section 762C.
32 Section 763B(a).
33 Section 763B(b).
34 The definition of “financial investment” arguably envisages a collective investment scheme, where the several contributions of investors are pooled and the investment of the pool is entrusted to a third party: this is supported by the comments in the Explanatory Memorandum to the Financial Services Reform Bill 2001 (House of Representatives, April 2001), para. 6.52.
35 It is also questionable whether the acquisition of a financial instrument – in particular instruments such as equity spread and fixed odds bets which are marketed as “bets” – solely or predominantly for speculative purposes constitutes an investment.
36 Section 763C(a).
37 Section 763C(b).
38 Section 763A(2).
39 As regards the use of derivatives to create financial exposure, see generally Stout, L. A., “Betting the Bank: How Derivatives Trading under Conditions of Uncertainty can Increase Risks and Erode Returns in Financial Markets”, 21 Journal of Corporation Law (1995) 53Google Scholar; Ali, P. U. and Gold, M., “Using the Market to Beat the Market: A Look at ‘Geared Beta’ Strategies and Implications for Fiduciaries”, 19 Company and Securities Law Journal (2001) 379.Google Scholar
40 Sections 762A(2) and 764A(1)(c).
41 Section 761D(1)(a).
42 Section 761D(1)(c). This “something else” specifically includes assets, interest and exchange rates, indices and commodities: section 761D(1)(c)(i) to (iv).
43 The FSR Act has clarified the status of options under the Corporations Act. It was previously unclear whether an instrument, such as an option, where only one of the parties would ever be under an obligation to provide consideration at some future date was a “futures contract”: Sydney Futures Exchange v Australian Stock Exchange (1995) 16 ACSR 148, at 182-183 and 208.Google Scholar
44 Section 911A(1).
45 Section 911D(1).
46 Section 761 A.
47 Sections 761C and 766A(l)(b) and (c). The on-line providers of equity mini-derivatives surveyed for this article provide “execution-only” services – the on-line providers do not provide recommendations to investors about particular transactions, but only provide generalised information about the equity mini-derivatives that they offer. Accordingly, it is not necessary to consider whether such on-line providers are engaged in giving “financial product advice” for the purposes of the FSR Act: see further sections 766A(l)(a) and 766B(4).
48 Section 766C(1).
49 Sections 761 A, 766A(1)(b) and 766C(1)(b).
50 Sections 761A and 761E(2). The secondary trading of a financial product by the product's issuer on a principal-to-principal basis falls outside the scope of the financial services licence provisions: section 911A(2)(c). There is, however, little or no secondary trading of equity mini-derivatives.
51 Sections 761A and 761E(1) and (3). As a general rule, a person who deals on his or her own behalf in a financial product will not be taken to be dealing in that product. However, this exception is not available where the dealing is in relation to a product issued by that person: section 766C(3).
52 Section 761E(5).
53 Section 761E(6)(e). The attribution of “issuer” status to the operator of the market is due to the fact that the on-line provider of the equity mini-derivatives and the investor are transacting the derivatives on a principal-to-principal basis. Where, however, one of the parties to the derivative is transacting that derivative as the agent for a third party principal, the agent will be considered the issuer: section 761E(6)(c) and (d).
54 Section 766D(1)(a).
55 Section 766D(1)(b).
56 Sections 766D(1)(c) and 767A(2)(a).
57 Section 79 lA(1)(a).
58 Section 765A(1)(1)(i).
59 Section 911 A(2)(d). The making of a market for financial products and the operation of a financial market for financial products are mutually exclusive: section 766D(1)(c).
60 Section 767A(1)(a).
61 Section 767A(1)(b).
62 The term “facility” is broadly defined for the purposes of the definition of “financial product”: see supra n. 30.
63 Section 767A(2)(a).
64 Explanatory Memorandum, supra n. 34, para. 7.15. In addition, it is doubtful whether an internet service provider or any other party on whose servers the on-line provider's web-site is hosted will, by reason only of that activity, be considered to be operating a financial market in Australia: the Explanatory Memorandum, ibid., para. 7.14 states that the FSR Act is not intended to regulate persons whose sole involvement in a financial market is the operation of an electronic means of communication or as an ISP.
65 The self-dealing exception in section 766C(3) is therefore not available to the retail investor: see supra n. 51.
66 This situation can readily be rectified by the promulgation of a regulation or the publication of a notice by the Australian Securities and Investments Commission which provides that the entry by a retail investor as principal into an equity mini-derivative (or any other derivative) in the Over-the-Counter markets will not constitute the carrying on of a financial services business in Australia: section 911 A(2)(k) and (1). In any event, a retail investor that is an issuer of derivatives will be exempt from the more onerous disclosure requirements of the FSR Act. The key disclosure requirement under the FSR Act concerns the provision of “Product Disclosure Statements” (such documents are analogous to prospectuses for the offer or issue of securities). An issuer of a financial product is required to provide such a document to its counterparty prior to the making of an offer for, or the issue of, the product (section 1012B(3)). This requirement, however, has no application where the issuer is not carrying on the business of issuing derivatives (section 1010B(1)) or the issuer's counterparty is not a retail client (section 1012B(3)(b)). Thus, an on-line provider of equity mini-derivatives but not a retail investor in such derivatives will, as a general rule, be required to provide a Product Disclosure Statement to its counterparty.
67 The relevant provisions of the State legislation are: section 56(1), Unlawful Gambling Act 1998 (New South Wales); section 248(1), Racing and Betting Act 1980 (Queensland); section 50, Lottery and Gaming Act 1936 (South Australia); section 114, Racing and Gaming Act 1952 (Tasmania); section 15, Lotteries, Gaming and Betting Act 1966 (Victoria); section 4(1), Gaming and Betting (Contracts and Securities) Act 1985 (Western Australia). The relevant provisions of the Territory legislation are: section 13, Games Wagers and Betting-Houses Act 1901 (Australian Capital Territory); section 135(1), Racing and Betting Act 1983 (Northern Territory); section 4, Unlawful Betting Act 1989 (Northern Territory). The historical antecedents of this legislation are discussed in: Latimer, P., “Futures Contracts and Gaming Laws”, 14 Company Lawyer (1993) 67, at pp. 68–69Google Scholar; Ciro, T., “Gaming Laws and Derivatives”, 17 Company and Securities Law Journal (1999) 171, at pp. 172–182Google Scholar; Gabaldon, T. A., “John Law, with a Tulip, in the South Seas: Gambling and the Regulation of Euphoric Market Transactions”, 26 Journal of Corporation Law (2001) 225, at pp. 249–250.Google Scholar
68 The key case on point is Thacker v. Hardy (1878) 4 QBD 685.
69 Indeed, the statutory prohibition against wagering and gaming contracts is specifically directed at contracts for differences: Grizewood v. Blane (1851) 11 CB 526; Universal Stock Exchange Ltd v. Stevens (1892) 66 LT 612; Universal Stock Exchange Ltd v. Strahan [1896] AC 166. See generally Stout, L. A., “Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives”, 48 Duke Law Journal (1999) 701, at pp. 713–720CrossRefGoogle Scholar. The same issue arises in the case of all other derivatives that provide for cash settlement (since the payer is taken to have “lost” and the payee to have “won” on settlement): Universal Stock Exchange Ltd v. Strahan [1896] AC 166; See v. Cohen (1923) 33 CLR 174; Morley v. Richardson (1942) 65 CLR 512; Jackson Securities Ltd v. Cheeseman (1986) 4 NSWLR 484. However, the courts will examine the intention of the parties and the substance of the transaction, so the mere presence of an obligation to make delivery will not prevent a transaction from being characterised as a void gaming or wagering contract: Grizewood v. Blane (1851) 11 CB 526; Barry v. Croskey (1861) 2 J&H 1; Buttenlandsche Bankvereeniging v. Hildesheim (1903) 10 TLR 641; Cooper v. Stubbs [1925] 2 KB 753; Burnett v. Sanker (1925) 41 TLR 660; Ironmonger & Co v. Dyne (1926) 44 TLR 491; Weddle, Beck & Co v. Hackett [1929] 1 KB 321; Woodward v. Wolfe [1936] 3 All ER 529; Salt v. Chamberlain [1979] STC 750; City Index Ltd v. Leslie [1991] 3 WLR 207. Compare Universal Stock Exchange Ltd v. Stevens (1892) 66 LI 612; Forget v. Ostigny [1895] AC 318 and Philp v. Bennet & Co (1901) 18 TLR 128, where the courts considered that this issue should be determined exclusively by the form of the contract. The status of futures contracts as contracts by way of gaming or wagering forms the subject of Chaikin, D. A. and Moher, B. J., “Commodity Futures Contracts and the Gaming Act”, Lloyds Mercantile and Commercial Law Quarterly [1986] 390, at pp. 392–395.Google Scholar
70 Re Gieve [1899] 1 QB 794.
71 Universal Stock Exchange Ltd v. Strahan [1896] AC 166.
72 For a discussion of the distinction between speculation and gambling, see generally Fridson, M. S., “Exactly What Do You Mean by Speculation?”, Journal of Portfolio Management, Fall 1993, 29Google Scholar, and Gabaldon, supra n. 67, at pp. 241-243.
73 Section 11011, Financial Services Reform Act 2001.
74 Refer to the cases cited in n. 69 supra concerning the “in-substance” approach employed by English and Australian courts in determining whether or not a contract is a gaming or wagering contract.
75 Section 15(1). The IG Act also prohibits the provision of interactive gambling services by Australian on-line service providers to persons in designated countries (to date, no countries have been designated for this purpose): section 15A(1).
76 Section 6(1).
77 Section 4.
78 Sections 5(3)(b), 6(3)(a) and 9 (as amended by section 2(8) and Schedule 1, items 250 to 256, Financial Services Reform (Consequential Provisions) Act 2001 (Cth)).
79 Sections 12(1) and 16(1), Interactive Gambling (Player Protection) Act 1998 (Queensland); section 9( 1), Interactive Gaming (Player Protection) Act 1999 (Victoria); sections 10(1) and 14, Interactive Gambling Act 1998 (Australian Capital Territory).
80 Sections 76A(a), 76B(2) and 76U, Gaming Control Act 1993 (Tasmania).
81 Section 47B(1), Gaming Control Act 1993 (Northern Territory).
82 Section 6( 1), Interactive Gambling (Player Protection) Act 1998 (Qld); section 5(1), Interactive Gaming (Player Protection) Act 1999 (Vic); section 3, Interactive Gambling Act 1998 (ACT); section 3(1), Gaming Control Act 1993 (Tas), s 3(1). The definition of “internet gaming business” in the Gaming Control Act 1993 (NT) is merely defined to include the conduct of lotteries and games (section 47A).