ANYONE FOLLOWING THE coverage of the trial of three senior Anglo executives at the Dublin Circuit Criminal Court will have heard the same three letters coming up again and again.
On the very first day of the trial, the lead lawyer for the prosecution spent almost an hour talking about them.
“I think Mr Warren Buffett described them as weapons of mass destruction,” counsel for one of the accused bankers told the trial.
The letters are CFD, which stands for contracts for differences, and they’re at the very heart of the problems faced by Anglo Irish Bank as its fate became intertwined with that of Sean Quinn.
CFDs are one of those weird things that could only have ever existed in the past two decades as the financial industry sought out new and more swaggering ways to make money for clients. They exist solely to create wealth; you never actually own an asset or anything tangible, it’s all about creating money.
Depending on which way you look at it, they are either an investment or gambling (this particular line came up at the Anglo trial when one barrister told the court that Sean Quinn had been gambling with CFDs. “There’s no other polite way of putting it,” he said. The former CEO of the Quinn Group disagreed. “Personally, I think the word gambling is wrong,” Liam McCaffrey said. “It was a highly leveraged derivative”).
So on the one hand, they can seem like a dream investment for the already uber-rich. You don’t necessarily have to put up a lot of money at the start but you can still win big. The problem is that while the gains can be big, the losses can be unlimited.
Background
CFDs were invented by Swiss financial giant UBS in the late 1980s but were only introduced to the retail market in 1998.
At their most basic, they allow someone to make a bet on – well, usually on a share price, but it can be on anything: the price of gold, currencies, two people running down a street, anything. The person makes a gamble – or investment, if you want to call it that – on which way the share price will move in the short term.
If the share price goes the way you want, then congratulations: you’re a winner. At a set time – say, every 3 months – you get to settle up with whoever provided you with the CFD and if it’s all going well then you get to claim your winnings and get even richer.
If it goes the other way though, then the margin call – the period when you have to settle up – can be much less pleasant and you have to pay the provider the difference.
UCC economics lecturer Seamus Coffey who was called as a witness to the Anglo trial on day one compared CFDs to shares by using a racehorse analogy.
He told the court that while owning shares is similar to actually owning a horse, CFDs are more comparable to placing a bet on the horse so that you have an interest in the outcome of the race.
The key word in CFD is difference, he told the court. Continuing the horse racing analogy, if the horse wins by a certain distance then you would win more money, he explained.
Barrister for Sean Fitzpatrick, Michael O’Higgins, compared it to a film from the 1980s, noting that whatever about the customer, the CFD provider will always win:
“It’s a bit like that Trading Places movie where they’re explaining that the great thing was that win, lose or draw, the great thing was that they always got paid,” he told the court.
One of the biggest benefits of CFDs from a customer point of view is that you don’t even have to pay all the money up front. If you were to buy €10,000 worth of shares in a company, then you would have to pay all the money at the time of purchase. However with CFDs, you only have to come up with a small amount, such as 5 or 10 per cent at the start.
So, say you invest €10,000 into shares and the price goes up 10 per cent, then you make €1,000. But if you invest €10,000 into CFDs and it goes up 10 per cent, congratulations, you’ve just €10,000. And, of course, if it goes down by 10 per cent, then you owe a lot more money.
‘Spectacular punt’
The fraught nature of CFDs has been well recognised. They’re banned in some countries, including in the US, which generally has a freewheeling approach to financial products.
Other countries – including Germany, India and Singapore – introduced prohibitions on some elements of CFDs at the height of the global financial crisis when many financial institutions were brought to the brink due in part to the effects of CFD trading.
The financial ombudsman in Australia has called for investors to be banned from trading in CFDs unless they can prove that they actually understand how they work. Some spread betting websites carry a message on their homepage warning potential customers that their losses may exceed their initial deposit and they should get to know the risks involved.
(Pic: Niall Carson/PA Wire)
Part of the reason why Anglo Irish Bank officials never realised just how much of a stake Sean Quinn had built up in the bank was because he did it through CFDs.
He never actually owned physical shares in the company, but invested – or bet – relentlessly on the share price, even as it cratered dramatically throughout 2008, in the mistaken belief that at some stage it would have to go back up again.
It was only in September 2007 that Quinn met with Sean FitzPatrick and then-CEO of Anglo David Drumm to let them know that his stake in the bank had risen to 24 per cent.
Liam McCaffrey, the former CEO of the Quinn Group, told the Anglo trial that his former boss at lost at least €2.4 billion in a “spectacular punt” on CFDs.
“He paid a very high price for investing in that bank,” McCaffrey said.
“In fairness, he paid a very high price for investing in CFDs, if that can be called investing,” said Brendan Grehan SC.
McCaffrey hesitated. “It’s a matter of terminology”.
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