A retail focus

South Africa has developed one of the world's biggest single-stock futures markets by volume. But the increasing popularity of over-the-counter contracts for difference, much of it driven by retail traders, is challenging the market's growth. By John Ferry

Single-stock futures (SSFs) contracts have overwhelmingly dominated trading activity on the Johannesburg Stock Exchange (JSE) for the past few years. In the last quarter of 2007, SSFs accounted for a whopping 80.5% of all contracts traded on the bourse (see figure 1) - making South Africa one of the world's biggest markets for single-stock futures. But market-makers say the dominance of SSFs is being challenged by increasing demand from retail investors to trade contracts for difference (CFDs).

South Africa's CFD market is exclusively over the counter, so no volume figures are available. However, dealers say volumes are rising exponentially, and much of this growth is driven by retail investors who value the simplicity and value that CFDs offer. "We were the first investment bank in South Africa to offer online CFD trading at the beginning of 2007 and, since then, we have seen an almost 30% growth in our turnover each month," says Nicholas Kunze, head of CFD sales at Nedbank Equity Capital Markets in Johannesburg.

Nedbank did not explicitly set out to capture lots of business from retail investors, Kunze says. "We started with the mandate to create an online trading platform for our brokers, but have ended up with a majority of clients being retail investors almost by default. This is probably due to the financial education of the 'man on the street' having improved, and the low cost of these instruments has also added to it," he adds.

The increasing popularity of CFDs is even challenging the dominance of some exchange-traded equity derivatives instruments; and, on the back of this growth, several new players have entered the market, including the big South African banks. "Over the past five years, we've evolved and developed the CFD market to the point where everybody is now on the bandwagon," comments Rudolph Vermeulen, a Johannesburg trader with Global Trader, which offers spread betting and CFD trading.

Warrants, in particular, have been hard hit by the growth in the CFD market. Vermeulen describes the instrument as a "dead market", noting they have now been almost entirely replaced by CFDs. "The price transparency isn't there with warrants, and that's quite obvious. Because we're not an open market, the market is basically controlled by the four big banks that issue warrants," he explains. "So, the retail client has definitely moved on and is either trading CFDs or single stocks. And, slowly but surely, even the guys that used to trade the single-stock market, which is still very active on the institutional front, are starting to look at CFD as an alternative also."

Warrants are increasingly perceived as an expensive way to access South African equities, while few retail investors understand how the instruments are priced. These two factors have encouraged retail investors to embrace CFDs and SSFs in favour of warrants - a fact acknowledged by the JSE's director of trading, Allan Thomson. "The warrants market was there before SSFs and was the established market. But warrants market-makers have done themselves a disservice in advertising warrants as a way to gain cheap entry into the exchange, when in fact they are a very expensive way to gain entry due to the way they are priced," he says. "Also, they are complex. There's volatility there that has to be factored in - most investors have no concept of a Black-Scholes pricing model. So I think it's a difficult product to market."

While warrants trading activity has declined, the simplicity of SSFs has meant that they continue to attract strong investor interest - as demonstrated by the dominance of SSF trading on the exchange. However, CFDs have also benefited from their simple payouts. Indeed, Thomson acknowledges CFDs increasingly compete with SSFs - although he believes the exchange-traded instrument has an advantage: "I think SSF is a better market because it is regulated and has the backing of a large and financially powerful central counterparty - a clearing house - backing all of these trades."

Thomson notes that retail trading of SSFs is still "growing phenomenally", although institutional investors, and increasingly hedge funds, make up the bulk of trading. "In terms of volume, retail trading is relatively small, but there's a large retail component in terms of the number of trades that we have. What I do know is the number of retail clients we are loading has been growing exponentially. SSFs are becoming a mainstream investment in the retail market instead of a fringe investment," he says.

Although many participants now view CFDs and SSFs as directly competing products, there is one major difference between the two contracts - dividend risk. One of the big advantages associated with CFD trading is the absence of dividend exposure. Unlike SSFs, which are priced using a forecasted dividend, a CFD contract entails the agreement to swap dividends.

Dividend risk, and in particular the historically erratic nature of the dividends paid by South African companies, held back the growth of the SSF market back for a number of years. In particular, a lack of standardised rules on how corporate actions should be treated meant dealers were unable to make markets on SSFs with any certainty (Risk South Africa Autumn 2007, pages 18-19).1 However, the JSE launched the world's first dividend futures contract in 2002 as a way to hedge dividend risk, while new standardised corporate action rules came into effect in 2003, which removed much of the uncertainty over dividend forecasts.

The existence of dividend futures contracts means the JSE has been able to keep pace with the growth of CFDs by offering an exchange-traded alternative. By trading an SSF and an equivalent dividend futures contract in combination, investors can effectively achieve the same economic exposure as they can through a CFD.

Indeed, much of the retail equity derivatives business currently taking place on the exchange is believed to be the result of investors seeking an exchange-traded CFD-type contract. Market-makers even combine SSFs and their equivalent dividend future on a single screen and frequently trade the two automatically and simultaneously.

Having to combine two different exchange-traded contracts - with all the additional complexity and cost this entails - is not ideal, some dealers claim. While investors may draw comfort from the absence of counterparty credit risk through trading on an exchange, others prefer the simplicity of trading a single contract. "Clients are becoming more cost-conscious, and the fact that you can trade a CFD a lot easier than the underlying stock, and you don't have the rollover costs associated with the futures contract, helps," says Kunze at Nedbank Equity Capital Markets.

"Retail investors find CFD much more transparent and easier to understand," adds Corrie de Bruyn, chief executive of CFD brokerage firm PSG Online in Johannesburg.

Whatever their preferences, it is clear that retail investors have played a large part in driving both SSF and CFD trading. But could anything reverse this trend? Clearly, a strong rise in the South African equity market has encouraged retail investors to put their cash into stocks. The FTSE/JSE Africa All Share index hit a high of 31,531.05 on October 11 last year, a 72% rise since January 3, 2006, when the index was trading at 18,335.70. Conversely, a prolonged period of losses could encourage retail clients to retreat to the sidelines. Since October, the index has dropped by 20%, closing at 25,135.13 on January 23. "The retail investor is generally geared long in a bull market and that has assisted us, and no doubt the CFD market as well," says Thomson.

However, exchange controls are seen as the greatest impediment to further growth by CFD dealers. "The main constraint we have in the South African market has always been, and still is, the exchange control," notes Vermeulen at Global Trader.

"Exchange controls is the biggest obstacle to our business," says Kunze. Under exchange control rules, an institution cannot lend money to a foreign entity for investing. That effectively means any non-South African trading in the CFD market cannot gear up by borrowing from one of the country's banks. The only loophole in the system is that banks can lend money for trading, provided the client goes through a regulated exchange - in other words, the JSE.

The exchange control restriction aside, South Africa's CFD providers say there is still plenty of scope for growth. Even though CFD trading has seen exponential growth in the past few years, it has come from a very low base and, as such, there is plenty of room for the market to develop further, dealers note.

"I think growth is sustainable as long as there is wealth creation and the country is growing," says Kunze. "You have to figure there is at least another couple of hundred percent growth possible. I think there are a good few years left before we reach saturation point."

Ironically, the big hope for CFD providers is that their market will become regulated. Unconfirmed rumours are circulating that South Africa's Financial Services Board, an independent institution established to oversee the South African non-banking financial services industry, is looking to regulate the market. "The flow we've seen of late has included institutional trades purely from the hedge fund side. Institutions are constrained by mandates to only deal with exchange-traded products, so as soon as regulation came through, I would expect the funds to really get involved. I think we'll then see a big explosion in the CFD market," says Vermeulen.

Regulation would also establish market standards and help investors differentiate between various CFD providers in terms of quality of service, he adds: "Everyone is positioning themselves to get more of the institutional flow."

But others say they are not putting too much hope in regulation. "Provided it's credible, regulation can only be good for our market. But, in saying that, there has been talk of regulating the market in London for years and it still hasn't happened," says Kunze.

Dealers agree that institutional investor activity would be a big boost to CFD businesses. Ultimately - and unusually for an OTC derivatives market - regulation could be the making of CFDs.