The Best Way to Inside Trade: Unlisted Derivatives Outside U.S.

  • CFD traders increased by 14 percent from 2013 to 2014 in U.K.
  • Traders tied to $100 million hacking scam used the derivatives

U.S. regulators are becoming increasingly concerned about a complicated derivative that’s popular abroad and was used by scammers to earn millions of dollars based on inside information.

The derivatives, called contracts for differences, are banned in the U.S. and have proven difficult for regulators like the Securities and Exchange Commission to track since they don’t trade on exchanges. They’re legal in the U.K. and becoming more common there, with the number of people who trade CFDs increasing by 14 percent to 24,000 in 2014 from a year earlier, according to a survey from research firm Investment Trends.

That’s motivating the SEC to focus more on investigating CFDs since they often involve trading of U.S. stocks, according to a person familiar with the agency’s thinking who asked not to be identified because the matter is private.

The contracts allow investors to make amplified wagers on the movements of shares, commodities or currencies, without actually owning them. The key to making huge returns, or potentially outsized losses, is that CFD investors can obtain big market exposures with just a small down payment.  

Losing Money

A typical transaction works like this: If you want to bet that a stock will rise, you enter into a contract on say 100 shares that are priced at $10 each. But instead of ponying up $1,000, you only have to pay a deposit, which often equals 5 percent of the transaction, or $50. 

If the stock rises to $15, your $1,000 exposure is now worth $1,500. Subtract the buy-in price of $1,000 from the new price of $1,500 and you have your profit. So the initial $50 investment has turned into $500, excluding commissions paid to a broker and other fees. However, if the stock falls to $5, you’d be on the hook for $500.

As with most investments that promise fast riches, the majority of people who trade CFDs lose money most of the time. But if you have an edge, like advanced knowledge that a company is going to report profits that beat analyst estimates, the contracts are a gold mine. 

$100 Million

That’s the kind of advantage the SEC alleges a group of Ukraine-based computer hackers had in one of the biggest financial schemes announced this year. They allegedly obtained access to more than 100,000 press releases, including corporate earnings ahead of publication, which served as tip sheets on which companies were poised to rise or fall, according to the SEC. Traders used the information stolen by hackers to make bets that ended up yielding more than $100 million, the SEC said in August.

“It’s a complete regulatory blind spot” since CFDs trade overseas, Michael Osnato, head of the SEC’s complex financial instruments unit, said in an interview. “We’re going to be looking very hard for this type of conduct.”

U.S. regulators typically detect aberrational trading by reviewing listed securities on exchanges. The SEC spotted the transactions in the alleged corporate earnings scheme by tracking brokers such as Cantor Fitzgerald that entered into the contracts with the traders and took parallel trades in the U.S. Cantor wasn’t accused of wrongdoing.

For example, an earnings announcement from Walter Energy Inc. was intercepted by hackers in August 2012. When the traders who received the information loaded up on CFDs, Cantor Fitzgerald Europe legally entered into the trade and then hedged that exposure through long positions stateside, according to the SEC complaint.

Karen Laureano-Rikardsen, a spokeswoman for Cantor, declined to comment.

One of the trading firms, Ukraine-based Jaspen Capital Partners Ltd., and its CEO Andriy Supranonok agreed to return their $30 million of profits to settle the SEC’s allegations that they traded on confidential information. Jaspen and Supranonok didn’t admit or deny the SEC’s allegations. The agency’s litigation against the remaining 32 defendants charged in the case is ongoing.

Prosecution Headwinds

Retail users in the U.S. were officially blocked from using CFDs that aren’t on exchanges by provisions in the Dodd-Frank Act in 2010. But even before that, since the contracts were considered swaps under U.S. securities laws, they were viewed as too risky for individual investors and most avoided them, according to Bob McLaughlin, a partner in the asset management and financial services practices at law firm Fried Frank in New York.

In addition to having difficulty tracking overseas use of CFDs, U.S. law enforcement has been confronting a more challenging environment for policing insider trading at home. To secure convictions, prosecutors must show a defendant knew that the source of their tips came from someone who had a duty to keep the information secret and that the leaker got a benefit from passing it on, the U.S. Court of Appeals in New York said in December 2014.

Outside of the U.S., CFDs are popular in countries such as the U.K. and Chile that have varying degrees of oversight of the products. In both countries, the investments tend to draw small-time speculators.

In the U.K., CFDs rely mostly on self-policing with firms that offer them required to have a license with the Financial Conduct Authority, a market watchdog. Such companies have a duty to report any suspicious activity to the FCA. Regulators have been pushing to have the contracts trade on clearing platforms, which would make them easier to keep tabs on, said Alasdair Steele, a partner at law firm Nabarro LLP in London.

Those involved in the industry say concerns about illicit conduct are overblown. CFDs are a long standing product and subject to the same suspicious transaction reporting as all other investments, said Chris Alfred, a spokesman for IG Group, which says it’s one of the largest CFD providers in the U.K.

Freezing Assets

Another hurdle the SEC faces with CFDs is limits on how much they can penalize perpetrators from afar beyond recouping ill-gotten gains and freezing assets. In a separate case, an alleged hacker in Bulgaria, Nedko Nedev, used CFDs to capitalize on the rising price of Avon Products Inc. in May after a fake takeover announcement, according to the SEC. The regulator froze his assets a month later. The case is still ongoing.

“It’s an area of enforcement that’s relatively new and involves complex products, where evidence may be located overseas,” said David Miller, a former federal prosecutor in Manhattan who’s now a partner at law firm Morgan Lewis and Bockius. “These cases can be very difficult to prosecute.”

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