Where Differences Matter

Aaron Yong provides a primer on the Guidelines on Contracts for Difference.

In a move to promote and develop the Malaysian derivatives market, the Securities Commission of Malaysia (“SC”) introduced the contracts for difference (“CFD”) framework with the issue of the Guidelines on CFD (“Guidelines”) together with a list of Frequently Asked Questions for the Guidelines (“FAQ”) on 6 April 2018. At the same time, the SC revised its Licensing Handbook (“Handbook”) to set out the requirements for the licensing of CFD providers.
 
Although the Guidelines are only effective on 1 July 2018, it has been released early to enable the industry to familiarise itself with the requirements for offering CFDs.
 
WHAT IS A CFD?
 
CFD is defined in the Guidelines as a contract made between a buyer and a seller to gain exposure in the allowable underlying instrument whereby differences in settlement are made through cash payments. The FAQ further clarifies that CFD is a leveraged derivatives product that tracks the price movement of an underlying instrument.
 
In effect, CFDs are financial derivatives which allow investors to capitalise on price movements of the underlying instruments without having any interest in such instruments.
 
The Guidelines set out some of the key features of a CFD and the requirements which are applicable to a CFD provider in Malaysia.
 
PRODUCT REQUIREMENTS
 
Allowable underlying instruments
 
The Guidelines provide that CFDs are only allowed to be offered based on shares or indices.
 
If the CFD is based on shares, the shares must either be listed on the Main Board of Bursa Malaysia Securities Berhad (“Bursa Securities”) or a securities exchange outside Malaysia.
 
Shares listed in Malaysia
 
If the shares are listed on the Main Board of Bursa Securities, the underlying company must have an average daily market capitalisation (excluding treasury shares) of at least:
 
(a)     RM1 billion in the past three months ending on the last market day of the calendar month immediately preceding the date of issue; or
 
(b)     in the case of a newly listed company that does not meet the three-month market capitalisation track record, RM3 billion.
 
The underlying company must also meet the public shareholding spread requirement.
 
Shares listed outside Malaysia
 
If the shares are listed on a securities exchange outside Malaysia, the underlying company must be listed on an exchange in a jurisdiction where the capital market regulator is a signatory of the International Organization of Securities Commissions multilateral memorandum of understanding concerning consultation and co-operation and the exchange of information among securities regulators.
 
The underlying company must also have an average daily market capitalisation of at least:
 
(a)     RM3 billion in the past three months ending on the last market day of the calendar month immediately preceding the date of issue; or
 
(b)     In the case of a newly listed company that does not meet the 3-month market capitalisation track record, RM5 billion.
 
However, the Guidelines do not specify whether treasury shares are to be taken into account when computing the average daily market capitalisation of the underlying company whose shares are listed outside Malaysia.
 
Index
 
Where the underlying instrument of a CFD is an index, the constituents of the index must be listed on a securities exchange in or outside Malaysia. The index must (a) be broadly based; (b) have a transparent composition; and (c) be a recognised benchmark. Further, information on composition and performance of the index must be conveniently accessible by investors.
 
Margin requirements
 
As CFDs are leveraged trading instruments, they are traded on margin. Instead of paying the full value for the underlying instrument, an investor pays an initial margin to open the position and is required to maintain the minimum margin requirement for open positions at all times. 
 
For a CFD based on shares, a minimum of 10% and 20% margin is required for index shares and non-index shares respectively. If the CFD is based on an index, a 5% margin is required. A CFD provider may require a higher margin than the prescribed minimum requirements.
 
A CFD provider must make additional calls for margin when necessary and if an investor fails to comply with the demand for margin within reasonable time, the CFD may be terminated.
 
Settlement of CFD
 
A CFD must only be settled in cash and not by delivery of the underlying instruments. This is to prevent an investor from circumventing disclosure requirements and stealthily building a stake in the issuer of the underlying instrument.
 
The Guidelines further provide that a CFD in respect of shares must not carry any voting rights or any options for conversion into the underlying shares.
 
Stop loss measures
 
To mitigate some of the risks involved in trading CFDs, the Guidelines require a CFD provider to make available stop loss measures to its clients. A stop loss measure allows an investor to set a stop-loss price at which an open trade will automatically be closed out.
 
When underlying shares are suspended, halted or delisted
 
A CFD provider is prohibited from creating new positions when the trading in the underlying instrument has been halted or suspended.
 
Although the Guidelines do not specify how an open position on a CFD is to be dealt with in the event that the underlying instrument is suspended, halted or delisted, a CFD provider is required to provide its clients with clear information on its procedure to address these situations.  
 
Sophisticated investors
 
In Malaysia, CFDs can only be offered to sophisticated investors, i.e. any person who falls within any of the categories of investors set out in Part 1 of Schedules 6 and 7 of the Capital Markets and Services Act 2007.
 
PROVIDER REQUIREMENTS
 
Among the requirements that a CFD provider has to satisfy are the following -
 
Licensing requirements
 
Only a holder of a capital market services licence for (a) dealing in derivatives; or (b) dealing in derivatives restricted to CFD, may carry out the offering of CFDs. The financial requirements that an applicant or a licensee is required to comply with are set out in the Handbook.  
 
Suitability assessments
 
Notwithstanding that CFDs may only be offered to sophisticated investors, a CFD provider is required to conduct a suitability assessment on an investor who wishes to invest in CFD. If a CFD trading account may be opened online, an online questionnaire may be used for this purpose.
 
Disclosure requirements
 
Before a CFD is offered, the CFD provider must register a product highlight sheet and a disclosure document with the SC. Similarly, the product highlight sheet and disclosure document must be provided to an investor before opening a CFD account for the investor.
 
Information required to be disclosed in the product highlight sheet and disclosure documents include (a) background information of the CFD provider; (b) product description of the CFD; (c) key features of the CFD; and (d) key risks in CFD trading.
 
Risk management and managing conflicts
 
A CFD provider is required to have adequate risk management practices in place. These include (a) adequate infrastructure and processes; (b) comprehensive internal control and audit procedures; and (c) documented policies and procedures for managing risks.
 
Further, a CFD provider must also have in place supervisory and internal control procedures and systems to address potential conflicts of interest and establish effective Chinese walls between the various divisions of its business.
 
Segregation of assets
 
If a CFD provider also offers other derivative contracts, it must segregate the client’s assets for CFD trades from the client’s other assets. Rehypothecation of clients’ assets is prohibited.
 
Maintenance of records
 
A CFD provider must maintain certain records, including (a) instructions by a client; (b) the date and time of receipt, sending and carrying out of those instructions; and (c) the person by whom those instructions are received, the person by whom they are sent and the person by whom they are carried out.
 
Reporting requirements
 
A CFD provider must submit to the SC a monthly report of (a) transactional information to the SC in the format prescribed in the Guidelines; and (b) specified financial information, such as its financial condition and adjusted net capital.
 
COMMENTS
 
The Guidelines do not contain requirements to deal with changes in the capital structure (e.g. a bonus issue or a capital reduction) of an underlying company that is announced and completed during the tenure of a CFD for shares. It would appear desirable that provision, similar to those applicable to company warrants, be made to deal with these contingencies. 
 
The introduction of CFD would be eagerly anticipated by Malaysian investors and would most certainly bring the Malaysian derivative markets closer to the likes of Singapore and Australia where CFD offerings are already available. It remains to be seen whether Malaysian investors are equipped for CFD trading.