Risky bets Gambling Your Life Away

Contracts for differences are a highly risky gambling product that promise huge rewards if a bet comes off. The problem is that stakes of just a few hundred euros can also lead to financial ruin in seconds, and many small-time gamblers aren’t aware of the risks.
Flatline: The removal of the cap on the Swiss franc/euro exchange rate sent the franc plummeting.

When Moritz Faber started up his computer, the world still seemed to be in order. It was Thursday, January 15. Outside it was cold and rainy, a typical winter morning in North Rhine-Westphalia. It may not have looked like the nicest day of the year, but nothing could have prepared the 27-year-old for the storm that was about to descend.

Mr. Faber (his name has been changed to protect his privacy) had just started working as an engineer. While reading the morning’s e-mails in his office, he was also secretly keeping his eye on the financial markets via the web. Mr. Faber had bet around €3,200 ($3,570) on the exchange rate between the Swiss franc and the euro using so-called contracts for difference. If it moved up by a few hundredths of a cent, Mr. Faber would make a few euros in profit.

This had already worked several times, and Mr. Faber was not the only one who was counting on it working again. Many amateur traders hoped to make large sums of money from tiny movements in the value of the franc. They were relying on a cap imposed by the Swiss National Bank, which prevented the Swiss franc from falling below the value of CHF 1.20 per euro. It was a cap that had been in place since the euro zone's debt crisis had gathered steam, designed to prevent people fearful of the euro's demise from throwing all their money into the safe Swiss currency.

He used a lever of 400 to 1 for his bet. With a €3,200 stake, that would mean a €51,200 profit. The problem was that it also worked the other way.

But that wasn't what happened on January 15. At 10.30 a.m, the SNB made an announcement that had the force of an explosion. The first sentence said: "The Swiss National Bank is abolishing the ceiling of CHF 1.20 per euro."

Mr. Faber was sitting at his desk when he read it. About 45 minutes later he was sitting on €281,666.54 of debts.

How did Mr. Faber manage to bring about his own financial ruin with just a few clicks of his mouse? The simple answer is that he backed the wrong horse. But that is only half the truth. The fact that Mr. Faber was able to bet against the Swiss franc with money he did not actually have was due to a loophole in the system. Although contracts for difference are highly risky, their users are not protected by the government against subsequent claims, which can prove to be horrendous.

The consequence is that they have been left owing millions to their brokers following the shock announcement regarding the franc.

If you want to understand how this could happen, you'll have to follow a trail that leads from Mr. Faber's home village to Zurich and from there to London.

The events of January 15 have their origins in a wood-paneled office on the fourth floor of a building on Zurich's Börsenstrasse. It's from here that Thomas Jordan controls the fortunes of the Swiss central bank, the SNB. The central bankers had promised the Swiss people that they would not let their currency get too strong – even though it is in demand as a safe haven.

The SNB had been buying up euros for three years in order to artificially weaken the franc, which had inflated the central bank's balance sheet to dangerous levels. In January, the European Central Bank, which controls monetary policy for the 19-nation euro zone, was about to announce a bond-buying program worth billions with the aim of stimulating continent's economy.

The ECB's looming decision meant that Mr. Jordan would have to buy many more euros to prevent the Swiss franc from rising further in value. The SNB had thus reached an impasse.

So Mr. Jordan chose to abolish the cap while it was still possible to estimate the consequences. However, he was not able to give any warning. If central bankers were to hint at a possible end to the price limit, speculators would immediately launch an attack. "Communicating such an exit is a very delicate business," Mr. Jordan would say later.

Mr. Faber therefore had no idea when he was betting against the franc that the Swiss had been preparing to light the fuse for some time.

He came across the idea of betting on CFDs on an online forum. He didn't want his pay check to be swallowed up by inflation in a savings account – something many Europeans are battling with in today's era of record low interest rates. The CFD broker’s offer sounded like just what he needed. Such firms target career-minded types. "Because I can" is the slogan used by IG Markets, the broker that Mr. Faber opened an account with.

He used a lever of 400 to 1 for his bet. This meant that he would make a profit of 400 percent on his stake if the euro gained just 1 percent against the franc. With a €3,200 stake, that would mean a €51,200 profit. The problem was that it also worked the other way.

Just 39 seconds after the central bank's press release was dispatched, the headline of one news agency reported: “Swiss central bank abandons cap.” That headline was enough for high-frequency traders, which use computers to make automated, immediate bets on derivatives, to pounce on the franc. Fund managers started to shift billions.


Easy money: People line up at a currency exchange in Geneva, Switzerland, in January after the Swiss National Bank abandoned its exchange rate control. Source. DPA


If we imagine the foreign exchange market as a motorway leading to Switzerland, which everyone is driving on to get to the mountains on the first day of the winter vacation, Mr. Faber is the only person traveling back to Germany. In the wrong lane. On a bicycle.

His computer said that he had lost several thousand euros within a few seconds. Just like that. The losses grew and grew: €150,000, €300,000. That's not possible, Mr. Faber thought. If the figures were correct, he would have just lost the value of a house.

At 10.39 a.m., another news report read “Swiss franc rapidly approaching the value of the euro.”

Mr. Faber rang his broker. The employee he spoke to said that the losses were real. Mr. Faber thought there must have been a mistake. After all, he had set a price limit, a so-called stop-loss order.

It was supposed to close open positions and limit losses. But the safeguard failed, because a sale at the stop price is not guaranteed. IG said that liquidity "largely dried up" when the limit for the franc was abandoned. In other words, no one wanted to sell francs.

IG negotiated the next available price of €0.9250 to the Swiss franc and passed it on to customers. Mr. Faber's contracts were finally closed at 11.15 a.m. His account balance was minus €281,666.54, and the money was due immediately.

Mr. Faber realized that he had made a huge mistake. When he bought the contracts for difference, he was not buying francs or euros, but merely a bet on how the currency pair would develop.

The idea of contracts for differences had been born in London in the 1990s. Investment bankers at the Swiss bank SBV worked out that they could offer big companies a bet on whether share prices would rise or fall without any party having to actually buy shares, or pay the tax on share deals.

Instead, a contract would be made and when it expired, the difference between the opening and closing prices would be the amount won or owed.

The bankers had invented a tool that could be used to bet on almost anything on which it is possible to pin a price, including shares, oil and gold. Anyone concluding a contract for difference can multiply their profit with only a small stake.

In the late 1990s, brokers had the idea of turning these professional contracts into a product that was suitable for the masses. The sector, often referred to as spread betting, boomed in Britain, and in 2005 it expanded to Germany, where providers initially recorded triple-digit growth rates. By 2014, there were more than 100,000 CFD accounts in Germany. One of them belonged to Mr. Faber and was deep in the red.

IG would argue that he had accepted their terms of business. If you log on to the broker's website, a message at the top of the screen says: "Losses may exceed your initial investment."


A Bad Day For Mr. Faber-01


But Mr. Faber says he would never have thought that so much money was at stake. Losing a few euros is one thing, he says, "but who would place a bet in which they could lose almost €300,000?"

The day after the disaster he made an appointment with a debt advisory service. The advisor explained to him how personal insolvency works: For six years, he would have to transfer a large proportion of his salary to a trustee. By then he would be 33.

Mr. Faber decided to help himself. He issued an appeal for help on an Internet forum. He received over 3,200 replies. His case was reported in the press.

He believed he was being ripped off by his broker: "I can't understand how the prices that we were offered were calculated." He complained that the entire matter was "completely lacking in transparency".

IG said that he had used the platform intensively and was well aware of the risks, explaining that the loss resulted from the enormous size of the position and the drastic discount. This could be summed up in three words: His own fault.

On the surface, it looks as though Mr. Faber was simply unlucky and was in the wrong place at the wrong time. But appearances can be deceptive.

Currencies do not fluctuate that sharply. If there were no levers, no one would trade in these products. Drew Niv, Head of broker FXCM

A study by the Australian financial regulator into the CFD market looks like a blueprint for his case. The regulator established that the main source of information for most CFD traders was the Internet, as was the case with Mr. Faber.

It found that most traders considered themselves to be well informed - like Mr. Faber. Half of respondents said that they used stop-loss orders, but failed to realize that the stops were not guaranteed, like Mr. Faber. Around one in six CFD users, the regulator discovered, had plowed almost their entire savings into CFDs - just like Mr. Faber did.

The study has thrown up a question that Mr. Faber is still asking: "How can it be that in such a consumer-friendly country like Germany, you can rack up so much debt with just a few clicks of a mouse?"

There are laws regulating virtually everything in Germany, from walking across bridges to stock trading. But CFD trading has somehow slipped through the legislators' net.

BaFin, Germany's financial regulator, checks providers regularly. "We monitor CFD providers' advertising communications and their websites very intensively," a spokesperson said, adding that the regulator also examined whether securities services for customers were appropriate. However, it explained that the obligation to make additional payments that has proved to be Mr. Faber's downfall is a "civil law problem".

Even a new law for the protection of small investors, one that has been in place since July, will not change this. It regulates many things, from crowdfunding to subordinated loans, but there is no mention of contracts for difference. "CFD investors are still fair game in Germany," said Peter Mattil, a lawyer who represents investors. "There is no legal protection for them."

Although the law to protect small investors prohibits obligations to make additional payments, it does so only for so-called capital investments, which do not include contracts for difference. Even in the United States, stricter rules apply; the maximum lever is 50:1. Some brokers on the German market are offering bets at a ratio of 400:1 and more.

The U.S. financial regulator had wanted to limit the lever to 10:1, but CFM providers wrote a letter of protest. One of the signatories was Drew Niv, head of broker FXCM. In December he said: "Currencies do not fluctuate that sharply. If there were no levers, no one would trade in these products."

When the Swiss central bank announced the end of the cap on the franc a few weeks later, Mr. Niv had to take out a rescue loan of $300 million for his company to avoid insolvency.

Mr. Faber does not have a white knight to lend him money. And if he did, he wouldn't take it. "I want to sort it out myself," he says. IG has offered to let him pay back less, but he is waiting for IG to make the next move.

His bet on the Swiss franc was his last trade. "I'll never do anything like that again," he says. When he goes out now with friends, he stops after his first beer and puts the rest of his money into his savings account, low interest rates or not.

But who is responsible for the fact that Mr. Faber is now threatened with insolvency? Mr. Faber himself, or his broker? The central bankers because they broke their promise? The investment bankers whose invention allowed the gambling to happen? The politicians who let them do what they liked? Perhaps it's no longer possible to say in the age of globalization.

That doesn't mean that there are only losers in this story. Foreign exchange traders at U.S. bank JP Morgan, for example, were also betting on the Swiss currency when Thomas Jordan started the avalanche. However, they were banking on a stronger franc, and are thought to have made up to $300 million.

Money never disappears; it simply changes owners.


Michael Brächer is a financial editor in the investment team in Frankfurt. To contact the author: [email protected]