Preamble
This Risk Notice pertains to certain salient risks associated with leveraged / margin trading in certain inherently-leveraged derivative instruments. It is not intended, nor should it be construed as, any comprehensive exposition or compendium of such risks (which are numerous and multifarious), nor does it pertain to unleveraged ‘cash’ instruments. You should engage in such leveraged / margin trading of derivatives only if you are sufficiently aware of the nature, attributes, risk-return profiles, margining, clearing, settlement and legal aspects of such trading and such instruments. Such trading and such instruments entail significant risks and are not for all traders / investors; accordingly, should you decide to engage in such trading of such instruments, you will be doing so at your own and sole risk. You must thoroughly evaluate to what extent such transactions are suitable and appropriate for you, taking into consideration your experience, aims, financial resources, and other key circumstances.
Derivatives
Derivatives include futures, options, CFDs, and cash-settled FX forwards (whose economic exposure is that of a zero-coupon cross-currency swap). The value of such instruments is derived from or related to the value of volatile underlying / ‘reference’ asset(s) such as equities, indices, bonds, currencies or commodities. The common characteristic of all such instruments is that they can be entered into, and a position established thereon, at nil or relatively small initial expenditure (whether initial margin for futures, CFDs or cash-settled FX forwards, or premium for options), thereby engendering ‘leverage’ or ‘gearing’ of your financial position, whereby small changes in the prices of the underlying asset(s) can result in substantial changes in the price of a derivative, necessitating the payment of variation margin.
Futures
Futures contracts are listed derivatives whose prices depend on the prices of their underlying assets and can be influenced inter alia by interest rates, changing supply or demand conditions, trade, fiscal, monetary and exchange control policies of governments, as well as national and international political and economic events. Futures are also subject to the risk of failure of any exchange(s) on which they trade, or any clearinghouse(s) via which they settle. Futures may on occasion be illiquid, as certain exchanges limit fluctuations in certain futures prices during a single day by regulations referred to as ‘daily price fluctuation limits’ or ‘daily limits’, under which, during any trading day, no trades may be executed at prices beyond these limits. Once the price of a particular futures contract has increased or decreased by the daily limit, positions in that contract can neither be taken nor liquidated, unless traders are willing to effect trades at or within the limit. This may prevent you from promptly liquidating unfavourable positions, resulting in substantial losses, or prevent the execution of desired trades. The relatively low margin normally required for futures trading may provide a large amount of leverage, and therefore a relatively small change in the price of a reference asset may result in a disproportionately larger profit or loss. In extraordinary circumstances, an exchange or regulator may suspend trading in a particular contract, or order the liquidation or settlement of all open positions.
Options
Options may pay off at expiry (‘in-the-money’) or expire worthless (‘out-of-the-money’). Accordingly, long option positions may expire worthless, leading to full and unrecoverable loss of the premium paid (whether upfront or, in some cases, upon exercise or maturity of the option). Moreover, even if a long option position pays off, such payoff may be less than the premium paid, leading to a net loss. Short option positions may theoretically entail, in the case of a ‘put’ option, a maximum net loss equal to the difference between the strike price and the premium paid and, in the case of a ‘call’ option, an unlimited maximum loss, insofar as the underlying asset price can theoretically increase without limit.
OTC
Whilst all futures contracts are exchange-traded by definition, many option contracts are not, and no contracts for differences (‘CFDs’) or FX forwards are. These latter instruments trade ‘over-the-counter’ (‘OTC’) instruments and are not standardised like listed futures and options. Whilst some OTC markets are highly liquid, OTC derivatives may involve greater risk than exchange-traded ones, as there is no exchange or liquid market on which to close out an open position. It may be impossible to liquidate an existing OTC position and/or assess its value or its exposure to risk. Bid and offer prices need not be quoted and, even where they are, they will be established by dealers in these instruments, and consequently it may be difficult to establish a ‘fair value’. OTC derivatives also entail counterparty default risk due to the inability or refusal by a counterparty to perform such contracts and (re-)deliver cash or securities. OTC market illiquidity or disruption may thus result in substantial losses. Certain OTC derivatives also involve the risk of model-dependent mispricing, and the risk that changes in the value of the derivative may not correlate perfectly with changes in the price of the underlying asset(s).
Leverage
Leverage/gearing, as afforded by the nil or relatively small initial expenditure involved in derivatives, allows you to make additional investments so that your exposure may be greater than your committed capital. Accordingly, moves in the prices of reference assets may result in exaggerated moves in the value of your positions, whether down or up, which will increase the volatility of your trading returns and may entail sudden and large falls or rises in your net financial position. In addition, failure to meet your obligations under relevant financing / margin-trading arrangements may result in your lenders closing out your positions and/or realising, perfecting or otherwise obtaining title to any security(ies) which they may have over your trading account. Thus, the effect of leverage in a market that moves adversely to your positions may result in substantial losses, greater than if no leverage were present.
In margin trading, you are, in effect, borrowing funds from your broker, and you may leverage your exposure (relative to unleveraged fully-paid-up / ‘cash’ instruments) by the use of derivatives such as futures and CFDs, which are inherently leveraged, and products with embedded leverage, such as options or other derivative contracts of varying complexity, payoff and risk-return profile. The level of interest rates generally, and the rates at which you are able to borrow particularly, will affect your trading returns. The amount of borrowing and leverage which you may have at any given time may be substantial in relation to your capital. Borrowing and leverage will be subject to interest, transaction and other costs, which may or may not be covered and recovered by your margin-trading returns.
Leverage via derivatives, margin trading, or other types of borrowing, based on the market value of your account or any particular positions therein, require you to post initial margin or collateral by pledging cash and/or securities. Should these decline in value, you may be subject to a ‘margin call’, pursuant to which it must deposit additional cash or securities in your account, or suffer mandatory liquidation of the pledged securities to compensate for their decline in value. In such cases, you may be unable to liquidate positions quickly enough to satisfy margin calls, and you may be forced to close out your positions at a loss (or such positions will be forcibly closed out by your broker, again at a loss).
The brokers that finance clients’ margin trading can apply essentially discretionary margin, ‘haircut’, and security or collateral valuation policies. Changes in such policies, or the imposition of other credit limitations or restrictions, whether due to market circumstances or government, regulatory or judicial action, may result in large margin calls, loss of financing, forced liquidation of positions at highly disadvantageous prices, termination of contracts and agreements, and cross-defaults to other dealers. Any such adverse effects may be exacerbated in the event such limitations or restrictions are imposed suddenly and/or by multiple market participants. The imposition of any such limitations or restrictions could force you to liquidate all or part of your portfolio at highly disadvantageous prices, possibly leading to the complete loss of your committed capital. There can be no assurance that you will be able to secure and/or maintain adequate financing and/or collateral for margin trading at all times.
Default
All transactions entail counterparty credit and default risk. These risks are mitigated for exchange-traded instruments, which are generally backed by clearinghouse guarantees, daily mark-to-market and settlement, and segregation and minimum capital requirements applicable to intermediaries. However, transactions entered into directly between two counterparties, such as cash-settled FX forwards, do not generally benefit from such protections, and expose the counterparties to a greater risk of counterparty default. Moreover, in certain circumstances, it may not be possible for the cash, securities and other assets deposited with custodians or brokers to be clearly identified as belonging to you, whereby you may be exposed to broker or custodian credit, default, settlement, clearing and delivery risk. In addition, there may be practical, legal, operational or temporal problems associated with enforcing your rights to your assets in case of insolvency of any counterparty, custodian or broker.
If you engage in OTC derivatives transactions, whose stability and liquidity depends in large part on the creditworthiness of your counterparty, you will be exposed to the risk that the counterparty will not settle a transaction in accordance with its terms because of a solvency or liquidity problem. Delays in settlement may also result from disputes over contractual terms. In addition, you may have a concentrated risk in a particular counterparty whereby, if such counterparty were to become insolvent or illiquid, your losses could be greater than if you had entered into contracts with multiple such counterparties. Certain OTC derivatives contracts require you to post margin or collateral. Collateral not segregated with a third-party custodian does not benefit from client asset segregation rules. If a counterparty becomes insolvent, you may be subject to the risk of not recovering your collateral, or to the risk that such recovery might be much delayed (even for several years) under administration.
If a counterparty defaults, you may have under normal circumstances contractual remedies pursuant to contractual documentation. However, exercising such contractual rights may involve delays or costs which could result in erosion and loss of part of your capital. Furthermore, there is a risk that any such counterparty could become insolvent and/or the subject of insolvency proceedings. In such case, the recovery of your positions and securities from such counterparty, or the payment of claims therefor, may be significantly delayed, and you may recover substantially less than the full value of the contracts or the securities underlying them. Risks similar to the foregoing are also inherent in your relationship with brokers or prime brokers. You should generally assume that insolvency of any counterparty will result in a loss to you, which may be material and exacerbated in case of non-segregation of your assets.
FX Risk
Profits and losses of transactions in contracts denominated in foreign currencies that differ from the base currency of your account are affected by exchange rate fluctuations when converted from the contract currency to your account currency, and may thus materially influence your trading returns.
Trading
Execution of transactions on markets in jurisdictions other than your own, including markets formally connected with your home market (e.g. ADRs) may entail additional risks. Regulation of such other markets may differ from yours in the degree of investor protection, which may be lower than in your home market. Your local regulatory authority is unable to ensure compulsory compliance to the rules determined by regulatory authorities or markets in other jurisdictions where you execute transactions.
The majority of electronic trading systems use information technology hardware (e.g. computers or servers) and software (i.e. order-book protocols and order management programmes) to route orders, match bids and offers, balance operations, and register, clear and settle transactions. As with other information technology devices and systems, such trading systems are subject to failures and faulty operation. Your chances for reimbursement of certain losses may depend on the limits of liability determined by the supplier of the trading systems, markets, clearinghouses and/or dealing firms. Such limits may vary; it is necessary for you to get detailed information from the dealing firm on this matter.
Trading executed on Electronic Communications Networks (‘ECNs’) may differ not only from trading on any usual ‘open-outcry’ market, but also from trading where other electronic trading systems are used as well. If you execute any transactions on an ECN, you bear the risks specific to such system, including the risk of hardware or software failure. System failures may result in your order not being carried out in accordance with your instructions, or not being executed at all, and it may be impossible to continually receive information on your positions, or to meet any associated margin requirements.