Derivatives like backing horses, economist tells trial

Investment products known as contracts for difference (CFDs) and based on the value of shares, were "black arts", the trial of three former directors for Anglo Irish Bank heard yesterday.

Michael O’Higgins, counsel for former Anglo director Seán FitzPatrick, said CFDs were “all done in the dark” and there was “a lack of transparency” around them.

Brendan Grehan SC, for former Anglo director Pat Whelan, quoted Warren Buffett in describing CFDs as [financial] "weapons of mass destruction".

Mr Fitzpatrick (65) of Greystones, Co Wicklow, William McAteer (63) of Rathgar, Dublin, and Mr Whelan (51) of Malahide, Co Dublin, have been charged with 16 counts of providing unlawful financial assistance to 16 individuals in July 2008 to buy shares in the bank, contrary to section 60 of the Companies Act.

Mr Whelan has also been charged with being privy to the fraudulent alteration of a loan facility letters to seven people.

All three men have pleaded not guilty to the charges.

Contracts for difference
In 2008, the court heard, there were media reports that some individuals had taken out CFDs on Anglo shares and there were concerns.

Séamus Coffey, lecturer in economics at University College Cork explained CFDs were also known as derivatives and were a bit like placing bets on horses. The person placing the bet didn’t own the horse but he had an interest in the horse’s performance and if the horse won he would benefit.

If a share price rose, the owner of a CFD would make a profit based on “the difference” between the starting price and the increased price. But if it fell he would not and either the investment would be closed and he would take the loss or he could continue with it. If he wanted to continue on with the investment he would need to give the CFD provider more money. This additional payment was referred to as “the margin call”.

Mr Coffey also said CFDs were private contracts between a purchaser and a CFD provider, often a broker. Because they involved private contracts they were not recorded by the Irish Stock Exchange, he said, unlike when a person purchases shares and their name is recorded and is visible publicly.

'Exponential returns'
Mr Coffey agreed with counsel for the State Úna Ní Raifeartaigh that it was the CFD provider's decision to sell shares not the CFD purchaser's decision. He also agreed that CFDs did not attract stamp duty, while share purchases did. And CFD purchasers could make "exponential returns" if share prices went up, he said.

He explained that CFDs were complex in nature and the level of complexity was bounded only by the imagination of those working in the financial markets.

“And they have vivid imaginations,” he said.

Mr Coffey said that, in order to protect themselves, CFD providers often bought the shares on which the CFD was based. This meant if share prices increased they would not have to pay for the CFD profit from their own pockets but could simply sell the shares. They would also sell the shares when a CFD had closed.

'Detrimental effect'
Under cross-examination from Mr O'Higgins, Mr Coffey agreed that if a large proportion of a company's shares became available on the market "it would have a detrimental effect".

The court also heard investment banks could take shares as collateral for a loan on condition they could lend the shares on to a third party. In 2008 up to 12 per cent of Anglo shares were out on loan, Mr O’Higgins said. Mr Coffey agreed the loaned shares could be used by “hedge funds” whose operators might sell the shares if they were considered vulnerable and then buy them back at a lower price. They were “not saying Hail Marys” but were selling large numbers of shares [to depress the price], Mr O’Higgins said.

“So all of a sudden my shares have fallen in value,” he said.

If a hedge fund “got a sniff” a CFD purchaser could not keep “making margin calls forever”, “eventually the inevitable will happen”, Mr O’Higgins said.

Mr Coffey pointed out that the rules had changed around CFDs and now interests had to be declared. This was because of “a sense there was unseen risks in the market”.

Mr O’Higgins said CFDs were “off screen, off centre and completely unregulated”.

“Whatever the opposite of transparency is, that’s it,” he said. Mr Coffey said it was known as the grey market. Mr O’Higgins responded that “black arts” might be more appropriate.

The case continues.