The derivative lure catching SMSFs
As official interest rates hover at an all-time low of 0.25 of a percentage point, the derivative lure catching SMSFs originates from their inability to generate acceptable returns through defensive assets such as cash and term deposits.
While this predicament severely impacts SMSF trustees who have reached or are fast approaching retirement age, getting enough money into an SMSF for retirement purposes plays on the mind of all trustees, regardless of age.
SMSF trustees are starting to look towards investing in high-risk assets such as derivatives because they think they can outperform the market and get a quick return.
Typically, very few SMSFs make a profit from these types of investments. And unless they’re professional stockbrokers, most of them post losses (sometimes significant ones) and take only short-term gains.
SIS compliance with derivatives
Firstly, the fund’s trust deed must permit (or not exclude) investments in derivatives and, secondly, the investment strategy must explicitly state that the fund intends to invest in derivatives.
The next hurdle is SIS regulation 13.14.
Under r13.14 SISR, SMSF trustees may not give a charge over the fund assets which includes a mortgage, lien or other encumbrance. The regulation prohibits trustees from activities such as:
- Participating in margin lending products
- Creating a mortgage over a property
One of the exceptions to this prohibition is an LRBA, which has its own set of restrictive rules laid out in s67A and s67B of SIS.
Another exception is where the fund creates a charge over fund assets as a result of investing in derivatives, such as options and futures.
Charge over fund assets
Under r13.15A SIS, an approved charge on fund assets can be provided for investments with Australian and specified foreign stock exchanges and futures exchanges (“approved body”) as long as:
- The derivatives contract complies with the rules of the approved body (SISR 13.15A).
- The fund has a Derivatives Risk Statement (DRS) in place.
The DRS must be in place as a separate document to the investment strategy and outlines:
- Policies for using derivatives, including an analysis of the risks associated with using derivatives within the fund’s investment strategy.
- The restrictions and controls on using derivatives, taking the expertise of the staff involved into consideration.
- The compliance processes to ensure the controls are effective.
Remember, too, that while the term “derivative” applies to a variety of financial arrangements, not all are eligible obligations that will meet the requirements of SIS.
What are CFDs?
A CFD provides the investor with an opportunity to profit from price movement without owning the underlying asset. CFDs are synthetic financial products (or derivatives) which are tradable on stock indices, stock options, currencies and futures contracts.
The CFD price is calculated by the asset’s movement between the entry and exit price, with the investor not required to own the underlying assets.
In Australian terms, CFD trading is like betting on two flies crawling up a wall.
The appeal of CFDs is that SMSF trustees can leverage by only having to put up a small margin deposit to hold a trading position.
SIS compliance with CFDs
An SMSF trustee may invest in a CFD as long as it is allowed under the fund’s investment strategy and not explicitly prohibited in the trust deed.
While a CFD is a derivative, it is not an options or futures contract, and SMSF trustees do not allow a charge over the assets of the fund. By definition, regulation 13.15A SIS does not apply because there is no charge given in relation to the rules of an approved body.
When opening a CFD, the trustee pays a deposit into a CFD bank account. They may also need to make additional margin payments to cover running losses on open positions. All money deposited into the CFD bank account by the fund is the property of the CFD provider, in which the fund has no beneficial interest.
According to the ATO, this does not constitute a loan between the CFD provider and the fund because needing to pay a deposit and meet margin calls does not represent a borrowing. They are contractual liabilities to make payments if and when required — not repayments.
As there is no loan between the CFD provider and the fund, the borrowing prohibition in s67 also does not apply.
Where CFDs go wrong
It is a breach if the trustee, under a separate written related agreement with the CFD provider, deposits fund assets with the provider as security relating to the trustee’s obligations to pay margins.
The terms of the agreement state the circumstances in which the fund’s assets would be realised and show intent to create a charge over the assets.
By entering into this type of agreement with the CFD provider, the trustee has contravened regulation 13.14 of the SISR.
Derivative trading patterns
ASIC has provided a warning for SMSF trustees at risk due to increased trading activity in derivative investments in the current volatile markets created by COVID-19.
An analysis of security markets during the COVID-19 period has revealed a substantial increase in retail activity as well as greater exposure to risk. ASIC has found that some investors are engaging in short-term trading strategies unsuccessfully attempting to time price trends.
Additionally, the number of new retail investors increased sharply to the market — up by a factor of 3.4 times — and the number of reactivated dormant accounts also increased.
The trading frequency has significantly increased, as has the number of different securities traded per day. Also, the duration for holding the securities has dramatically decreased, indicating a concerning increase in short-term and “day trading” activity.
For SMSF trustees to attempt the same type of trading is incredibly dangerous, according to ASIC, and likely to lead to massive losses which could not happen at a worse time for many trustees during COVID-19.
CFD trading patterns
Since October 2019, ASIC has required SMSF trustees to have a Legal Entity Identifier (LEI) if they are trading non-exchange traded instruments such as CFDs and foreign exchange.
SMSFs accounted for the majority of growth in LEI applications, which increased by 84 per cent during the September 2020 quarter due to COVID-19. Given the current low interest rate environment, this further supports the increased risk appetite of SMSF trustees chasing higher returns through derivatives.
High-risk investments are possible within an SMSF, with the ATO warning trustees not to use derivatives as a speculative tool.
SMSF trustees need to understand all the risks and make sure they have the correct documentation in place. In most cases, SMSF trustees will be betting against professionals, and every contract they enter into has a winner and a loser.
Let’s hope that the derivative lure currently catching SMSFs does not result in losses and (potential) compliance issues.
Shelley Banton, head of education, ASF Audits