by Emmanouil Lemonakis, Head of Central Eastern Europe Region, Saxo Bank.
CFDs – Investing in a crisis
Contracts for difference (CFDs) are simply a financial derivative in the form of an agreement between the issuer (seller) and the buyer (purchaser), when respective sides commit themselves to pay the difference between the current value of the contract and its value on the date of issuing. In other words, the investor can use this mechanism and successfully invest their capital in both bear and bull markets. Due to their character, CFDs are particularly well suited for a period of increased economic uncertainty, when stability of the economy is uncertain and asset prices are affected by fluctuation – these determine the rhythm of trading on global markets.
CFDs, or the sheik on vacation
The current macroeconomic situation seems unique in many respects. Increased activity in capital markets, unexpected changes in trends and a remarkably complicated geopolitical situation may all be a harbinger announcing a change in the course of the history – not just the economy. However, all those who managed to mark the current unrest around the world as the end of times should first study the real economic tornado that swept the financial markets in the latter century. It would lead to a conclusion, that the current oil prices are not as unfathomable, and the “war” waged on countries outside the OPEC cartel are all but an inept rhetoric – of a rather worn Saudi dynasty – which is a composite of influences of the American administration and increasing threats from Iran and Russia. As well as the current problems of the Kremlin with foreign capital outflow, though making most analysts stare in shock, seem almost frivolous compared to the Crunch that happened in the United States around 1930’s.
History repeats itself – using an investor’s time machine, Saxo Bank checks how much you could earn on history-shaping economic events from before the year of 1990, assuming CFDs were to exist back then.
Comparing historical events with the modern ones, Saxo Bank will also answer the question: Do we really live in groundbreaking times?
The second fall of Moscow – oil conspiracy
Moscow is a giant with feet in ‘oil’ – a transparent fact well known to the main opponents of the Kremlin prior to the collapse of the Union of Soviet Socialist Republics. And though during the Cold War there were many military tensions between opposing factions, falling of the Eastern Comrades in fact needed no bullets to be fired – at least officially. All that was needed was to increase the production of ‘black gold’, the export of which – as well as today – was paramount to the survival of the state. The ‘dirty work’ was done by the Saudis in cooperation with the Americans and other countries interested in lifting the iron curtain: “A joint action like that had a precedent, which led to the fall of the Soviet Union (…) In 1985 the Kingdom increased its production from 2 to 10M barrels daily, knocking the price to 10 dollars.” – as reminded recently by one of the Russian newspapers referring to current oil prices.
If any of the investors were to receive a tip from the Saudi sheiks of the planned ‘action’, he or she could take a short position to earn a fortune on the oil market. From November 1985 to April 1986 oil prices fell 69%.
Assuming the hypothetical possibility of investing in CFDs on oil, this market move with a minimal security deposit of 4% could lead to opening a short position of nominal value of 1,000,000 USD with a deposit in the amount of 40,000 USD. With such commitment to capital investment the customer would gain 690,000 USD investing only 40,000 USD, which means over 17-fold increase of the value of the portfolio (1725%).
It seems that after almost thirty years Russia failed to do its history homework and again made its economy highly dependent on the export of energy resources. Forgetting the requirement of prior restructuring of trade, Vladimir Putin decided to return Russia to its former glory – beginning with attacks on Georgia and Ukraine… and that would be it. Former allies (USA and Saudi Arabia) joined forces once again on the resource market leading to a significant reduction in prices of natural gas and crude oil. In just a few months the value dwindled by over 60%, reaching historical minimums. Russia ran out of petrodollars necessary to maintain military operation, and the restoration of the empire clearly lost its impetus, being between an increasing budget deficit and an abject inefficiency of the banking sector.
Those who spotted an analogy to year of 1985 could earn a profit of 61% during the last year. But only employing a CFD would give the investor the tools for optimal capital use. Just as in the previous example, assuming a hypothetical possibility of investing in CFD on oil, this market move of a minimal security deposit of 4% would allow to open a short position of a nominal value of 1,000,000 USD with the deposit valued at 40,000 USD. With this level of capital investment the customer would gain 610,000 USD investing only 40,000 USD, which means over 15-fold increase of the value of the portfolio (1525%).
Uncle Sam vs Russian bear
The Russian invasion of Crimea, and the escalation of the conflict to the eastern regions of Ukraine, especially in Lugansk and Donetsk, were direct factors which significantly contributed to the economic collapse of Moscow – even though it would most certainly reach our eastern neighbors, who were reforming their economy in a manner that was dilatory. Even though the outflow of foreign capital from Russia in previous years remained at a relatively high level (61 billion dollars in 2013.), what happened during the last year meant a real Armageddon for the local capital market. The imposition of sanctions by Western countries, as a consequence of the aggressive rhetoric adopted by Vladimir Putin, clearly weakened investment enthusiasm across the river of Bug, leading to the ‘escape’ of more than 150 billion dollars throughout the year of 2014. Panic among entrepreneurs leaving cold Siberian taiga and the Russian bear, moving to the sunny beaches of the west coast of the United States, were additionally stimulated by suspicious legal solutions as, for example, so-called “nationalization of losses” in the energy sector. This, as you might think of a “charitable” activity of the Kremlin authorities was nothing but an attempt to reach a more effective control of the economy, by making unruly oligarchs dependent on the state capital (read: Putin’s). There was and still is nothing to prevent socialization of the losses in other sectors … This concern “shared” the main Russian RTS index, which since only the July of last year depreciated more than 40 percent.
Investors, who while fleeing from capitulating Moscow took short positions on the RTS index, could have achieved a rate of return of up to levels as high as 60 percent.
Russian problems with the drainage of foreign capital, is nothing compared to the Great Depression, which hit the United States in the 1930s, and then the whole globe. Suffice it to say that, according to many experts, the then crash on Wall Street indirectly contributed to the outbreak of the World War II, radically changing the geopolitical system in the coming decades. “Black Thursday” – determining the official “start” of the deepest recession of the twentieth century had its roots primarily in the ever growing oversupply of goods overseas, which had not met with sufficient demand from the US market, due to its relatively limited absorptive capacity. Intense credit activity in the overenthusiastic banking sector, generated industrial production in enterprises, which were unable to offset the operating costs through the sale of overproduced goods. This in turn influenced the decline in the profitability of companies allocating substantial sums for investment activities (often financed by means of loans). The Great Depression is also a consequence of an irresponsible lending to European countries, which after WWI attempted to heave itself from the rubble. American bankers, hoping for a better situation on the Old Continent, came too liberal to risk assessment, which turned out to be too high. A few years after the “Black Thursday” one of the major US indexes, the Dow Jones Industrial Average, melted from 381.17 points to 41.22 points in mid-1932. This meant a decrease by about 90 percent!
If Saxo Bank had been offering CFDs in the 30s, the investor-clairvoyant, investing only the amount of $ 200,00, would have increased his balance by $ 900,000. How? Through the described market move, with a minimum security deposit of 2% for the DJI index CFDs, would allow the opening of a short position with a nominal value of $ 1,000,000 with a deposit in the amount of $ 20,000. A change of 90% in the value of DJI index, would bring a customer a profit of $ 900,000, with an initial investment of only $ 20,000, and that means more than 45-fold increase in the value of the portfolio (4500%).