In the lead-up to the November 2012 meeting of the Reserve Bank, a variety of markets were offered by bookmakers to punters. As one bookmaker publicly claimed that the likelihood that the RBA was going to lower the cash rate was so high that betting on this outcome was like putting money on Black Caviar to win, another bookmaker ceased offering a binary "yes, the cash rate will drop" market and instead offered bets on the margin by which the cash rate would drop.
In September, it was reported that ASIC warned bookmakers that, unless they hold a financial services licence, they may be in breach of Australian law by offering odds on share prices, movements in sharemarket indices and interest rates. ASIC's concern is that, by offering these markets, bookmakers may be offering derivatives.
The availability of odds on interest rate movements suggests that a view has been taken (by the bookmakers at least) that bets on interest rate movements are not derivatives – rather, they are purely speculative and akin to bets on any other "novelty" market, such as whether the baby of Kate Middleton will be born before the baby of Kim Kardashian.
However, the more pressing question is perhaps not whether a gambling operator requires a financial services licence (and should be subject to regulation by ASIC) but whether a financial service provider offering derivatives requires a gambling licence (and should be subject to regulation by gambling regulators).
What is a Derivative?
The Corporations Act's definition of "derivative" is deliberately broad and captures an arrangement under which:
- a party must provide consideration by a future time (that is, not less than one business day or, in the case of foreign exchange contracts, three business days, after the date on which the arrangement is entered into); and
- the amount of this consideration, or the value of the arrangement, is ultimately determined by, derived from or varies by reference to "the value or amount of something else (of any nature whatsoever and whether or not deliverable)".
Assets, rates (including an interest rate or exchange rate), indices and commodities are all listed in the legislation as examples of "something else".
What is Gambling?
It is commonly accepted that a person engages in gambling if they:
- stake or risk consideration upon;
1.1 a game of chance (for example, roulette); or
1.2 a future contingency not under their control or influence (for example, a bet on a sporting event); and
- pursuant to an agreement or understanding under which they or someone else will receive something of value in the event of a certain outcome.
Both definitions require consideration to be staked with the outcome of the stake to be determined by a chance outcome (or a contingency) being:
- in the case of gambling, a game of chance; or
- in the case of both gambling and derivatives, an event which is completely outside the control of the investor/gambler.
.....But they're Also (Very) Different
In offering markets on interest rates, bookmakers are likely to take the view that, because the consideration provided by a punter to bet on, for example, a drop in the cash rate is limited to the amount nominated by the punter at the time they place the bet (ie the amount they bet) and therefore the amount of the return if the punter wins is fixed by the odds under which the punter places the bet, bets on these movements are exempt from the Corporation Act's definition. That is, the amount of the consideration or the value of the arrangement is not determined by the value of "something else" – it is in fact determined by the amount bet and the odds at the time of the bet.
On the other hand, in the context of a derivative, the potential amount of consideration to be provided, and the value of the arrangement, can vary depending on what the "something else" does. For example, the value of an option in relation to BHP shares will vary depending on the change in price of the underlying shares: the extent of the movement in price of the shares will determine the extent of each party's gain or loss. In other words, the outcome is not binary.
Derivatives: Does Australian Law Understate the Risk?
While speculation has traditionally been a legitimate part of the financial services industry, the 2008 global crisis (which resulted in significant losses from the unravelling of large scale investments in high risk products and the widening of the Dodd-Frank safety net so that derivatives clearing houses are now protected by the US government on the basis that they are "too big to fail"), as well as a reported increase in the participation of Australian retail investors in derivatives such as CFDs, have given rise to a legitimate question – does Australian law strike the correct balance in treating derivatives and bets so differently?1
Various court decisions in cases involving claims to recover losses made through investments in derivatives have highlighted the need for greater regulation. In many instances, the courts have criticised these products by referring to them in gambling terms. For example, as part of his judgment in favour of several NSW councils which brought successfully a class action against the Australian arm of Lehman Brothers after failed investments in synthetic collateralised debt obligations, Rares J described these derivatives as "sophisticated bets". The plaintiffs' expert witness used similar language.
ASIC's Moneysmart website includes a page entitled "Complex Investments",2 which lists and explains a number of different derivatives. At the bottom of the page is the following warning:
"some complex products attract investments with the potential to make quick money. This can be tempting for people with personality types that are attracted to gambling".
In addition, ASIC provides a link to the Gambling Helpline. Whilst ASIC's approach here may be considered extreme, it is significantly more telling of the similarities between derivatives and gambling than its concern that betting operators should not offer odds on movements in interest rates without a financial services licence.
Is the balance right?
Whilst odds tell punters exactly what their chances are, investors purchasing derivatives are dealing with products in respect of which both the consideration and the return only become apparent after the level of risk incurred by the investor and obscure the investor's understanding of this risk.
The Australian gambling industry as a whole often refers to the highly regulated market in which it operates as a selling point to consumers. Accordingly, the high risk incurred by an investor who has committed to a derivative raises a number of questions, including about the form of regulation involved, the type of conduct that is being regulated, and whether the applicable regulation is appropriate in terms of the level of protection afforded to those investors.
The assistance of Jessica Azzi, Solicitor, of Addisons in the preparation of this article is noted and greatly appreciated.
1 Also refer to Alan Kohler's commentary: "Throw the Gaming Act at derivatives bookies", Business Spectator, 26 September 2012.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.