Contract for difference

"CFDs" redirects here. For other uses, see CFD (disambiguation) and CFDS (disambiguation).

In finance, a contract for difference (CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time (if the difference is negative, then the buyer pays instead to the seller). In effect CFDs are financial derivatives that allow traders to take advantage of prices moving up (long positions) or prices moving down (short positions) on underlying financial instruments and are often used to speculate on those markets.

For example, when applied to equities, such a contract is an equity derivative that allows traders to speculate on share price movements, without the need for ownership of the underlying shares.

CFDs are currently available in Australia, Austria, Canada, Cyprus, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, The Netherlands, Luxembourg, Norway, Poland, Portugal, Romania, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, United Kingdom and New Zealand. They are not permitted in a number of other countries. In the United States, under the Dodd-Frank Act, CFDs are considered to be “swaps” or “security-based swaps,” depending on the nature of the underlier on which they are based, and are subject to the regulatory framework for those products established by Title VII of the Dodd-Frank Act.[1] For example, a CFD on Apple common stock would be a security-based swap (SBS) subject to the regulatory framework for SBS established by the Dodd-Frank Act.[2] Under the Dodd-Frank Act, among other things, transactions in SBS with or for retail investors (that is, persons who are not “eligible contract participants”)[3] must be done on a registered national securities exchange[4] and offers and sales of SBS to retail investors must be registered under the Securities Act of 1933.[5]

History

CFDs were originally developed in the early 1990s in London as a type of equity swap that was traded on margin. The invention of the CFD is widely credited to Brian Keelan and Jon Wood, both of UBS Warburg, on their Trafalgar House deal in the early 90s.[6][7]

They were initially used by hedge funds and institutional traders to hedge cost-effectively their exposure to stocks on the London Stock Exchange, mainly because they required only a small margin and because no physical shares changed hands avoided the UK tax of stamp duty.

In the late 1990s CFDs were introduced to retail traders. They were popularised by a number of UK companies, characterized by innovative online trading platforms that made it easy to see live prices and trade in real time. The first company to do this was GNI (originally known as Gerrard & National Intercommodities); GNI and its CFD trading service GNI touch was later acquired by MF Global. They were soon followed by IG Markets and CMC Markets who started to popularize the service in 2000.

It was around 2000 that retail traders realized that the real benefit of trading CFDs was not the exemption from tax but the ability to leverage any underlying instrument. This was the start of the growth phase in the use of CFDs. The CFD providers quickly expanded their offering from London Stock Exchange (LSE) shares to include indices, many global stocks, commodities, bonds, and currencies. Trading index CFDs, such as the ones based on the major global indexes e.g. Dow Jones, NASDAQ, S&P 500, FTSE, DAX, and CAC, quickly became the most popular type of CFD that were traded.

Around 2001 a number of the CFD providers realized that CFDs had the same economic effect as financial spread betting in the UK except that spread betting profits were exempt from Capital Gains Tax. Most CFD providers launched financial spread betting operations in parallel to their CFD offering. In the UK the CFD market mirrors the financial spread betting market and the products are in many ways the same. However unlike CFDs which have been exported to a number of different countries, spread betting relying on a country specific tax advantage has remained primarily a UK and Irish phenomenon.

The CFD providers started to expand to overseas markets with CFDs being first introduced to Australia in July 2002 by IG Markets and CMC Markets. CFDs have since been introduced into a number of other countries; see list above.

Until 2007 CFDs had been traded exclusively over-the-counter (OTC); however, on 5 November 2007 the Australian Securities Exchange (ASX) listed exchange-traded CFDs on the top 50 Australian stocks, 8 FX pairs, key global indices and some commodities. There were originally 12 brokers offering ASX CFDs, but as of 2009 this had dropped to only five. As of June 2014 ASX ceased to offer CFDs.

In June 2009, the UK regulator the Financial Services Authority (FSA) implemented a general disclosure regime for CFDs to avoid them being used in insider information cases.[8] This was after a number of high-profile cases where positions in CFDs were used instead of physical underlying stock to hide them from the normal disclosure rules related to insider information.[9]

In October 2013, LCH.Clearnet in partnership with Cantor Fitzgerald, ING Bank and Commerzbank launched centrally cleared CFDs in line with the EU financial regulators’ stated aim of increasing the proportion of cleared OTC contracts.[10]

Risks

Market risk

The main risk is market risk as the contract is designed to pay the difference between the opening price and the closing price of the underlying asset. CFDs are traded on margin, and the leveraging effect of this increases the risk significantly. Margin rates are typically small and therefore a small amount of money can be used to hold a large position. It is this very risk that drives the use of CFDs, either to speculate on movements in financial markets or to hedge existing positions elsewhere. One of the ways to mitigate this risk is the use of stop loss orders. Users typically deposit an amount of money with the CFD provider to cover the margin and can lose much more than this deposit if the market moves against them.[11]

Liquidation risk

If prices move against open CFD position additional variation margin is required to maintain the margin level. The CFD provider may call upon the party to deposit additional sums to cover this, and in fast moving markets this may be at short notice. If funds are not provided in time, the CFD provider may close/liquidate the positions at a loss for which the other party is liable.

Counterparty risk

Another dimension of CFD risk is counterparty risk, a factor in most over-the-counter (OTC) traded derivatives. Counterparty risk is associated with the financial stability or solvency of the counterparty to a contract. In the context of CFD contracts, if the counterparty to a contract fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument. This means that a CFD trader could potentially incur severe losses, even if the underlying instrument moves in the desired direction. OTC CFD providers are required to segregate client funds protecting client balances in event of company default, but cases such as that of MF Global remind us that guarantees can be broken. Exchange-traded contracts traded through a clearing house are generally believed to have less counterparty risk. Ultimately, the degree of counterparty risk is defined by the credit risk of the counterparty, including the clearing house if applicable.

CFDs compared to other products

There are a number of different financial products that have been used in the past to speculate on financial markets. These range from trading in physical shares either direct or via margin lending, to using derivatives such as futures, options or covered warrants. A number of brokers have been actively promoting CFDs as alternatives to all of these products.

Although no firm figures are available as trading is over-the-counter, it is estimated that CFD related hedging accounts for somewhere between 20% and 40% the volume on the London Stock Exchange (LSE). A number of people in the industry back the view that a third of all LSE volume is CFD related. The LSE does not monitor the numbers but the original 25% estimate as quoted by many people, appears to have come from a LSE spokesperson.

The CFD market most resembles the futures and options market, the major differences being:

Futures

Futures are preferred by professionals for indices and interest rate trading over CFDs as they are a mature product and are exchange traded. The main advantages of CFDs, compared to futures, is that contract sizes are smaller making it more accessible for small trader and pricing is more transparent. Futures contracts tend to only converge near to the expiry date compared to the price of the underlying instrument which does not occur on the CFD as it never expires and simply mirrors the underlying instrument.

Futures are often used by the CFD providers to hedge their own positions and many CFDs are written over futures as futures prices are easily obtainable. CFDs don't have expiry dates so when a CFD is written over a futures contract the CFD contract has to deal with the futures contract expiry date. The industry practice is for the CFD provider to 'roll' the CFD position to the next future period when the liquidity starts to dry in the last few days before expiry, thus creating a rolling CFD contract.

Options

Options, like futures, are an established product, exchange traded and centrally cleared and used by professionals. Options, like futures, can be used to hedge risk or to take on risk to speculate. CFDs are only comparable in the latter case. The main advantage of CFDs over options is the price simplicity and range of underlying instruments. An important disadvantage is that a CFD cannot be allowed to lapse, unlike an option. This means that the downside risk of a CFD is unlimited, whereas the most that can be lost on an option is the price of the option itself. In addition, no margin calls are made on options if the market moves against the trader.

Compared to CFDs, option pricing is complex and has price decay when nearing expiry while CFDs prices simply mirror the underlying instrument. CFDs cannot be used to reduce risk in the way that options can.

Covered warrants

Similar to options, covered warrants have become popular in recent years as a way of speculating cheaply on market movements. CFDs costs tend to be lower for short periods and have a much wider range of underlying products. In markets such as Singapore, some brokers have been heavily promoting CFDs as alternatives to covered warrants, and may have been partially responsible for the decline in volume of covered warrant there.

Physical shares, commodities and FX

This is the traditional way to trade financial markets, this requires a relationship with a broker in each country, require paying broker fees and commissions and dealing with settlement process for that product. With the advent of discount brokers, this has become easier and cheaper, but can still be challenging for retail traders particularly if trading in overseas markets. Without leverage this is capital intensive as all positions have to be fully funded. CFDs make it much easier to access global markets for much lower costs and much easier to move in and out of a position quickly. All forms of margin trading involve financing costs, in effect the cost of borrowing the money for the whole position.

Margin lending

Margin lending also known as margin buying or leveraged equities have all the same attributes as physical shares discussed earlier, but with the addition of leverage, which means like CFDs, futures, and options much less capital is required, but risks are increased. Since the advent of CFDs, many traders have moved from margin lending to CFD trading. The main benefits of CFD versus margin lending are that there are more underlying products, the margin rates are lower, and it is easy to go short. Even with the recent bans on short selling, CFD providers who have been able to hedge their book in other ways have allowed clients to continue to short sell those stocks.

Exchange traded CFDs in Australia

The majority of CFDs are traded OTC using the direct market access (DMA) or market maker model, but from 2007 until June 2014[12] the Australian Securities Exchange (ASX) offered exchange traded CFDs. As a result, a small percentage of CFDs were traded through the Australian exchange.

The advantages and disadvantages of having an exchange traded CFD were similar for most financial products and meant reducing counterparty risk and increasing transparency but costs were higher.

Advantages

Disadvantages

The disadvantages of the ASX exchange traded CFDs and lack of liquidity meant that most Australian traders opted for over-the-counter CFD providers.

Criticism

Some financial commentators and regulators have expressed concern about the way that CFDs are marketed at new and inexperienced traders by the CFD providers. In particular the way that the potential gains are advertised in a way that may not fully explain the risks involved.[14] In anticipation and response to this concern most financial regulators that cover CFDs specify that risk warnings must be prominently displayed on all advertising, web sites and when new accounts are opened. For example, the UK FSA rules for CFD providers include that they must assess the suitability of CFDs for each new client based on their experience and must provide a risk warning document to all new clients, based on a general template devised by the FSA. The Australian financial regulator ASIC on its trader information site suggests that trading CFDs is riskier than gambling on horses or going to a casino.[15] It recommends that trading CFDs should be carried out by individuals who have extensive experience of trading, in particular during volatile markets and can afford losses that any trading system cannot avoid.

There has also been concern that CFDs are little more than gambling implying that most traders lose money trading CFDs.[16] It is impossible to confirm what the average returns are from trading as no reliable statistics are available and CFD providers do not publish such information, however prices of CFDs are based on publicly available underlying instruments and odds are not stacked against traders as the CFD is simply the difference in underlying price.

There has also been some concern that CFD trading lacks transparency as it happens primarily over-the-counter and that there is no standard contract. This has led some to suggest that CFD providers could exploit their clients. This topic appears regularly on trading forums, in particular when it comes to rules around executing stops, and liquidating positions in margin call. Although the incidence of these types of discussions may be due to traders' psychology where it is hard to internalise a losing trade and instead they try to find external source to blame. This is also something that the Australian Securities Exchange, promoting their Australian exchange traded CFD and some of the CFD providers, promoting direct market access products, have used to support their particular offering. They argue that their offering reduces this particular risk in some way. The counter argument is that there are many CFD providers and the industry is very competitive with over twenty CFD providers in the UK alone. If there were issues with one provider, clients could easily switch to another.

Some of the criticism surrounding CFD trading is connected with the CFD brokers' unwillingness to inform their users about the psychology involved in this kind of high-risk trading. Factors such as the fear of losing that translates into neutral and even losing positions[17] become a reality when the users change from a demonstration account to the real one. This fact is not documented by the majority of CFD brokers.

Criticism has also been expressed about the way that some CFD providers hedge their own exposure and the conflict of interest that this could cause when they define the terms under which the CFD is traded. One article suggested that some CFD providers had been running positions against their clients based on client profiles, in the expectation that those clients would lose, and that this created a conflict of interest for the providers.[18]

Bucket shops

CFDs, when offered by providers under the market maker model, have been compared to the bets sold by bucket shops, which flourished in the United States at the turn of the 20th century. These allowed speculators to place highly leveraged bets on stocks generally not backed or hedged by actual trades on an exchange, so the speculator was in effect betting against the house. Bucket shops, colourfully described in Jesse Livermore's semi-autobiographical Reminiscences of a Stock Operator, are illegal in the United States according to criminal as well as securities law.

See also

References

  1. ↑ “Further Definition of ‘Swap,’ ‘Security-Based Swap,’ and ‘Security-Based Swap Agreement’; Mixed Swaps; Security-Based Swap Agreement Recordkeeping,” Securities and Exchange Commission Rel. No. 34-67453 (Jul. 18, 2012), 77 FR 48207, 48259-60 (Aug. 13, 2012), available at: http://www.gpo.gov/fdsys/pkg/FR-2012-08-13/pdf/2012-18003.pdf
  2. ↑ Id.
  3. ↑ Section 3(a)(65) of the Securities Exchange Act of 1934, as added by the Dodd-Frank Act, available at: http://www.sec.gov/about/laws/sea34.pdf, cross-referencing Section 1a(18) of the Commodity Exchange Act, available at: https://www.law.cornell.edu/uscode/html/uscode07/usc_sup_01_7_10_1.html
  4. ↑ Section 6(l) of the Securities Exchange Act of 1934, as added by the Dodd-Frank Act, available at: http://www.sec.gov/about/laws/sea34.pdf
  5. ↑ Section 5(e) of the Securities Act of 1933, as added by the Dodd-Frank Act, available at: http://www.sec.gov/about/laws/sa33.pdf
  6. ↑ Richard Fletcher (March 20, 2005). "Gadget Shop deal unmasks the City's silent trader". London: Times Online.
  7. ↑ "Obituaries: Brian Keelan". London: The Telegraph. August 13, 2005.
  8. ↑ FSA brings forward CFD disclosure rules - Times Online - 3 March, 2009
  9. ↑ Griffiths, Katherine (2007-11-13). "FSA calls for more CFD Disclosure - The Daily Telegraph - 13 Nov, 2007". London: Telegraph.co.uk. Retrieved 2010-04-29.
  10. ↑ "Archived copy". Archived from the original on 2013-11-02. Retrieved 2013-11-01.
  11. ↑ "Contract for difference Market risk". NSFX. Archived from the original on 23 April 2016. Retrieved 30 March 2016.
  12. ↑ ASX to cease offering CFDs Archived January 23, 2015, at the Wayback Machine.
  13. ↑ "ASIC targets derivatives providers". Melbourne: News.theage.com.au. 2009-08-07. Retrieved 2010-04-29.
  14. ↑ Battersby, Lucy (2009-08-24). "ASIC raises alarm over new CFD trade risks". smh.com.au. Retrieved 2010-09-24.
  15. ↑ "Contracts for difference: complex and high risk?". Fido.gov.au. 2009-01-30. Retrieved 2015-04-22.
  16. ↑ "It's a gamble either way". Smh.com.au. 2009-09-02. Retrieved 2010-04-29.
  17. ↑ "Not Losing Keeps You From Winning". www.ibtimes.co.uk. 2010-04-15. Retrieved 2010-04-29.
  18. ↑ Stuart Washington and Adele Ferguson (August 28, 2010). "Cat's meat".

Further reading

This article is issued from Wikipedia - version of the 11/30/2016. The text is available under the Creative Commons Attribution/Share Alike but additional terms may apply for the media files.