In finance, a contract for difference (CFD) is a contract between two parties, typically described as “buyer” and “seller”, stipulating that the buyer will pay to the seller the difference between the current value of an asset and its value at contract time (if the difference is negative, then the seller pays instead to the buyer).
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.[need quotation to verify][failed verification]
They were initially used by hedge funds and institutional traders to cost-effectively hedge their exposure to stocks on the London Stock Exchange, mainly because they required only a small margin. Moreover, since no physical shares changed hands, it also avoided the stamp duty in the United Kingdom.[need quotation to verify]
In the late 1990s, CFDs were introduced to retail traders. They were popularized 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.
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, inasmuch as it relies on a country-specific tax advantage, has remained primarily a UK and Irish phenomenon.
CFD providers then started to expand to overseas markets, starting with Australia in July 2002 by IG Markets and CMC Markets. CFDs have since been introduced into a number of other countries. They are 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 – most notably the United States, where, due to rules about over the counter products, CFDs cannot be traded by retail investors unless on a registered exchange and there are no exchanges in the US that offer CFDs.[need quotation to verify]
In 2016 the European Securities and Markets Authority (ESMA) issued a warning on the sale of speculative products to retail investors that included the sale of CFDs.
Attempt by Australian exchange to move to exchange trading
The majority of CFDs are traded OTC using the direct market access (DMA) or market maker model, but from 2007 until June 2014 the Australian Securities Exchange (ASX) offered exchange traded CFDs. As a result, a small percentage of CFDs were traded through the Australian exchange during this period.
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. The disadvantages of the ASX exchange traded CFDs and lack of liquidity meant that most Australian traders opted for over-the-counter CFD providers.
Insider trading regulations
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. 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.
Attempt at central clearing
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.
European regulatory restrictions
In 2016 the European Securities and Markets Authority (ESMA) issued a warning on the sale of speculative products to retail investors that included the sale of CFDs. This was after they observed an increase in the marketing of these products at the same time as a rise in the number of complaints from retail investors who have suffered significant losses. Within Europe, any provider based in any member country can offer the products to all member countries under MiFID and many of the European financial regulators responded with new rules on CFDs after the warning. The majority of providers are based in either Cyprus or the UK and both countries’ financial regulators were first to respond. CySEC the Cyprus financial regulator, where many of the firms are registered, increased the regulations on CFDs by limiting the maximum leverage to 50:1 as well prohibiting the paying of bonuses as sales incentives in November 2016. This was followed by the UK Financial Conduct Authority (FCA) issuing a proposal for similar restrictions on the December 6, 2016. The German regulator BaFin took a different approach and in response to the ESMA warning prohibited additional payments when a client made losses. While the French regulator Autorité des marchés financiers decided to ban all advertising of the CFDs. In March the Irish financial regulator followed suit and put out a proposal to either ban CFDs or implement limitations on leverage.
UK low carbon electricity generation
To support new low carbon electricity generation in the United Kingdom, both nuclear and renewable, Contracts for Difference (CfD) were introduced by the Energy Act 2013, progressively replacing the previous Renewables Obligation scheme. A House of Commons Library report explained the scheme as:
Contracts for Difference (CfD) are a system of reverse auctions intended to give investors the confidence and certainty they need to invest in low carbon electricity generation. CfDs have also been agreed on a bilateral basis, such as the agreement struck for the Hinkley Point C nuclear plant.
CfDs work by fixing the prices received by low carbon generation, reducing the risks they face, and ensuring that eligible technology receives a price for generated power that supports investment. CfDs also reduce costs by fixing the price consumers pay for low carbon electricity. This requires generators to pay money back when wholesale electricity prices are higher than the strike price, and provides financial support when the wholesale electricity prices are lower.
The costs of the CfD scheme are funded by a statutory levy on all UK-based licensed electricity suppliers (known as the ‘Supplier Obligation’), which is passed on to consumers.
The main risk is market risk, as contract for difference trading 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 in other products.[contradictory] 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.
Main article: Margin call
If prices move against an open CFD position, additional variation margin is required to maintain the margin level. The CFD providers may call upon the party to deposit additional sums to cover this, in what is known as a margin call. In fast moving markets, margin calls 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.
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.[failed verification]
Comparison with other financial instruments
There are a number of different financial instruments that have been used in the past to speculate on financial markets. These range from trading in physical shares either directly 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.
The CFD market most resembles the futures and options market, the major differences being:
- There is no expiry date, so no time decay;
- Trading is done over-the-counter with CFD brokers or market makers;
- CFD contract is normally one to one with the underlying instrument;
- CFDs are not available to US residents;
- CFDs are not available to HK residents;
- Minimum contract sizes are small, so it’s possible to buy one share CFD, low entry threshold;
- Easy to create new instruments, not restricted to exchange definitions or jurisdictional boundaries, very wide selection of underlying instruments can be traded.
Professionals prefer future contracts 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 to the price of the underlying instrument near the expiry date, while the CFD 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, like futures, are established products that are exchange traded, 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.[contradictory] 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.[contradictory]
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.
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, 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.
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. 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. 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. 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 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.
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.
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