In finance, a contract for difference ( CFD ) is a contract between two parties, usually 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 the time of the contract (if the difference is negative, the buyer pays the opposite to the seller). As a result, CFDs are financial derivatives that allow traders to take advantage of rising prices (buy positions) or price moves down (sell positions) on underlying financial instruments. They are often used to speculate in the market. For example, when applied to equity, such a contract is an equity derivative that allows traders to speculate on stock price movements, without the need for ownership of the underlying stock. CFDs may be traded as stocks, bonds, futures, commodities, indices, or currencies. CFDs are also known as forward for difference ( FCD ) contracts.
CFDs are available in Australia, Austria, Canada, Cyprus, Czech Republic, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, Luxembourg, Norway, Poland, Portugal, Romania, Russia, Singapore, South Africa, Sweden, Switzerland, Turkey, England and New Zealand. They are not allowed in a number of other countries - notably the United States, where, due to counter product rules, CFDs can not be traded by retail investors except on registered exchanges and no exchange in the US that offers CFDs.
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History
Discovery
CFDs were originally developed in the early 1990s in London as a type of exchange of equity traded on margin. The discovery of CFDs was widely credited to Brian Keelan and Jon Wood, both from UBS Warburg, on their Trafalgar House deal in the early 90s.
They were initially used by hedge funds and institutional traders to effectively protect their exposure to stocks on the London Stock Exchange, primarily because they required only a small margin and because no physical stocks changed hands avoiding the UK transaction tax known as stamp duty.
Retail trade
In the late 1990s, CFDs were introduced to retailers. They are popularized by a number of UK companies, characterized by innovative online trading platforms that make it easy to see live prices and trades in real time. The first company to do this was the GNI (originally known as Gerrard & National Intercommodities); GNI and its GNI touch CFD trading services were later acquired by MF Global. They were soon followed by IG Markets and CMC Markets who began popularizing the service in 2000.
Around 2000, retailers realized that the real benefits of trading CFDs were not tax exemptions but the ability to capitalize on the underlying instruments. This is the beginning of the growth phase in the use of CFDs. CFD providers are rapidly expanding their offerings from London Stock Exchange (LSE) shares to include indices, many global stocks, commodities, bonds, and currencies. CFD trading index, such as indexes based on major global indexes, e.g. Dow Jones, NASDAQ, S & amp; P 500, FTSE, DAX, and CAC, are quickly becoming the most popular types of CFDs traded.
Around 2001 a number of CFD providers realized that CFDs had the same economic effect as financial bet in UK, except that profit-sharing spreads were exempted from Capital Gains Tax. Most CFD providers launch financial spread bet betting operations in parallel with their CFD offerings. In the UK, the CFD market reflects financial spreadsets and product spreads in much the same way. But unlike CFDs, which have been exported to a number of different countries, spread bets, to the extent that it relies on the country's special tax advantages, it remains a particularly British and Irish phenomenon.
The CFD provider then began expanding into overseas markets, starting with Australia in July 2002 by IG Markets and CMC Markets. CFDs have since been introduced to a number of other countries; see the list above.
Attempts by an Australian exchange to move into a trade exchange
The majority of CFDs are traded OTCs using direct market access (DMA) or model market makers, but from 2007 to June 2014, the Australian Securities Exchange (ASX) offers CFD traded exchanges. As a result, a small percentage of CFDs are traded through Australian exchanges during this period.
The advantages and disadvantages of CFD exchanges are similar for most financial products and therefore reduce counterparty risk and increase transparency but higher costs. Losses from CFX traded ASX exchanges and lack of liquidity mean that most Australian merchants opt for over-the-counter CFD providers.
Insider trading rules
In June 2009, the British Financial Services Authority (OJK) regulator applied a general disclosure regime to CFDs to avoid them being used in the case of insider information. This occurs after a number of high profile cases where positions in the CFD are used instead of the physical base stock to hide them from the normal disclosure rules associated with inside information.
Trying at clearing center
In October 2013, LCH.Clearnet in collaboration with Cantor Fitzgerald, ING Bank and Commerzbank launched CFDs centrally cleaned in accordance with EU financial regulators' objectives to increase the proportion of deleted OTC contracts.
European regulatory restrictions
in 2016, the European Securities and Markets Authority (ESMA) issued a warning about the sale of speculative products to retail investors that included the sale of CFDs. This is after they have observed the increased marketing of these products at the same time as the increase in the number of complaints from retail investors who have suffered significant losses. In Europe, any member-based provider may offer its products to all member countries under MiFID and many European financial regulators respond with new rules on CFDs after warnings. Most service providers based in Cyprus or the UK and the financial regulators of both countries first responded. CySEC Cyprus's financial regulator, where many companies are listed, upgraded CFD regulations by limiting maximum leverage to 50: 1 and prohibiting bonus payments as sales incentives in November 2016. This was followed by the UK Financial Conduct. The Authority (FCA) issued a proposal for a similar restriction on December 6, 2016. The German BaFin regulator takes a different approach and in response to the ESMA warning prohibits additional payments when a client makes a loss. While the French regulator Autorità ©  © des marchÃÆ'  © s financiers decided to ban all CFD ads. In March, Irish financial regulators followed and submitted proposals to ban CFDs or impose restrictions on leverage.
Maps Contract for difference
Risk
Market risk
The main risk is market risk, as contracts for different trades are designed to pay the difference between the opening price and the closing price of the underlying asset. CFDs are traded on margin, and their leverage effects increase risk significantly. The margin level is usually small and therefore a small amount of money can be used to hold a large position. It is this risk that encourages the use of CFDs, either to speculate about movements in financial markets or to protect existing positions in other products. One way to reduce this risk is the use of stop loss orders. Users usually deposit some money with a CFD provider to cover margin and can lose more from this deposit if the market moves against them.
Liquidation risk
If the price moves against the open CFD position, additional variation margins are required to maintain the margin level. The CFD provider may ask the parties to deposit an additional amount to cover this, and in this fast-moving market may be short-lived. If funds are not provided on time, CFD providers may close/liquidate positions on losses borne by others.
Counterparty Risk
Another dimension of CFD risk is counterparty risk, a factor in most over-the-counter (OTC) trading derivatives. Opponent's risk is associated with financial stability or partner solvency for the contract. In the context of a CFD contract, if the opposing party fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument. This means that CFD traders have the potential to incur substantial losses, even if the underlying instrument moves in the desired direction. OTC CFD providers are required to separate client funds that protect client balances in case of company failure, but cases like MF Global remind us that collateral can be broken. Trading traded on exchanges traded through clearing houses is generally believed to have fewer counterparty risks. Ultimately, the counterparty risk level is determined by the credit risk of the opponent, including clearing house if applicable.
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 either physical stock trading either directly or through margin loans, using derivatives such as futures, options or closed warrants. A number of brokers have been actively promoting CFDs as an alternative to all these products.
Although no exact figure is available due to over-the-counter trades, it is estimated that CFDs are related to hedging accounts for somewhere between 20% and 40% of the volume on the London Stock Exchange (LSE). A number of people in the industry support the view that one-third of all LSE volumes are related to CFDs. The LSE does not monitor numbers but the original 25% estimate, as quoted by many, appears to come from an LSE spokesperson.
CFD markets most closely resemble futures and options markets, the main differences are:
- No expiration date, so no time decay;
- Trading is over-the-counter with a CFD broker or market maker;
- The CFD contract is usually one on one with the underlying instrument;
- CFDs are not available to US residents;
- CFDs are not available to HK residents;
- Minimum contract size is small, so it's possible to buy one stock CFD, low entry threshold;
- Easy to create new instruments, not limited to exchange definitions or jurisdictional constraints, a very broad choice of basic trading instruments.
Futures
Professionals prefer futures to index and trade more interest rates than CFDs because they are mature and traded products on the exchange. The main advantage of CFDs, compared to futures, is that the size of the contract is smaller so that it is more accessible to small traders and the price is more transparent. Futures contracts tend to converge only closer to the expiration date than the price of the underlying instrument that does not occur on the CFD because it never expires and only reflects the underlying instrument.
Futures are often used by CFD providers to protect their own positions and many CFDs are written over the future as futures prices are easy to obtain. CFDs do not have an expiration date so when CFDs are written on futures contracts, CFD contracts must deal with the expiration date of the futures contract. The industry practice is for CFD providers to 'roll' CFD positions into the next future period when liquidity begins to dry up in the last few days before expiration, thus creating a rolling CFD contract.
Options
Options, such as futures, are established products traded on the stock, centrally cleaned and used by professionals. Options, such as futures, can be used to protect risks or take risks to speculate. CFDs are only comparable in the latter case. The main advantage of CFDs over options is the simplicity of prices and the range of underlying instruments. An important disadvantage is that CFDs can not be left hose, unlike options. This means that the downside risk of CFDs is unlimited, while the most missing in the options is the price of the option itself. In addition, no margin calls are made to the option if the market moves against the merchant.
Compared to CFDs, option pricing is complex and has a worsening of prices when approaching expiration while CFD prices reflect only the underlying instrument. CFDs can not be used to reduce risk in ways that the options can take.
Closed guarantee
Similar to options, closed warrants have become popular in recent years as a way of speculating cheaply on market movements. CFD costs tend to be lower for the short run and have a much wider range of underlying products. In markets such as Singapore, some brokers have strongly promoted CFDs as an alternative to closed guarantee letters, and may be partly responsible for the decrease in the volume of closed orders there.
This is the traditional way to trade financial markets, this requires a relationship with the broker in each country, requires paying broker and commission fees and handling the settlement process for that product. With the advent of discount brokers, it becomes easier and cheaper, but it can still be a challenge for retailers especially when trading in overseas markets. Without this use is capital intensive because all positions must be fully funded. CFDs make it easier to access global markets at a much lower cost and easier to move in and out of positions quickly. All forms of margin trading involve financing costs, which means the cost of borrowing money for all positions.
Margin lending
Margin lending , also known as margin buying or equity leverage , has all the same attributes as the physical shares discussed previously, but with the addition of leverage, which means like CFDs, futures, and options, much less capital is required, but risks are increasing. Since the advent of CFDs, many traders have moved from margin loans to CFD trading. The main benefit of CFDs versus margin loans is that there are more underlying products, lower margin rates, and it is easy to go short. Even with the recent ban on short-selling sales, CFD providers who have been able to hedge their books in other ways have allowed clients to continue selling the shares.
Criticism
Some financial commentators and regulators have expressed concerns about how CFDs are marketed in new and inexperienced traders by CFD providers. In particular the way that potential profits are advertised in a way that may not fully explain the risks involved. In anticipating and responding to these concerns, most financial regulators that include CFDs specify that risk warnings should be clearly displayed on all advertisements, websites 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 the general template designed by the FSA. The Australian financial regulator ASIC on its merchant information site suggests that trading CFDs is riskier than gambling on horses or going to casinos. It recommends that CFD trading should be undertaken by individuals who have extensive trading experience, especially during volatile markets and can bear the losses that can not be avoided by any trading system.
There is also concern that CFDs are little more than gambling that implies that most traders lose CFD trading money. It is impossible to confirm what the average return of trade is because there are no reliable statistics available and the CFD provider does not publish the information, but the CFD price is based on generally available instruments and opportunities are not stacked against merchants because CFDs are just price differences underlying.
There are also some concerns that CFD trading does not have transparency because it happens mainly over-the-counter and that there is no standard contract. This causes some people to suggest that CFD providers can exploit their clients. These topics appear regularly in trade forums, especially when it comes to rules around stopping execution, and liquidating positions in margin calls. Although this type of discussion may be due to merchant psychology in which it is difficult to internalize losing trades and instead try to find an external source to blame. This is also something done by the Australian Securities Exchange, which promotes their CFDs traded in Australia and some CFD providers, promoting direct market access products, has been used to support their special offerings. They argue that their offerings reduce 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 UK alone. If there is a problem with one provider, the client can easily switch to another.
Some of the criticisms surrounding CFD trading are connected with the reluctance of CFD brokers to inform their users about the psychology involved in such high-risk trading. Factors such as the fear of loss that translate into a neutral position and even loss become reality when the user changes from a demonstration account to a real one. This fact is not documented by the majority of CFD brokers.
Criticism has also been disclosed about how some CFD providers undermine their own exposure and conflicts of interest that can cause when they define the terms under which CFDs are traded. One article shows that some CFD providers have run positions against their clients based on client profiles, in the hope that the client will lose, and this creates a conflict of interest for the provider. In February 2017, the Zero Hedge conspiracy blog published details of complaints upheld by the NFA against FXCM CFD brokers suggesting FXCM through its subsidiaries participate in abusive practices known as "last look".
A number of providers have begun offering CFDs related to crypto currency. The instability of cryptocurrency and leverage CFD markets has proved too far in some cases with Coindesk reporting that UK-based Trading212 was forced to suspend Bitcoin Cash CFD trading in November 2017 which resulted in significant losses for some clients when trading resumed and the market has moved against them.
Shop bucket
CFDs, when offered by providers under the market-maker model, have been compared to bets sold by bucket shops, which flourished in the United States at the turn of the 20th century. These allowed speculators to place bets with high leverage on shares that are not generally supported or protected by real trading on the exchange, so the speculator is actually betting against the house. The bucket shops, pictured in color in semi-autobiographical Jesse Livermore, The Remembrance of a Stock Organizer, is illegal in the United States under criminal law and securities.
See also
References
Further reading
- Andy Richardson, Contract for Different Q & A
- What is CFD Trading
Source of the article : Wikipedia
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