History

Invention

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 1990s.[1][2][need quotation to verify][3][failed verification]

Asset Management and Synthetic Prime Brokerage

CFDs were initially used by hedge funds and institutional traders to cost-effectively gain an exposure to stocks on the London Stock Exchange, partly because they required only a small margin but also, since no physical shares changed hands, it also avoided stamp duty in the United Kingdom.[4][need quotation to verify]

It remains common for hedge funds and other asset managers to use CFDs as an alternative to physical holdings (or physical short selling) for UK listed equities, with similar risk and leverage profiles. A hedge fund’s prime broker will act as the counterparty to CFD, and will often hedge its own risk under the CFD (or its net risk under all CFDs held by its clients, long and short) by trading physical shares on the exchange. Trades by the prime broker for its own account, for hedging purposes, will be exempt from UK stamp duty.

Retail trading

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.[citation needed]

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.[citation needed]

CFD providers then started to expand to overseas markets, starting with Australia in July 2002 by IG Markets and CMC Markets.[citation needed] CFDs have since been introduced into a number of other countries. They are available in Australia, Austria, Canada, Cyprus, France, Germany, 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 the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) prohibit CFDs from being listed on regulated exchanges due to their high-risk nature.[5][need quotation to verify] The Securities and Futures Commission of Hong Kong totally forbid CFD trading. However, HK residents can trade CFD via oversea brokers.

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.[6]

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[7] 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.[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]

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.[10]

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.[6] 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.[11] This was followed by the UK Financial Conduct Authority (FCA) issuing a proposal for similar restrictions on the December 6, 2016.[12] 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.[13] In March the Irish financial regulator followed suit and put out a proposal to either ban CFDs or implement limitations on leverage.[14]

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:[15]

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.

Risks

Market risk

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, which amplifies risk and reward via leverage.[16]

It is this very risk that drives the use of CFDs, either for speculation 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.[17]

In the professional asset management industry, an investment vehicle’s portfolio will usually contain elements that offset the leverage inherent in CFDs when looking at leverage of the overall portfolio. In particular, the retention of cash holdings reduces the effective leverage of a portfolio: if an investment vehicle buys 100 shares for $10,000 in cash, this provides the same exposure to the shares as entering into a CFD for the same 100 shares with $500 of margin, and retaining $9,500 as a cash reserve. The use of CFDs in this context therefore does not necessarily imply an increased market exposure (and where there is an increased market exposure, it will generally be less than the headline leverage of the CFD).

Liquidation risk

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.[citation needed]

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. This risk is heightened due to the fact that custody is linked to the company or bank supplying the trading.[18][failed verification]

Comparison with other financial instruments

This section possibly contains original research. Please improve it by verifying the claims made and adding inline citations. Statements consisting only of original research should be removed. (October 2016) (Learn how and when to remove this template message)

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.[citation needed]

The CFD market most resembles the futures and options market, the major differences being:[19][20]

  • 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;
  • CFD trading is banned in the United States and Hong Kong;
  • Minimum contract sizes are small, so it’s possible to buy one share CFD;
  • Easy to create new instruments: not restricted to exchange definitions or jurisdictional boundaries, so very wide selection of underlying instruments can be traded.

Futures

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 traders 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.[citation needed]

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 expiration 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.[citation needed]

Options

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 (by a buyer) is the price of the option itself. In addition, no margin calls are made on options if the market moves against the trader.[citation needed]

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]

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.

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.