Contract for difference
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A contract for difference (or CFD) is a contract between two parties, 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.) For example, when applied to equities, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares
Contracts for differences allow investors to take long or short positions, and unlike futures contracts have no fixed expiry date or contract size. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 30% of the notional value for CFDs on leading equities.
CFDs are currently available in listed [i.e. mini-warrants and ASX CFDs listed on the Australian Securities Exchange] and/or over-the-counter markets in the United Kingdom, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand and most recently Sweden. Some other securities markets, such as Hong Kong, have plans to issue CFDs in the near future. CFDs are not permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on OTC financial instruments.
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[edit] History
CFDs were originally developed in the early 1990s in London. Based on equity swaps, they had the additional benefit of being traded on margin and being exempt of stamp duty, a UK tax. 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.
They were initially used by Hedge funds and institutional investors to hedge their exposure to stocks on the London Stock Exchange in a cost-effective way.
In the late 1990s CFDs were first introduced to retail investors. They were popularised by a number of UK companies, whose offerings were typically characterised by innovative online trading platforms that made it easy to see live prices and trade in real time. Investors quickly realised that the real benefit of trading CFDs was not the tax exemption but the ability to trade on leverage on any underlying instrument. This was the start of the growth phase in the use of CFDs.
The CFD providers quickly responded and expanded their offering from just London Stock Exchange (LSE) shares to include most global stock exchanges, indexes, commodities, treasuries 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, CAC and ASX200, quickly became the most popular individual CFD that is traded.
The CFD providers started to expand to overseas markets with CFDs being first introduced to Australia in 2002. Up to this point most CFDs were traded using the market maker model, but a peculiar development in Australia was the Direct Market Access (DMA) model, where the CFD provider would buy or sell the underlying instrument 1:1 for the CFD. This guaranteed the price matched the underlying share but increased costs and was limited to Australian share CFDs.
At about the same time a number of the CFD providers introduced financial spreadbetting to the UK. This has a very similar economic effect as CFD trading but makes them in effect tax free. This was specific to the UK tax environment and this has not been replicated in other countries.
CFDs have been introduced into a number of other countries since then. See list above.
Up until this point CFDs have always been traded OTC; however, in 2007 the Australian Securities Exchange (ASX) announced that it was going to introduce an exchange-traded CFD on the top 50 Australian stocks, 8 FX pairs, key global indices and some commodities.
[edit] Charges
The contracts are subject to a daily financing charge, usually applied at a previously agreed rate above or below LIBOR or some other interest rate benchmark. The parties to a CFD pay to finance long positions and (may) receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.
Traditionally, CFDs are subject to a commission charge that is a percentage of the size of the position, usually <0.25%, for each trade. Alternatively, an investor can opt to trade with a market maker, foregoing commissions at the expense of a (usually) larger bid/offer spread on the instrument.
Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (ranging from 1% to 30% usually). One advantage to investors of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the buyer to a margin calls in a downturn, which often leads to losing a substantial part of the assets.
As with many leveraged products, maximum exposure is not limited to the initial investment; it is possible to lose more than one put in. These risks are typically mitigated through use of stop orders and other risk reduction strategies (for the most risk averse, guaranteed stop loss orders are available at the cost of an additional one-point premium on the position and/or an inflated commission on the trade).
[edit] CFDs versus futures
CFDs are convenient for the stock market (if used under around 10 weeks, an estimated point where CFD financing charge exceeds financing charge for stocks) while futures are preferred by professionals for indexes and interest rates trading (but CFDs for indices are used too and futures for stocks also). In addition to avoiding stamp duty, increased flexibility and leverage are other advantages of CFDs over more conventional forms of margin trading (like stocks), although with futures there is usually enough leverage available (typically 20:1, but can be as high as 70:1). All forms of margin trading involve financing charges (with the exception of the Spot Foreign Exchange market), although in the case of CFDs and futures contracts these are already embedded in the price of the instrument. On the one hand, futures are more transparent (for instance: a group of hedge funds linked to BAE Systems managed to get more than 15% of Alvis plc through CFDs without having to warn the British regulator, see more in the "virtual positions" section of this IFLR article on virtual positions through CFDS). On the other hand – and that is evidence of their success – CFD-related hedging is estimated to account for more than 25% of the volume on the London Stock Exchange, a fact which corroborates the view that CFDs are recognised as very competitive (and are subsequently widely used) for profitable trading.
[edit] Exchange Traded CFDs - ASX CFDs
Exchange Traded CFDS are a new form of contract for difference that will be traded through an exchange based mechanism. Current CFD providers focus on either the direct market access CFD or market maker models. This new development is set to be launched in November 2007 on the Australian Stock Exchange (Source: ASX website www.asx.com.au).
The ASX claims that their Exchange Traded CFDs will enjoy the traditional benefits of leverage enjoyed by over the counter contracts for difference but with reduced transaction costs (although, they are as yet unknown and unpublished) from the central counter clearing model negating the financing charges traditionally imposed by third party CFD providers.[1]
Only accredited brokers will offer exchange traded CFDs and multiple market makers have been appointed to facilitate liquidity. No guarantees are given that there will be liquidity available, instead liquidity is dependent upon the market utilising differences between the underlying physical market and the corresponding CFD (arbitrage [2]). Additional information about exchange traded contracts for difference, including market developments is available here [3].
ASX has also launched (24 September 2007) an ASX CFD Trading Simulator. The simulator allow a user to learn the basics of the ASX CFD market as well as explore trading strategies in a life-like environment… without risk to their capital.
[edit] Difference between ASX CFDs and OTC
Market Independence. ASX is required under the Corporations Act to ensure that its markets are fair, orderly and transparent. As the central market operator, ASX is independent of the parties with whom a customer receives advice and deals through enabling it to act fairly and impartially. This separation of responsibility between broker and exchange also provides customers with choice as to whom they wish to execute their business through.
Having a central market also means there is one standard contract specification for all ASX CFDs, not a different product depending the OTC CFD provider.
Transparency. Unlike OTC markets, ASX reports on all ASX CFDs transacted, open positions, bid, offers and their volumes. ASX CFDs are traded in the same way as other ASX traded contracts.
All prices are formed in a fully transparent manner in ASX's CFD central market order book. Each trader's order is combined in the ASX CFD central market order book with those from other market participants, including market makers, and becomes an integral part of the price discovery process.
All trades are executed on a strict price/time priority. Price/time priority means the first person to enter the best price is traded against first.
Whilst prices are transparent in the ASX CFD market, the individual trader remains anonymous, which minimises market impact costs (especially those related to others identifying an individual's trading patterns and trading ahead of him/her).
The ASX CFD central market order book will include orders from market makers. Their activities help ensure the ASX CFD market has competitive prices and deep liquidity.
Risk Management. In the ASX CFD market all settlement obligations are guaranteed by SFE Clearing Corporation (SFECC).
All ASX CFD margins are calculated by "SPAN", recognized globally as the leading margin calculation system.
SFECC has a statutory obligation to operate "fair and efficient" clearing and settlement facilities. These facilities are monitored by both ASIC and the Reserve Bank of Australia (RBA).
Trading in the ASX CFD Market. There are fundamental differences in the way ASX CFDs are traded compared to OTC CFDs.
When trading ASX CFDs, the customer's order is entered directly via a Participant into the ASX CFD central market order book. This order book is available for the market to see. All orders are executed on a strict price/time priority. This means that the first order with the best bid or offer price is always executed first. Trading in the ASX CFD central market order book also ensures "client orders" are always given priority over a broker's "house orders".
In contrast, customers executing OTC CFDs do not have their orders in the ASX CFD central market order book. These orders are transacted with the OTC CFD counterparty (typically described as a CFD Provider). The customer's order is not protected by the ASX's price/time priority or client order precedence rules.
[edit] Risk
CFDs allow a trader to go short or long on any position using margin. There are always two types of margin with a CFD trade -
1) Initial (normally between 5% and 30%), and 2) Variable (which is then 'marked to market').
Initial margin is fixed at between 5% and 30% depending on the stock and overall perceived risk in the market at that time. For example, during and after 9/11 initial margins were massively hiked across the board to counter the explosion in volatility in the world's stockmarkets.
Many refer to initial margin as a deposit. For example, for large and highly liquid stocks such as Vodafone the initial margin will be nearer 5%, and depending on the broker and the client's relationship with the firm the deposit maybe even lower. But with a smaller capitalised and less liquid stock the margin is likely to be at least 10% if not a lot higher. This information is important for all CFD traders to consider before they actively look to take positions, long or short in stocks.
Variable margin however is never set as a simple percentage because it reflects the underlying movement of stock's price. For example, if a CFD trader was to buy 1,000 shares in ABC stock using CFDs at 100p and the price moved lower to 90p the broker would deduct £100 in variable margin (1,000 shares x -10p) from the client's account. Note, this is all done in real-time as the market moves lower, so called 'marked to market'. Conversely, if the share price moved higher by 10p the broker would credit the client's account with £100 in positive variable margin.
Variable margin can therefore have either a negative or positive effect on a CFD trader's cash balance. But initial margin will always be deducted from a customer's account and replaced once the trade is covered.da:Differencekontrakt de:Differenzkontrakt it:Contratto per differenza pl:Contract for difference ru:Контракт на разницу цен
