Contracts for Difference Introduction

History and the CFD revolution!

CFDs were originally developed in the early 1990's by the derivative desk of Smith New Court - a London based trading firm. CFDs first emerged in the over-the-counter (OTC) or equity SWAP markets which were used by institutions to cost-effectively hedge their equity exposure. CFDs enabled the firm's hedge-fund clients to easily sell short in the market (the London Stock Exchange) with the benefit of leverage, and to benefit from stamp duty exemptions that were not available to outright share transactions. By using CFDs, these large clients no longer needed to physically settle their equity/share transactions. They were also able to avoid the need to borrow stock when they wanted to sell short.

It is worth noting that at first, contracts for difference were only available to large corporations, but by the early 1990s, they became popular with hedge-fund traders who wanted to take advantage of the ups and downs of the market.

In the late 1990's CFDS were introduced to private clients and the retail market by Gerrard & National Intercommodities (GNI - now part of the Man Group plc) via its online trading arm - GNI Touch. GNI offered its clients CFD products and an innovative trading system that allowed private clients to trade via the internet directly into the London Stock Exchange - the CFD revolution was born and by the end of the decade, CFDs had already become widely available in the U.K.

Individuals trading their own accounts, small fund managers and institutions were now able to trade directly into the London Stock Exchange for the first time. These clients were now on a level playing field with the large institutions. They were able to take leveraged long (bought) positions and short (sold) positions without having to take delivery of the underlying shares. CFDs have today become one of the most popular derivative products in the global marketplace.

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, Thailand, South Africa, Australia, Canada, New Zealand, Hong Kong, Sweden, Norway, Belgium, Denmark, Netherlands, France (where they are known as contrats financiers pour différences) and Spain and the US (to non-residents only), with expansion into new markets occurring virtually every year. CFDs are also referred to as swaps, waves, turbo certificates, and callable bull/bear contracts (CBBCs). CFDs are not permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on OTC financial instruments.

Contracts for Difference (CFDs) are today one of the fastest growing tool in the financial services industry for trading in a range of markets including shares, global market indexes, forex, and commodities. Market participants from all backgrounds and levels of experience are now harnessing the power of CFDs to increase their returns, better manage their risk, and develop their trading strategy and skill.

The explosion in the use of this product is one of the reasons why London, as opposed to New York, is becoming the financial location of preference for many financial managers and hedge funds. Contracts for differences are not allowed in the U.S. due to legal restrictions imposed by the American Regulators.

CFDs in Australia

Contracts for difference have been available to Australian investors for about seven years now. In this time they have completely changed what it means to be a trader or speculator in many different investments. In fact, over this relatively short period, they have been adopted by both newcomers to trading as well as existing traders who have switched from other trading strategies. Previously most share market speculators in Australia dabbled in penny shares but CFDs have now given them access to much higher priced shares which are no longer the preserve of longer term investors who traditionally buy into these companies for their dividends and long term capital growth potential.

Originally CFDs first appeared in Australia in March 2002 when CMC Markets entered the market followed closely by IG Markets in July 2002, three years after their introduction in Britain and now have become one of the fastest growing financial products to enter the Australian market place. CFDs are today big business in Australia with industry estimates suggesting that there are more than 32,000 Australians currently trading the instruments (according to research firm Investment Trends), with about $400 million invested. Most of the trading doesn't take place on the Australian Stock Exchange per se' but on what are termed over-the-counter markets so the usual rules as laid down by the ASX do not apply. Investors can buy on large margins (that is, with little equity -- perhaps 5 per cent) and can buy and sell without the full sale price being transferred. Instead, the profit from the transaction is added to their balances, or the loss subtracted.

In Australia CFDs are provided by 5 primary providers who run their own trading platform: CMC Markets, IG Markets, MF Global, City Index and Macquarie Bank. Macquarie offers CFDs through Macquarie Prime, its all-in-one service that brings together stockbroking, margin lending, stock lending and CFD trading. MF Global uses the WebIRESS platform.

There is also a larger group of "white-label" providers, which re-badge another company's platform.

The market leader is thought to be IG Markets which offers both a direct market access and market-maker platform and which commands a 25 per cent market share and accounts for about 15% of group revenue [IG Group]. IG Markets was set up in Australia six years ago and has about 70 staff in Melbourne. Intense market volatility over the last 18 months has driven demand for CFDs in Australia, with IG Markets' client numbers surging by 55 per cent in the 12 months to July, chief executive Tamas Szabo said. Its Austrlian base consists of about 30,000 to 40,000 clients, with between 20 to 30 percent of traders being active. The next biggest is considered to be CMC Markets which in the past dominated market share (CMC had a share of up to 60% in 2007 but this dropped to 32% in 2008 and now lags behind IG Markets). Third in the market is considered to be DMA provider MF Global (including its white-label relationships) and then Macquarie Prime, followed by First Prudential Markets, E*Trade, Commsec, City Index, Sonray and Tricom to make up the top 10 providers.

ASX CFDs still only accounts for 1% of the CFD market share, despite the Australian Stock Exchange being behind this new product.

Business at CMC Markets has also been substantial, with global revenue for the year to March up 64 per cent to £181 million, and Australian revenue up 51 per cent. The average number of contracts traded each month in the Asia Pacific was 540,000 and the notional amount traded per month was $33 billion.

Howkins says IG Group's strong growth is partly attributable to volatility in markets and partly to the yearning among investors for speculative investments. "Our clients like leverage because it allows them greater access to assets than they could get without leverage,'' he says.

IG Group reported a 50 per cent rise in revenue to £184 million for the year to May 2008. Growth in Australian revenue was 115 per cent.

It is interesting to note that different countries have different characteristics - for instance an IG Markets spokesman has been recently quoted saying that the average holding period in Australian shares is approximately 3 days and if you compare that to the average holding period in Singapore this is more like 25 days.

Retail customer numbers are now somewhere between 150,000 and 180,000 and notional turnover in CFD shares and indices is running at about $10 billion a month, according to industry sources. Traders calculate that contracts for difference (CFD) make up 10-15 per cent of volume on the ASX, and the market is expanding. Estimated annual turnover of $120 billion would make the retail CFD market bigger than the wholesale over-the-counter equity derivatives market. The Australian Stock Exchange also launched exchange-traded Contracts for Difference in 2008, making it only the second exchange to have listed CFDs after London.

Volatility Woes

Despite the Australian Securities Exchange (ASX) recently launching a contracts for difference (CFD) service, a survey has shown that CFD traders are pulling back amidst the ongoing negative performance in the share market. The number of former or dormant CFD traders have increased from 14,000 to 24,000. According to Investment Trends' 2008 Contracts for Difference Report, the number of CFD traders in Australia decreased from 31,000 in April 2007 to 26,000 in August 2008.

The annual survey also found that the average CFD trade size had fallen from $55,000 to $41,000, but of those people still trading, the frequency of their trades had increased.

There has only been a modest adoption of ASX's CFD service, representing just about1 per cent of the total volume of CFD trades.

The problem is of course the volatility and of course CFD providers will try to attract dormant traders back into the market once the volatility has calmed down.

Volatility Effects

The persistent increase in volatility share prices has led to the number of active CFD traders in Australia falling from some 31,000 in April 2007 to 26,000 in August 2008, and average trade size fall from $55,000 to $41,000.

However, it appears that interest is shifting away from shares trading to index, currency and commodity trading. 'Eighteen months ago, CFDs on shares accounted for 80 per cent of our business. That's now about 15 per cent.' says Tamasz Szabo CFO of IG Markets. In the initial years CFDs were considered by Australian traders as a great means of getting lots of gearing and benefiting from the market's rise but now a change in conditions is increasingly making people use CFDs as a tool to manage risk.

IG's biggest market is now currency CFDs which account to around 35% of their business. Index CFDs represent 25% of the business taken and commodity CFDs have almost overtaken equities.

CFDs in South Africa

Over-the-counter contracts for difference, much of it driven by retail traders who value the simplicity and value that CFDs offer are also on the increase in South Africa.

Single-stock futures (SSFs) contracts have overwhelmingly ruled trading activity on the Johannesburg Stock Exchange (JSE) for the last few years. In the last quarter of 2007, single-stock futures accounted for a almost 80.5% of all contracts traded on the stock exchange - making South Africa one of the world's biggest markets for single-stock futures - however the dominance of single-stock futures is being challenged by increasing demand from retail investors into CFDs. An advantage that CFDs have over single-stock futures is the absence of dividend exposure - in fact as opposed to single-stock futures which are priced using a forecasted dividend, a CFD contract entails the agreement to swap dividends.

One of the greatest impediment to further growth of contracts for difference are exchange controls because under exchange control rules an institution cannot lend money to a foreign company/party for investing. This means that any non-South African trading in the CFD market cannot gear up by borrowing from one of the country's banks. Also, institutions are only able to deal with exchange-traded products which limits the institutional flow in CFDs. A loophole does exist in that banks can lend money for trading if the client goes through a regulated exchange - i.e. the JSE. Quite unusually for an OTC derivatives product regulation could prove the making of CFDs and currently the South Africa's Financial Services Board is looking to regulate the market.

CFDs in Singapore

In Singapore CFDs compete with 'extended settlement' (ES) contracts which have been offered by the SGX since February 2009 and basically work in a similar way. It seems, however, that CFDs are gaining ground since extended settlement contracts typically suffer from low liquidity.

The main market players here are local brokers like CIMB-GK Securities, Phillip Securities, and Kim Eng Securities and foreign CFD providers like IG Markets, Saxo Capital and CMC Markets.

The typical customer is a working professional between 25 and 55. About 40 per cent use CFDs to trade foreign currencies; another 35 per cent trade shares (with an average holding period of 25 days).

CFDs in Germany

Having been introduced to Germany in 2005, contracts for difference (in german known as a contract for differenz) have grown in popularity since last year's (2008) financial implosion, taking market share away from an even more popular trading instrument known as Zertificaten (Certificates), which, like contracts for difference, offer short-term traders leveraged exposure to market risk but without the counterparty guarantees of central clearing. In fact it is reported that while CFDs surged in 2008, volume in certificates dropped by as much as 40%. This can partly be attributed to the fact that CFDs are generally more liquid and tradable than certificates, which are structured products issued in specific tranches, often offering pay-outs triggered by specific events or price breaches.

Two German researchers recently stated that the notional value of an entire branch of Germany's retail derivatives sector had risen 49% in just one year on a 116% surge in volume. Traditional old guard companies like Goldman Sachs and Dresdner Kleinwort dominate the certificates markets while CFDs are offered by niche companies like CMC Markets.

The three biggest CFD providers in Germany are MarketIndex (now a subsidiary of the Royal Bank of Scotland), IG Markets and CMC Markets which are thought to have 90% of the German market between them. The number of customer accounts had reached 36,000 by the end of 2008 [latest figures January 2010, estimate the figure to 42,000] but this is still very small compared to the number of certificate customers.

In Germany much of the action is concentrated on major stock indexes with the bulk of trading being on the DAX rather than other European indexes.

Major Indices: 70.50%
Sectors: 0.50%
Individual Shares: 4.80%
Commodities: 5.30%
Forex: 18.90%
Source: CFD Verband

CFDs in Ireland

Confidential briefing documents seen by The Sunday Business Post disclosed that the Irish Stock Exchange estimated that CFD trading accounted for up to 50 per cent of all its share trading activity.

MiFID and the European Union

With the boom in CFD and spread betting business continuing unabated in the UK, the advent of MiFID in November 2007 [Financial Instruments Directive (MiFID)] has providers gearing up to market their products across Europe. Basically MiFID relaxes the way shares can be sold, and one of the big impacts will be that companies based in the European Union will be able to to advertise their services across the EU.

Germany is the country most frequently seen to see a high take up of contracts for difference. During the TMT boom between 1998 and 2001 which stimulated the explosion in online trading, Germany was at the top of the game with the Neuer Markt, the European answer to the Nasdaq, which sadly imploded in 2002. However, online trading was 'massive in Germany'. As the German market has seen overall growth higher even than the FTSE or the Dow in recent years, it is a prime market to enter, particularly as spread betters and online traders thrive on a bull market. The average continental European investor tends to trade a lot more sophisticated products than the average UK investor, so products like contracts for differences are likely to be more quickly accepted in Europe.

CFDs in Canada

CMC Markets Canada has been selling contracts for difference in Canada for years but only to accredited investors - informed individuals who passed the criteria established by provincial regulators; these would be individuals who have $1 million in financial wealth (real estate doesn't count) or a salary of $200,000 over the past 3 years. However, approval to sell the product to retail investors in Ontario and Quebec was given in October 2009, three years after CMC Markets had originally approached the Ontario Securities Commission and Industry Regulatory Organization of Canada for permission.

Regulators have imposed a number of conditions for investment firms looking to offer CFDs to retail investors in Canada. Issuers of contracts for difference must be registered as investment dealers and regulated by the Investment Industry Regulatory Organization of Canada (IIROC). They must also disclose the risks of contracts for difference and evaluate clients' past investment knowledge and trading experience. Finally, CFD issuers must establish cumulative loss limits for each client's account.

CFDs in New Zealand

The CFD market is still in its infancy in New Zealand but the number of retail investors interested in trading the markets are on the increase. CMC Markets is claimed to be New Zealand's leading CFD (Contract for Difference) provider having moved into the market in April 2006 and opened an office in Auckland. For instance in just one week in October 2008 CMC Markets reported a total trade count of 33,516 with turnover amounting to more than NZD$1.44bn across all instruments. At the time of writing (Oct 2009), IG Markets have also setup operations in New Zealand and started offering trading in New Zealand dollar-denominated CFDs which means that clients can trade gold, oil, the Dow the FTSE directly in New Zealand dollars and thus avoid currency conversions and foreign exchange fluctuations. IG Markets is hoping New Zealand will provide business equal to about 10 percent of its current Australian base, which has 30,000 to 40,000 clients (with about 20 to 30% of them being active).

The clients are somewhat less experienced in terms of trading the markets and for this reason certain providers like CMC Markets have launched limited risk accounts which provide traders with Guaranteed Stop Loss Orders (GSLO) on every trade. This allows traders to exit trades at predetermined prices should markets gap against them which guarantees that traders never lose out more than their original deposit (the catch is that the commissions are slightly higher than the standard account to cover the insurance risk and GSLO's are only offered on the more liquid and popular trading instruments).

Introduction to Contracts for Difference

Contracts for Difference (CFDs) have caught the imagination of the active private investor over the last four years since their introduction to the retail marketplace. A growing number of individuals have sought to gain financial independence and in the process embraced innovative financial instruments.

CFD stands for Contract For Difference.

The term "Contract for Difference" means that the product is a cash-settled product. There is no receipt or delivery of an underlying instrument, such as a share certificate.

The result of the trade is the cash difference between the bought and sold price.

A CFD is also described as a Derivative. The term derivative is a very common and is used to describe any product that that is based on an underlying instrument -- a derivative of an underlying instrument.

CFDs are available on numerous instruments, from individual equities to stock indices to foreign exchange and commodities.

The most popular use of CFDs is in Equity CFDs -- Contracts for Difference on individual equities or shares. Equity CFDs are available on shares traded on all European, North American and Asian Stock Markets.

The UK's (CFD market) has been around since the '80s and been traded more aggressively since the mid-'90s, with the introduction of the internet. The CFD market exploded in Britain as the bear market of 2000 - 2002 set in and investors demanded more leverage and better ways to short stocks. Since then CFDs have become a mainstay in the UK for both professional and private investors looking to participate in just about any market imaginable.

The volume of Equity CFD trades has grown significantly over the last few years. Recent data suggest that, excluding the trading between professional firms such as Investment Banks and Brokers, Equity CFDs account for approximately 30% of all share trading in the UK. There are a number of benefits in trading CFDs

CFD demand is also growing on continental Europe, especially in Germany and Belgium. The institutions there have been big users for years utilizing them mainly for hedging purposes, but at the retail level, development is just beginning. Apparently continental investors tend toward skepticism when it comes to new product developments preferring more traditional investment vehicles such as warrants and certificates. Tarken Bulut, Market Analyst at CMC Markets in Germany, says "At first people just don't believe us when we tell them about the advantages CFDs offer over other instruments - they think its too good to be true". But eventually people see the light. Bulut says in Germany alone CMC Markets is looking to grow their customer base to 25,000 investors this year.

The instrument was introduced to South Africa in 2001 by online financial derivatives business Global Trader.

Four significant events in the last few years have combined to accelerate the process of disintermediation, the removal of the 'middle man' and a significant shifting of financial power from the investment banks and financial institutions to the individual. In no particular order, these are the introduction of SETs in October 1997, the evolution of new financial and derivative instruments, the total visibility of the marketplace through Level II and the impact of the internet both as a means of resource and execution.

CFDs entered the retail market in 1998, nearly ten years after becoming established as a legitimate alternative to traditional share trading in the institutional arena. The driving force behind their evolution was a combination of the prohibitive stamp duty regime in the UK and the difficulty in establishing and maintaining short positions in individual stocks. CFDs are ideally suited to short-term trading. They are neither a substitute for, nor alternative means of long term investment such as ISAs or contributory pension schemes. However, as a cost-effective means of short-term trading, they are second to none.

As the UK's fastest growing instrument, CFDs have increased in popularity by 25% in recent years. They allow you to trade on the same terms as many large institutions and are one of the most exciting products around.

Definition

A CFD is an agreement between two parties to exchange, at the close of the contract, the difference between the opening price and the closing price of the contract, with reference to the underlying share, multiplied by the number of shares specified within the contract. In some ways it can be compared with an equity swap or single-stock non-expiring futures contract. The principal advantages are, that under current legislation, no stamp duty is payable on CFD transactions, participants can go 'short' as easily as long and that the product is margined like a futures contract. In other words the user only has to 'put up' a percentage of the underlying value of the contract, typically 10%. CFDs are now established as the preferred primary instrument of equity execution in the UK among hedge funds and other proprietary traders who do not enjoy stamp-duty exemption like market makers. There are currently around a dozen retail providers of CFDs and it is important at this point to understand the mechanics behind their execution.

The majority of CFD providers structure their product in the traditional way and may offer a dealing service by telephone or on-line. In other words, they are not risk takers, but hedge their CFD transactions in the underlying 'cash' market. The term 'cash' market is often used to describe the everyday stock market. So if a client were to submit an order to buy 10,000 CFDs in Vodafone, the provider would simultaneously enter the market, buy 10,000 shares in Vodafone as a hedge, and write a CFD to the client at the same price. The client establishes the position that he wants, i.e. long 10,000 Vodafone CFDs and the provider has hedged his short CFD contract with the client by buying stock in the market, utilizing his stamp duty exemption, and earns commission on the trade as well as charging the client for the funds he has lent him to complete the transaction. Margin rates are typically 10%, so the client only has to maintain a balance on his account of 10% of the underlying contract value together with any running losses. The CFD provider lends the client the other 90% at an agreed rate over base rates, typically 3%. There is a common misconception, that, like the options market, the CFD marketplace is a parallel market, where before buying CFDs in Vodafone, a seller must be found. This isn't what happens, the hedging transactions take place in the underlying market. Therefore if the liquidity exists in the cash market, the CFD can be executed. Liquidity in one market is easily reflected in the other.

At this point it is useful to calculate the cross-over point between the cost of stamp duty in a traditional transaction and the funding charge associated with running the CFD position. In other words, how many days need to elapse before the saving in stamp duty is exceeded by the higher cost of buying the CFD and borrowing 90% of the funds? This is easily calculated by finding the crossing point between the stamp duty cost incurred up front in a traditional transaction and the incremental daily funding cost of a CFD, typically 3% over base rates on 90% of the value of the transaction. This is calculated as ((50/300)*365)/0.9 = 67.6 days, just less than 10 weeks.

In other words, comparing financing costs with the saving in stamp duty, we find that economically it is more beneficial to hold the CFD for a short-term trade, however if the investment is held for longer than about ten weeks, it will probably be more efficient to pay the stamp duty. There is one other intangible factor, in that the stock may offer several quick trading opportunities or reach its target price much faster than initially anticipated and this would suit the CFD trader more as he only pays the funding for each day the position is held overnight, whereas stamp duty has to be paid up front regardless of how long the position is held. This reinforces the assertion that CFDs are more suited to short-term trading than long-term investment.

A more accessible marketplace

As mentioned above, four quite significant events have converged recently to make the UK stock market more accessible, visible, cost effective and user-friendly.

In October 1997, the London Stock Exchange introduced SETs, the computerized order-driven system, replacing the traditional market-making system for the top 200 or so stocks. Although initially treated with scepticism, SETs has now firmly established itself as the primary source of price discovery and liquidity with latest LSE figures showing that well in excess of 60% of all transactions take place on SETs. SETs is also used to determine official closing prices and pre-, intra- and post-market auctions are also providing CFD users with many trading opportunities. The ability to become pricemaker than just price taker and be able to submit limit orders within the market spread is a key feature of the modern market.

CFDs are not the only financial instrument to have experienced recent strong growth. The popularity of financial spreadbetting, the introduction by LIFFE of Universal Stock Futures and increasing use of the traded options market are all indications of the individual's appetite for alternative means of trading. A brief comparison between CFDs and spreadbetting is discussed later. Needless to say, actively trading the UK stock market and paying 0.5% each time for the privilege simply isn't economically feasible.

Level II, or the ability to view the full market depth has now become essential viewing. A number of websites offer this service, and being able to see all bids and offers submitted to the market can provide a picture of how well a stock is supported or if there is an overwhelming imbalance of sellers. However such information should also be regarded with caution, as market makers and other participants are not immune from 'loading' up the book with several orders to give the appearance that a stock is well supported, for those orders to magically disappear when there appears a risk that those orders may be filled. Full market depth places the individual on a level footing with the bigger institutions, but it should only be regarded as an aid to trading and not relied on as a sole source of information.

The fourth event of significance is the growth and proliferation of the Internet, both as a resource and a means of execution. The fact that online spreadbetting has enjoyed such strong growth cannot be completely unrelated to the fact that it is anonymous and can be conducted with little human contact. Some people find it intimidating to close positions at a steep loss and admit to such a loss both to themselves and others. The Internet has played a major role in bringing the markets closer, increasing their visibility, reducing the cost of trading and allowing an almost 'straight-through' type of trade processing. In the UK, unlike the US, price sensitive information is often released during the trading day traditionally giving an inherent advantage to investment banks and market makers who could adjust their prices accordingly. Now, with an order book and direct access, individuals can also act swiftly to take advantage of inaccurate pricing.