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 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.

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!

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 are currently traded in the UK, Australia, New Zealand, Germany, Italy, Switzerland, Sweden, Norway, Belgium, Denmark, Netherlands, France, Spain, South Africa, Hong Kong, Singapore 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).

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.

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.