Contracts for Difference - A Controversial Investment Choice

CFDs used to be a fiddly, niche product used by investors to avoid stamp tax on UK share trades. Today, so-called "contracts for difference" are commonplace. And their uses range from giving hedge funds cheap leverage to providing exposure to exotic equity sectors in emerging markets.

A CFD is not a security like a bond or equity, but a contract typically between an investor and an investment bank. At the end of the contract, the parties agree to exchange the difference between the opening and closing prices of a specified financial instrument.

That instrument could be a share or a bond - or a portfolio of shares, such as an index, or even a mix of different assets.

But why use a CFD instead of just buying the financial instruments direct?

When CFDs originated in the late 1980s, the answer was that they gave UK investors the returns of equities without two major downsides. First, they did not carry UK stamp duty. And secondly, they were not subject to the disclosure rules that force investors to say when they are holding large positions in UK stocks.

One controversial episode in CFDs' early history was their use by Brian Keelan, the legendary SBC banker, to help his client Trafalgar House profit on its bid for Northern Electric in 1995 regardless of whether it succeeded. When the secret CFDs later became public, there was uproar.

If CFDs were only about avoiding certain aspects of UK securities law, they would not have been replicated around the globe under names such as synthetic equity swaps.

But CFDs - or swaps as they are commonly known - have many other advantages over trading direct in financial assets.

One is that investors can buy exposure to financial assets for a fraction of the cost of buying those assets for real.

As CFDs have become more popular, so the fees - or spread - taken by providers have been bid down by competition. That means CFDs are becoming a cheap source of leverage for hedge funds.

Moreover, banks are now offering CFDs on an array of stocks, instead of only one or two.

"You can now have a whole strategy within a CFD," says Eric Deudon, head of BNP Paribas' prime brokerage.

Moreover, hedge funds have been using CFDs to invest in sectors - or hedge existing sector exposure - because there is no capital markets alternative.

"In the last year, we have seen investors increasingly asking us to structure swaps giving them exposure to a sector or index that the exchanges have not had the capacity to offer as listed derivatives," said Jack Inglis, European head of prime brokerage at Morgan Stanley.

Mr Inglis says this is now the fastest growing area within CFDs, with hedge funds using them to get into emerging markets, Eastern Europe in particular.

CFDs are a fantastic business for investment banks. Firms hedge their own exposure to the CFD contract by investing in the trade specified by the client. Then they net off different clients' positions. So if two hedge funds wanted to enter into CFDs on identically opposite trades, the bank writing the CFDs would not need to hold any of the underlying shares - but could still pick up either commission or spread on the way.

In London, around 30 per cent of cash equities trading is related to CFD contracts, according to Clive Cooke, chief executive of the CFD provider City Index.

To some, the benefits of CFDs make them among the great innovations of the capital markets. But to others, CFDs carry a potential for abuse that demands regulatory action.

The particular area of concern, in the UK especially, has been the anonymity that CFDs give investors taking large economic positions in companies.

CFDs carry this benefit because they do not have the voting rights of ordinary shares. The UK requires disclosure of large stock positions on the grounds that the market deserves to know if an investor is building up influence over the company. As CFDs carry no votes, they carry no influence, the argument goes.

But some companies and investors fear CFD positions can be easily turned into ordinary voting shares if the investment bank is willing to hand over the stock it bought to hedge its position. So an investor could appear from nowhere with a near-controlling stake.

Investment banks deny they do this, although some hedge funds say it used to be possible.

All the same, 10 months ago the UK Takeover Panel introduced a rule that investors should disclose CFDs over stock positions of 3 per cent or more of a company's equity as soon as it entered a bid situation.

The effect of the new rules was illustrated most starkly in June when the Panel forced Och-Ziff and Cycladic Capital, the US hedge funds, to reveal their 19.9 per cent CFD interest in Photo-Me International, the UK photobooth operator, following a takeover approach.

The Association of British Insurers is lobbying hard for the rules to be extended to all large CFD positions, regardless of whether or not a company is in a bid situation. Moreover, it wants large short CFD positions disclosed. These are bets that the share price will fall, which the CFD provider hedges by selling borrowed stock. A large short is potentially destabilising for a company's share price.

Against that backdrop, the UK's Financial Services Authority recently launched the first regulatory consultation on CFDs. However, some users say meaningful disclosure would require revealing both long and short CFD positions, their expiry dates, and any related stock positions, long and short - information that might not only be costly to produce but ultimately impossible to comprehend. In the meantime, the market continues to grow, and using CFDs is getting cheaper and easier.