Exchange Traded CFDs

For the first five years that CFDs were introduced in Australia from 2002, all CFD promoters were independent providers. The Australian Securities Exchange (ASX) listed CFD contracts on a separate market place to its stockmarket in 2007, which expanded the range of trading products available to retail investors in Australia.

What are Exchange Traded CFDS (aka as Listed CFDs)?

Exchange Traded CFDS (aka as Listed CFDs) are a new form of contract for difference launched in November 2007 on the Australian Stock Exchange. These instruments, unlike OTC derivatives are traded through an exchange based mechanism. They are claimed to offer the traditional benefits of leverage enjoyed by over-the-counter contracts for difference but with reduced transaction costs with the central counter clearing model negating the financing charges traditionally imposed by third party cfd providers.

Exchange Traded CFDs

Basically the goal of the exchanges to launch exchange traded CFDs is to create a regulated market for trading CFDs (as well as to generate an extra revenue stream for the exchange ), where individual trades are monitored by an authorized government body. The ultimate purpose for this type of market is enhanced transparency with having an exchange traded and regulated clearing mechanism. The simple workings of exchange traded CFDs are that the broker or provider is required to replicate every CFD transaction by placing a corresponding stock order in the underlying market. This means that the provider is hedging client business one-for-one on the Australian Stock Exchange. This should in turn provide better synchronization between the CFD traders and the price movements of the underlying exchange. Essentially, Exchange Traded CFDs aim to include all the desirable components we associate with stock exchanges along with all the desirable components associated with trading CFDs.

Ken Chapman, general manager for new markets at the ASX, says the introduction of CFDs was really an exchange response to the growing popularity of the product by stockbrokers in the over-the-counter trading market.

'We recognised that these were not available in an exchange environment, which of course is where people like to trade, because of things like transparency and regulatory supervision,' Chapman says.

The industry's problems are quite clear, according to the ASX, which offers the only exchange traded CFD service. It says the market maker pricing model for over-the-counter CFDs is open to abuse by CFD providers and is fundamentally unfair and inequitable. It says that allowing the trading, reporting, price and volume to be determined by the CFD provider means you are "betting against the house". A market maker using this model would only make a price where they can make a profit from the trade.

The ASX, however, admits that big moves in markets means that stop loss orders can be gapped out and not filled. It has warned its customers that if they want a guaranteed stop loss they should take out a separate put option over the underlying security. It says the exchange traded CFDs have the advantage that the price discovery is determined by a group of market makers.

Exchange Traded CFDs Workings

ASX CFDs are traded through a broker approved by the ASX to trade Contracts for Differences (CFDs). Orders are placed in a centralised order book similar to what happens on a share order book. This is because when trading ASX Listed CFDs, your order is entered directly via a participant into the ASX Listed CFD central market order book. This order book is accessible for all the market to see. All orders are filled on a strict price/time priority. This means that the initial order with the best bid or offer price is always executed first.

The ASX CFDs can be bought and sold through different brokers as the ASX uses standardised contracts that are all traded on the ASX CFD exchange. The ASX product has market makers; known as designated price makers who have been organized by the ASX and whose role is to offer prices and be ready to trade ASX CFDs in a way that will encourage other traders to be involved. This is unlike what happens with a normal market maker CFD provider where if you open a CFD position via that market maker you have to close the contract with that same CFD provider.

Exchange price makers are professional traders who are in the business of making markets and may be involved in other financial products such as exchange traded options, exchange trade warrants and futures contracts. ASX price makers are in the CFD business for the spreads they can earn between the trading prices they quote for opening or closing a CFD position. They also get a share of an incentives pool created by the ASX from the daily interest charge levied on each contracts for difference contract.

As well as multi-price makers, Exchange Traded CFDs also have multiple brokers who introduce clients to listed CFDs. While some over-the-counter providers allow their trading platforms to be accessed by outside brokers, Exchange Traded CFD brokers are major participants in this market.

A charge of 1.5 per cent per annum of the position value is levied on investments over which CFDs are created and is used to finance the ASX CFD business and pay for such expenses as the involvement of price makers. From this pool comes special incentives to reward price makers who offer the smallest or tightest spreads between offer and buyback prices.

Standard over the counter contract for difference financing costs are payable for holders of long positions and paid to holders of short positions. The same mechanics apply to exchange traded CFDs.

The interest calculations extend to non market days so holders of positions over the weekend are subject to financing charges calculated over Friday, Saturday and Sunday.

Traders and investors will need to be aware of the differences in finance charge calculations on the basis of the underlying currency the contract is denominated in.

Exchange Traded CFD Open Interest Rates

The daily open interest charge is the charge imposed by the ASX for holding an open position in the market. In traditional over the counter cfd markets this cost is the differential imposed on top of the overnight cash rate commonly referred to as the financing rate.

The OIC rate is set by the exchange and payable daily on open positions and can be changed by the asx in response to market circumstances. It is, however, according to the ASX, intended to be changed infrequently. Holders of open positions pay this charge the next trading day.

Open long positions are subject to the financing rate plus the open interest charge. i.e. benchmark cash rate + OI charge. Short position holders are subject to the financing rate and receive payment of the open interest charge. i.e. benchmark cash rate - OI charge.

As opposed to OTC CFD providers that charge varying fees, typically ranging from 2 to 3 per cent, the ASX CFD market currently has an 'open interest charge' of 1.5 per cent over the cash rate for long and short positions. This rate is fixed by the ASX and cannot be changed by a broker.

Source Reference:(ASX Website).

Exchange Traded CFDs Advantages

  1. Leverage and Short Selling: Initial margin requirements for exchange traded CFD's require a reduced upfront capital commitment than that required to take the same position in the underlying physical product Short selling is of course the ability to short sell securities not already owned..
  2. Prices are established in a transparent process in the ASX's CFD central market order book. Each trader's order is pooled in the ASX Listed CFD central market order book with those from other market participants, including market makers, and becomes an important part of the price discovery process.
  3. Reduced transaction costs: The ASX Listed CFD central market order book incorporates orders from market makers. With multiple market makers Optiver Australia Pty Ltd, Susquehanna Pacific Pty Ltd, Merrill Lynch Australia, (Commonwealth Bank of Australia, UBS Australia, and Timber Hill Australia Pty Ltd) traders will not be required to accept the prices of a single market maker. This will result in improved liquidity and a reduction in the spread between bid and offer. The conventional spread offered by CFD providers constitutes a cost to the trader so a reduction in this practice is a positive development for the traders' bottom line.
  4. Any participant can input a better bid or offer into the market, as happens in all exchange based markets. No-one is forced to agree to the price available in the market. However, once a trade is filled, you are committed to settle the trade. All prices in the market are firm in the volume indicated.
  5. The central counter party clearing model will negate the financing charges utilized by Over the Counter CFD providers reducing the cost of carry significantly. The savings from this development are passed directly onto the market.
  6. Trades executed on a Strict Price/Time Priority. Price/time priority implies that the first participant to enter the best price is traded against first. This results in each person in the central market order book being dealt with fairly and consistently, no matter how big or small a trader you are.
  7. Franking Credit Cashflow: In addition to the Dividend/Yield Cash flow, Exchange Traded CFD's include a cashflow which represents the value of any applicable franking credit. Holders of short positions pay the Franking Credit Cashflow. Holders of long positions receive the Franking Credit Cashflow discounted by the percentage of open short positions held by the designated price makers.
  8. Reduced Exposure to Broker Failure: The SFE Clearing Corporation (SFECC) will provide central counter-party clearing i.e. trades are carried out with SFECC and not with the original party to the trade. The positions are managed by SFECC via the established margining system currently used by the global futures market. The trades will be backed by the Exchange Clearing Guarantee Fund which negates creditworthy exposure that exists under non-exchange CFD brokers and traders. The protection of margin payments is considered a principal issue of Exchange Traded CFDs. While Exchange CFD brokers chase up margins payments from clients, the SFE clearing house chases brokers and ensures that they meet their obligations.
  9. Market Regulation: There is a worry that over-the-counter CFDs operate in very much an unregulated market environment. ASIC does require all OTC brokers to hold a financial services license which carries certain responsibilities like belonging to an independent dispute resolution panel that hears any complaints from clients but the marketplace is still largely self-regulating. The Australian regulator ASIC will oversee the activities of the entire market for Exchange Traded CFDs. ASX regulation teams will be responsible for monitoring any unusual activity and trading conditions deemed to be unfair thereby safeguarding participants.
  10. Accredited Brokers: Only accredited brokers will be able to offer Exchange Traded CFDs.
  11. Standardisation And Consistency: Exchange Traded CFD's have standardized contract specifications, a transparent, consistent operating model and are subject to SFE operating rules. Those trading Exchange Traded CFD's will benefit from full anonymity of position and trades.
  12. Notably, while prices are transparent, the individual market participant remains anonymous, which reduces market impact expenses (especially those relating to others recognizing an individual's trading patterns and trading in front of him/her).
  13. Exchange for physical: Traders can convert their ASX Equity CFD position into shareholdings. This conversion is allowed through the Exchange for Physical (EFP) facility. The Exchange for Physical facility enables you to complete both sides of the conversion at a set price eliminating the risk of a price movement before you complete the transaction. To undertake an EFP, you need to speak to your ASX CFD adviser.

Exchange Traded CFDs Disadvantages

  1. ASX CFDs are generally available on a limited number of stocks rather than all stocks on the exchange.
  2. The costs associated with trading ASX contracts for differences are usually higher than trading with OTC providers.
  3. The pricing of the ASX's exchange traded CFDs is still dependent on market makers. The market makers who are employed to facilitate ASX's CFDs are large banking and financial services institutions staffed with experienced professional traders. Retail investors are trading in direct opposition to these firms which have an obvious and distinct advantage.

Comparison to OTC Providers

There is some confusion in the marketplace around over-the-counter CFDs and those exchange traded on the ASX. OTC CFD providers are offering a product that they originate and against whom the customer is trading, whereas the ASX operates a regulated market in CFDs where there is absolute contract consistency for all ASX CFDs, irrespective of the broker. For instance the exchange imposes an 'open interest charge' of 1.5 per cent over the cash rate for long and short positions on its products. This rate is fixed by the exchange and cannot be increased by a broker. Margin requirements for ASX CFDs are also homogeneous amongst the providers with the ASX clearing house setting minimum initial margins on each CFD, based on the particular volatility of the underlying stock, and the margins are reviewed regularly based on market volatility. The margins are quoted per CFD, regardless of position size.

In OTC contracts for difference (market maker), you trade with and against the provider, and you get the provider's price, however with exchange traded ASX CFDs the prices will be the same as the underlying physical shares like as in OTC DMA providers. If dealing with a CFD market maker you have to trade at the provider's price and if the broker gives you an unsatisfactory price the only way to avoid that risk is to avoid dealing at the market maker's price. Contracts are opened directly with the CFD provider and to close out the contract a transaction must be made with the same provider. Contracts opened with one CFD provider cannot be closed via another broker or provider.

Compared to Exchange Listed CFDs, providers of OTC CFDs have considerable regulatory freedom. They set and organise the collection of initial margin requirements from client accounts, the creation of contracts for differences and the daily settlements and money management required to ensure traders have the funds to settle their daily positions. OTC providers also calculate margins for traders who wish to hold their positions overnight. In some cases they are also active participants in their own trading platforms acting as market makers and thus encouraging trading by taking the opposite side in many trades. The launch of ASX CFDs in late 2007 introduced the ASX as a provider offering CFDs in a more regulated market. While trading ASX CFDs offers a similar experience from a trading perspective, the real difference is the involvement of the ASX in the trading process.

It is important to note that ASX CFDs are a separate market with a separate book to that of physical stock trading on the ASX. This means that the ASX CFD order book is priced by market makers along with orders submitted by listed CFD traders. The prices of listed CFDs are different to that of the physical market, therefore the market spreads and liquidity will be different to that of the physical ASX share market that share traders would normally see. 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.

As the ASX exchange acts as the counterparty for all the trades in the market meaning it provides optimal investor protection. Once an investor has bought an exchange-traded CFD product the relationship between the two original contracting parties is broken, with the exchange becoming the counterparty for both buyer and seller. Effectively, the exchange guarantees the performance of all parties by imposing strict margin requirements on the individual clearing member firms. These should prevent participants from accumulating large unpaid losses that could potentially impact on the financial position of other market users and thereby removes a potential obstacle to participation in the CFD market. ASX CFDs are however only offered on a limited number of shares rather than all shares on the exchange.

However, at least one CFD provider, IG Markets, is said to offer an alternative that is superior to the ASX exchange model: Guaranteed Market Prices. IG guarantees that for ASX listed equities their clients will always trade at the underlying market price. This means that whilst you are in effect trading with a market maker, they are bound to reflect exactly the prices on the ASX. If prices are identical to the shares on which the CFDs are made, then there should be no room for the unscrupulous measures most mainstream brokers and the press claim to plague over-the-counter offerings. Not even ASX's exchange traded CFDs can offer guaranteed market prices.

The OTC market implies that a contract that is opened with one CFD broker must be closed with the same broker; this means that traders must consider the counterparty risk when opening a CFD account i.e. the financial strength of the CFD broker. In the context of CFD contracts, if the counterparty to a contract is unable to meet their financial obligations, the CFD may have little or no value regardless of the underlying asset. Although OTC CFD brokers are required to segregate client funds protecting client balances in event of company insolvency, exchange-traded CFDs 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, and most brokers are large companies that are publicly traded so information on their financial strength is easily available. However, some CFD providers are private enterprises and checking out their financial strength may be more difficult.

It is however important to note that from a trading perspective the same risks apply to ASX Listed CFDs as OTC contracts for differences and it makes little difference to the way CFDs trade. The CFD provider usually mirrors the real exchange market and orders placed with the provider may be executed directly in the underlying market (as happens in DMA CFDs). Similar to their over-the-counter counterparts, ASX CFDs follow the same underlying principles. A trader is still buying or selling CFDs on margin with the scope of magnifying small movements in the price of underlying shares, indices and forex pairs, through their gearing. Thus, the same risks and rewards principles associated with trading OTC CFDs apply to ASX CFDs. The same requirement to deal with trading risks and have a money management plan are also essential.

Exchange Traded CFDs (Listed CFDs) - Peculiarities and Risk Management

Exchange Traded CFDs initial margins requirements are set at levels intended to cover reasonable possible losses between the close of business on one day and the next. For this reason the daily price volatility of the investment is also taken into consideration. While the end responsibility with contracts for differences lies with the traders on either side of the contract, with Exchange Traded CFDs there is an extra security step. After a CFD trade has taken place, the bond between the two sides is broken through a process known as novation. This security process sees an ASX subsidiary, the SFE Clearing Corporation; taking over the role of the other party - the counter-party in each trade.

In this case the clearing house becomes the buyer to the contracts for difference seller and the seller to the CFD buyer. At the same time it guarantees that all contracts will be settled according to the rules. This change of counter party from traders to the exchange is a principal part of ASX involvement in the listed CFD regulation process. This means that the Clearing House becomes the principal to all trades and liable to perform against all contracts to which it is a party and effectively 'guarantees' performance to other Clearing Participants.

This exposure is then managed and the clearing guarantee setup in a number of ways. Principally this is realised by the collection of the various margins. The collection of these monies protects against severe price movements and prevents participants from accumulating big unpaid losses that might possibly adversely impact on the financial position of other market participants. This is a major element that differentiates exchange-traded markets from over-the-counter (OTC) markets, where such a strict margining system is not in place. The ASX Listed CFD market also has access to the Clearing Guarantee Fund which is intended for use in the event of failure of one or more Clearing Members.

Holders of Exchange Traded CFDs may also be eligible for a cash payment equivalent to the dollar value of the dividend imputation tax credit. This is a special characteristic available to Listed CFDs not available to over-the-counter holders and is referred to as a franking credit cash flow. Similar to a cash dividend payment, holders of short CFD positions pay this amount if they control CFDs when the shares become ex-dividend. However, CFD price makers who hold a short CFD position in the form of a Listed CFD are exempted from this obligation. For instance if a dividend is 100 per cent franked then the multiplier is about 0.43. If it is 50 per cent franked the multiplier is just 0.21. As ASX CFD price makers do not have to pay the franking credit cash flow, their part in trading must be taken into consideration.

Criticism - ASX CFDs

The demutualisation of the Australian Stock Exchange and the listing of ASX Ltd on the stock exchange brought its own share of problems as the institution now has the role of dual but contradictory roles of market regulator and profit-making enterprise.

On the one hand, it has to make sure the market has integrity, that investors are adequately protected and that there's a high level of confidence among all investors - ranging from highly sophisticated types all the way down to 'accidental' shareholders, who became market participants through demutualisations over which they had no control or influence.

But the other hand, it has to produce ever-escalating profits for its own shareholders - and the ASX profit is tied directly to the volume of trading on the sharemarket. So encouraging more and more people to trade (as opposed to invest) on the market is a clear ASX business strategy.

The recent introduction of contracts for difference (CFDs) to the ASX is a classic example of the Jekyll and Hyde issue. For the ASX, the launch of exchange traded cfds adds money to its coffers and the ASX has begun staging CFD seminars to generate new business. CFDs no doubt increase trading volumes, which is good for the ASX bottom line. But in the wrong hands CFDs, because of the high levels of leverage involved, can be catastrophic. And that's not good for market confidence.

Critics also say that the increasing ease of short selling is leading to an increase in volatility in share prices which can be unsettling for the average investor as share prices no longer move in accordance with fundamental measurements, such as profitability, dividends and growth prospects. This, they say, is leading to a number of investors losing trust in the system and marketplace.

Moreover, whilst account openings and trading volumes on over-the-counter platforms like IG and CMC have grown exponentially, the ASX's exchange traded CFDs languished on a relative basis. Some CFD industry experts have labelled exchange traded CFDs as a poor interpretation of what CFDs are supposed to be to investors broad-based, easy, and cheap access to the world's markets.

Comments and Experiences

Clearly in Australia IG Markets and CMC are the powerhouses in contracts for difference. To gain a foothold in the market place the ASX CFD had to spin it and they came up with "security". Goldmans bought 10% of CMC for $300 million a while ago. That's as good as security goes for most of us.

A problem with ASX CFDs is the lack of liquidity - in fact there is no liquidity at all in these instruments other than that provided by the designated market makers as traders rely on someone else to take the other side of their CFD trade. The depth is a wasteland of inactivity. The Bid/Ask spread is always significantly wider than in the underlying market. (The worst I saw was in the early ASX CFD days when the initial takeover offer for RIO was announced. The real market spread was 3 cents. The ASX CFD spread at the same time was 10 dollars.) Most of the time now the spread is about double the underlying. There is not really a market apart from that provided by the market makers so very few traders use them. This is unlike what happens when dealing with other OTC CFD providers that ensure that the liquidity is similar to the underlying stock by taking the other side of every trade.

Progress

ASX Limited (ASX) was created by the merger of the Australian Stock Exchange and SFE Corporation, holding company for the Sydney Futures Exchange, in July 2006. ASX operates under the brand name Australian Securities Exchange and is one of the world's top-10 listed exchange groups measured by market capitalisation. In November, the ASX introduced ASX CFDs to the market.

ASX CFDs include:

  1. The top 50 stocks listed on ASX
  2. Key global equity indices
  3. A range of major foreign currency exchange rates
  4. Selected commodities like Gold

Australia's stock exchange-traded market in contracts for difference (CFD) has been operating for almost four years now (up to November 2011), having launched trading in 16 equity-based CFDs on November 5, 2007. That list grew quickly to 26 with the addition of foreign exchange CFDs, the S&P/ASX 200 index, the Dow Jones Industrial Average and gold.

The ASX's 2007-08 annual report indicates that only 50,777 CFD trades occurred on the exchange between November 2007 and the end of the fiscal year. The most recent ASX market activity report, for September 2011, showed it had traded 8803 CFDs in the month, a dip on the previous September's 9012. To put things in perspective, the ASX traded 2.52 million derivatives contracts overall, including futures and options trades.

Research by Investment Trends shows that only four per cent of traders opted for the ASX model for the majority of their CFD activity. This could be for a number of reasons as outlined by the Sydney Morning Herald, possibly -:

-> that the five year head start that OTC CFDs - the term given to those derivatives where trading happens directly between providers and traders - has been enough to keep them well ahead. OTC CFDs have the market momentum and most of the estimated 32,000 regular CFD traders in Australia;

-> that the markets that exchange traded listed CFDs offer access to on a limited number of prominent Australian equities, forex pairs, a few global indexes and gold provides little choice compared to the thousands of potential trading choices that OTC providers offer;

-> that exchange traded listed CFDs are still very seen in the minds of traders as a new product with features that many traders are still not familiar with. Moreover market conditions since the launch of exchange traded funds haven't exactly been favourable for new trading products.

However, the ASX is preparing to issue new CFD offerings. But the critics say that the ASX pricing model means there is no connection between the customer and the CFD broker. They say the poor trading figures for exchange traded CFDs show customers are voting with their feet and using other pricing methods.

The ASX claims higher levels of transparency and greater investor protection than the over-the-counter (OTC) market for CFDs. Unfortunately, that transparency does not include details of how many CFDs are traded short and how many are long positions.

However, figures provided to Business Spectator by Australia's two largest players in the OTC market, CMC Markets and IG Group, show that about 30 per cent of all trades are short positions.

The leverage involved is sometimes huge. An investor buying a CFD over any of the big four banks or BHP at CMC Markets would be allowed leverage of up to 100 times their capital. The leverage for the top 50 is 33 times, and outside the top 50 it falls progressively to more conservative leverage of about three to two times the invested capital. An interest rate of about 9.25 per cent is built into the price of each contract.