Exchange Traded CFDs

Exchange Traded Contracts For Difference

Exchange Traded 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.

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

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).

EFT CFDs Advantages

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.

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.

Lastly but importantly as the ASX exchange acts as the counterparty for all the trades in the market meaning it provides optimum 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.

Criticism

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.

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. 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.

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:

The ASX exchange traded CFD business is doing well according to figures just released showing 56.4 million contracts have been traded since November and the notional value of contracts traded since November was $1.5 billion. Almost 6 million contracts were taken out in June 2008, with a notional value of $170.1 million. In fact the products are proving so popular that other exchange (like the London Stock exchange) are seeking to implement a similar system.

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.