As the name implies, a CFD is a contract between two parties where investors can bet on changes in the price of an underlying share, commodity or index. CFDs are derivatives, so investors don't invest in the stock, index or commodity on which the CFD is issued. Instead, they invest in a contract with an issuer. This is because contracts for difference are usually traded over the counter (OTC), which means trading and price formation occurs between investors and individual CFD providers rather than on an exchange. With an over-the-counter derivative contract, the two counterparties are compelled to take on each other's risks. If an investor defaults, this could adversely affect all the other clients that have positions with that derivative provider.
A 'counterparty' as the name implies is an entity or company on the other side of a financial transaction. When you buy or sell a CFD, the only asset you are trading is a contract issued by the CFD provider, so the CFD provider acts as your counterparty. This is because a CFD is in essence a contract between the trader and the issuing CFD broker which means that the contract can only be closed out with the counterparty that issued the contract. In addition to the CFD provider, trading CFDs also exposes you to the provider's other counterparties, including other clients and other companies the CFD provider deals with.
Further risks for investors and traders alike in OTC derivatives include whether the derivative provider is hedging its exposures effectively, the quality of its compliance procedures and its overall risk management. When any of these potential risk hazards translate into actual problems, investors cannot simply transfer their over-the-counter derivatives to other parties. Even under good market conditions, inadequate risk management and clearing processes can still cause a provider to run into difficulties.
CFDs are synthetic, derivative trading instruments that demand responsible risk management by the CFD provider you are trading with. While this holds true for any trading instrument, the over-the-counter nature of the CFD market, as well as the fact that that there is no real underlying asset being acquired to which legal possession rights can be transferred, make counterparty risk a risk factor. Trading is hard enough and you can't afford to have any counterparty risk. You should have no doubts about the financial standing of your CFD provider.
Now, when you consider how even the largest of the financial institutions have struggled to survive in the current economic climate, you have to think twice about counterparty risk and client money risks when trading CFDs with companies that are far smaller. The simple truth is that once you have funded your CFD account you become in most cases an unsecured creditor. In other words you have to rely on your CFD provider remaining in business. Many CFD brokers are market makers, which means that your counterparty, i.e. the entity taking the other side of the trade is your CFD provider which implies that the CFD provider may be betting directly against the trader.
And although a number of traders think this is not true because they hedge all trades, go ahead and read their company disclosure statements. They will tell you that they are not obliged to hedge client positions and that they don't have to inform you if they hedge. You will also read a clause about their conflict of interest, that they may take positions opposite to yours and be in competition with your interests. You then have to click something that states you understand all that, even when you don't.
Certainly this is not supposed to happen. CFD providers are meant to cover all their positions by buying or selling the underlying stock. This makes them neutral with respect to the trader, and whether the stock goes up or down. They make a profit by the spread between the bid and ask prices.
But with competition, when traders shop around to find the lowest rates, there is pressure on the CFD brokers to find ways to increase their profits. One obvious way is to take the opposite side to the trader whenever it seems appropriate. Effectively the CFD brokers are taking their own view on the direction of the market, and profiting when they are correct and the trader is not. The other big problem is the risk which unhedged CFDs pose to the rest of the market.
Many CFD dealers insist that they fully hedge their positions by buying the underlying, but it seems likely that does not apply in every case. The profit margins would be too small for the CFD provider to stay in business. In the current financial climate, it may be a choice of the dealer having to do this or risk going under.
One of the problems that can arise from this pressure on the broker, if they have a dealing desk, is that they may be accused of rigging the prices, perhaps spiking the price in a way not seen generally to take out a trader's position with a stop loss order. The dealer is open to this accusation whether or not they have acted questionably, simply because of the set up. Given that many traders do not make money, these same people would be eager to find someone to blame for their failure.
The recent collapse of MF Global highlights the wider issues of client monies and counterparty issues. When the company ceased operating the message sent to existing clients with open positions was simple; liquidate long positions and close out short trades. This is dangerous because usually, leveraged positions might require a good deal of cash to settle. Clients who wish to continue might be able to open or transfer their positions to a rival provider but that involves considerable hassle and uncertainty; let alone the certainty that your transactions will be honoured.
So you should really take time to make your due diligence and ask pertinent questions about your provider. In particular for client money, are the client monies pooled or segregated? What happens to this money if there is a default? With regards to counter-party risk, who owns the company they are trading with, what is their financial standing and what is their business model? This is the fine print that traders and investors need spelled out in plain language, not buried at the back of a legalistic product disclosure statement.
In any case it is possible to reduce your counterparty risk when trading CFDs by choosing a broker who has market connections and does not bear the risk entirely himself. This is known as Direct Market Access (DMA), and that allows traders to deal directly into the electronic stock market. This can cost money for the price feed, but on the other hand may give better bid-offer spreads. You will also find that the execution speed is usually better.
A possible disadvantage with the DMA setup is that you will not be able to get guaranteed stop losses using the market. Guaranteed stop losses are only available because of the dealer's intervention in the price, as a normal stop loss order simply becomes a market order when the price is reached, with no assurance of the level at which it will be filled. But you pay for guaranteed stop losses, even if they are not needed or used, so you may not want them as part of your trading plan.
The success of CFD trading doesn't simply depend on getting the market direction right. When you trade CFDs, you are relying on the CFD broker to execute your trades, make payments owed to you while your trades are open (for instance, notional 'dividend' payments), credit any proceeds of profitable trades to you, and pay you money out of your CFD trading account when you ask for it.
There's also a fundamental difference between buying stocks and trading CFDs - in the case of CFDs you are basically buying a promise from the issuing company, let's say CMC Markets. The CFDs issued by CMC Markets are not tradeable by any other CFD company, and if CMC Markets went out of business my investment in their CFDs would be worthless.
A recent report found that CMC Markets and IG Markets control about 70% of the CFD market in Australia. However, most CFD providers are non-bank financial institutions are not regulated by APRA (Australian Prudential Regulation Authority) – about 26 out of 30 of the investors interviewed in the report claimed CFDs were under the regulatory jurisdiction of the ASX when in fact they are self-regulatory.
Let's see how this could lead to problems... Because most CFD providers pool all their clients' monies together in one or more accounts, if one big investor happens to fail to pay money they owe, the pooled client account which is holding your funds could be in negative territory. If the CFD provider does not cover this deficit, there may not be sufficient monies in the account to pay you what you are owed. If the CFD company goes out of business while the pooled client account is in deficit, there is no guarantee that you will recover all or any of your money that is in the account.
CFD brokers are expected to segregate clients' funds from their own but they are not prevented from using that money to service their hedging activities.
The CEO of CFD provider IG Markets, Tamas Szabo, stated that his company made a statement in 2009 to the corporate regulator, ASIC, where it urged that all CFD providers be required to fund their own broker positions instead of utilising clients' funds to do so. But ASIC's latest statement on contracts for differences, although it warns of counterparty risk and states that segregation of funds does not necessarily guarantee their safety, does not go as far as that. 'ASIC wants to go down the route of disclosure,' Szabo says. 'My view is it's too hard for people to understand and should be dealt with through legislation.'
Szaobo further pointed out that allowing CFD providers to fund positions with clients' money is designed for traditional sharebrokers and futures brokers, where there are guarantees and a clearing house, unlike contracts for differences, the overwhelming majority of which are OTC products.
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