Dear Trader is my attempt to respond to the many users of this website who have been writing me with general questions about contracts for differences. Since I thought some of them might be of interest to our visitors I’m publishing the answers here:
Q:Where did CFDs come from, and why the weird name?A: A CFD is a ‘Contract for Difference’. CFD’s are a leveraged derivative product that were created in the UK. But who actually invented it? The answer is quite oddly – the Swiss. Respectively, the Investment Banking division of UBS in London. They were originally used by investment funds and major financial institutions as a way of escaping the British stamp duty tax but were introduced to the retail market in 1998 by Phil Adler and GNI touch. CFDs have only been available to private investors since the late 1990s but they’re quickly becoming one of the most popular retail derivative products on the market!
The reason for the name is simple. A CFD is a contract which you buy at one price and sell at another. The purchaser of the contract will gain or loose from the difference of the buy and sell price. In other words you just own the right to the price difference – hence the name again – ‘Contract, For Difference’.
Q:Tell me more about the origins of CFDs?A: CFDs have been around for over 30 years, with their first appearance tied to the volatile post-crash period of the late 1980’s. At the time, fund managers and professional investors were trying to find a mechanism which would help them offset the risks in their portfolios and give them protection against protracted market declines. This led to the development of the so-called equity swap which empowered traders to short securities with gearing. However, while investment funds and major financial institutions were celebrating, it wasn’t until the 2000s that contracts for difference started gaining a foothold amongst private investors. At last, retail traders were able to access markets and organise their investment portfolio with the same flexibility and efficiency as institutional investors. Thus, we can say that contracts for difference leveled the playing field for private investors.
Since then, CFDs have been rapidly gaining popularity amongst retail traders around the world. In the United Kingdom, for instance, the LSE estimates that CFDs accounts for more than a third of all stock trades that go through the exchange. The same trend is now happening throughout Europe, Australia, Japan and Singapore.