Originating in Futures and Options, CFDs were originally developed in the early 1990’s by the derivative desk of Smith New Court – a London based brokerage trading firm that was later purchased by Merrill Lynch in 1995, in a deal worth £526 million. The innovation is accredited to Mr. Brian Keelan and Mr. Jon Wood of UBS Warburg. CFDs first emerged in the over-the-counter (OTC) or equity SWAP markets which were used by institutions to cost-effectively hedge their equity exposure by utilising certain risk-reducing and market neutral trading strategies. Initially, CFD trading represented a cost-effective way for Smith New Court’s hedge fund clients to easily sell short in the market (the London Stock Exchange) with the benefit of leverage, and to benefit from stamp duty exemptions that were not available to outright share transactions. In particular, by using CFDs, institutional traders and hedge funds no longer needed to physically settle their equity/share transactions which in practice meant that such contracts didn’t require delivery or acceptance of the underlying instrument. In this way these large clients were also able to avoid the cumbersome and sometimes costly process of borrowing stock when they wanted to sell short.
In the early days, only market makers in listed stocks were the only market participants permitted to go short of securities and so these market makers quoted CFDs as over-the-counter products to institutional traders. It is worth noting here that at first, contracts for difference were only available to large corporations, but by the early 1990s, they became popular with hedge-fund traders who wanted to take advantage of the ups and downs of the market.
In the late 1990’s CFDS were introduced to private clients and the retail market by Gerrard & National Intercommodities (GNI – now part of the Man Group plc) via its online trading arm – GNI Touch. GNI offered its clients CFD products and an innovative trading system that allowed private clients to trade via the internet directly into the London Stock Exchange. This was an important development as it created the framework for the inclusion of retail stock trading directly onto the SETS limit order book at the London Stock Exchange. From here the retail market was quick to embrace CFD trading – the CFD revolution was born and by the end of the decade, CFDs had already become widely available in the United Kingdom.
Individuals trading their own accounts, small fund managers and institutions were now able to trade directly into the London Stock Exchange for the first time and enjoy the same benefits as Smith New Court’s institutional clients did when the product was first created. These clients were now on a level playing field with the large institutions and investors quickly realised that the real advantage of CFDs was not the exemption from stamp duty, but the ability to trade on leverage. This is because traders and investors were able to take leveraged long (bought) positions and short (sold) positions without having to take delivery of the underlying shares.
It is a fact that CFDs are an acceptable tax-free product, but they’re also an operationally efficient one and it’s really a misconception that CFDs are all about tax avoidance – there are many investors who deal CFDs on a pan-European basis, even though stamp tax only applies to one or two countries. Trading CFDs is quite a clean, collective process, although regulations may change that in a few years’ time with European Market Infrastructure Regulation (EMIR) coming through. Having said that, CFDs have continued growing in popularity and are expected by industry participants to become the medium of choice for the majority of global traders over the course of the next decade.
Which countries can you trade CFDs in?
CFDs are currently available in listed [i.e. mini-warrants and ASX CFDs listed on the Australian Securities Exchange] and/or over-the-counter markets in the United Kingdom, Germany (Differenzkontrakte), Switzerland, Italy (Contratti Per Differenza), Singapore, Thailand, South Africa, Australia, Canada, New Zealand, Hong Kong, Sweden, Norway, Belgium, Denmark, Netherlands, France (where they are known as Contrats Financiers pour Différences) and Spain (where they are referred to as as Contratos por Diferencias (CFDs)) and the US (to non-residents only), with expansion into new markets occurring virtually every year. It is interesting to note that CFDs are also referred to as swaps, waves, turbo certificates, and callable bull/bear contracts (CBBCs). In the United Kingdom, regulations currently allow CFDs to form part of a Self Invested Pension Plan (SIPP) although they are not permitted to form part of ISAs or PEPs. CFDs are not permitted in the United States, due to restrictions by the USA Securities and Exchange Commission on OTC financial instruments.
Worldwide growth CFD trading continued unabated in 2010. While CFDs are an established investment tool in the UK and Australia they are now available in 16 other countries. A wide-ranging study into the market by Tabb Group (relesaed January 2011), the US research group found that about €1,300bn of UK turnover is business related to CFDs, which accounted for 31 per cent of total equity turnover.
CFDs are increasingly popular with private investors who can see the advantages of margin trading and of the capacity for profit to be generated in both falling and rising markets. This inherent flexibility and transparency has helped contracts for difference become one of the fastest growing products available to private investors.
The outlook for global CFD trading looks quite promising and analysts in the 2010 UK Financial Spread Betting and Contracts for Difference Report, reported that they expected an additional 9,000 CFD traders to enter the market in 2011. Given these forecasts, contracts for differences are expected by industry participants to become the medium of choice for the majority of global traders over the course of the next decade.
The power and scope of CFDs continues to grow amongst traders who can see the advantages of exploiting the movement in shares without actually owning those shares. Moreover, there is an increasing number of forex trading brokers who are adding CFDs to their product offerings. In addition, the simplicity of CFDs as a trading tool is adding greatly to their popular appeal amongst the retail public. One reason for the increased popularity of online broking is the growing disenchantment with the advice investors received throughout the global financial crisis which has pushed many to take a more active role in their investments with more investors opting to take their financial affairs into their own hands and make decisions for themselves. In fact, contracts for Difference (CFDs) are today one of the fastest growing tool in the financial services industry for trading in a range of markets including shares, global market indexes, forex, and commodities. and it is expected that CFDs will become the medium of choice for the majority of global traders within the next decade. Market participants from all backgrounds and levels of experience are now harnessing the power of CFDs to increase their returns, better manage their risk, and develop their trading strategy and skill.
The explosion in the use of this product is one of the reasons why London, as opposed to New York, is becoming the financial location of preference for many financial managers and hedge funds. Contracts for differences are not allowed in the U.S. due to legal restrictions imposed by the American Regulators.
CFDs in the United Kingdom
In the early days in the United Kingdom where CFDs originated they were referred to as ‘SWAP’ contracts, however it was only around 2001 that CFDs became popular with private investors. At the time it was CMC Markets and IG Markets, two large spread betting providers based in the UK that brought CFDs to the forefront in the retail trader’s arsenal. CFDs rapidly gained increasing popularity at the time in the UK because transactions didn’t attract any stamp duty.
But how is the marketplace today? The Australian research specialist company Investment Trends has published a report noting that IG Index and IG Markets lead the UK financial spread betting and CFD marketplace. IG Index has about 39% of the UK spread betting market while its CFD division; IG retains 27% of CFDs. The number of CFD traders and investors in the United Kingdom registered a spike of 40% in 2010 (rising from 18,000 to 25,000), reaching 26,000 active traders in 2012. Pawel Rokicki of Investment Trends also noted that forex trading providers are increasingly targeting the European markets to expand their businesses due to the recent unfavourable regulatory frameworks adopted by both the USA and Japan. To maintain a competitive offering in Europe, they started offering CFDs to complement their Forex offering. As a consequence, local spread betting brokers responded by increasingly injecting more advertising monies to promoting CFDs, driving an increase in CFDs trading.
CFDs in Ireland
Confidential briefing documents seen by The Sunday Business Post disclosed that the Irish Stock Exchange estimated that CFD trading accounted for up to 50 per cent of all its share trading activity.
MiFID and the European Union
With the boom in CFD and spread betting business continuing unabated in the UK, the advent of MiFID in November 2007 [Financial Instruments Directive (MiFID)] had providers gearing up to market their products across Europe. Basically MiFID liberalised and deregulated markets meaning that companies based in the European Union could now advertise their services across the EU. This means that today spread betting and CFDs are spreading in the more sophisticated investment communities of the European Union: Germany, France, Italy and Spain. ‘In those markets IG have between 1500 and 2500 clients trading regularly every month’ says Tim Howkins CEO of IG Index. ‘There is no reason that should not grow to the levels of our Australian business where we have 8000 regular traders monthly.’ [quote taken April 2010].
Germany is the country most frequently seen to see a high take up of contracts for difference. During the TMT boom between 1998 and 2001 which stimulated the explosion in online trading, Germany was at the top of the game with the Neuer Markt, the European answer to the Nasdaq, which sadly imploded in 2002. However, online trading was ‘massive in Germany’. As the German market has seen overall growth higher even than the FTSE or the Dow in recent years, it is a prime market to enter, particularly as spread betters and online traders thrive on a bull market. The average continental European investor tends to trade a lot more sophisticated products than the average UK investor, so products like contracts for differences are likely to be more quickly accepted in Europe.