One issue that Contracts For Difference (CFDs) have been involved with is the lack of transparency when you trade those rather than the shares themselves. Regulators are considering ways in which this situation can be dealt with.
The problem is that there are many ways that CFDs are traded, and many market makers, and there is no central control or databank of traders’ interests. Unlike share trading, you cannot easily keep track of who is involved with which securities.
This means that some persons are involved in insider trading, which is defined as taking an unfair advantage over the market by trading on private and restricted information, and it is difficult to keep a check on the money flow because of the lack of transparency that CFDs offer. In particular larger orders may be placed in a hidden fashion; this may allow for insider trading to go undetected, and can also result in large funds using the investment product as a means to implement their proprietary strategies without having to disclose full details. There are cases coming to light where the insider trading was specifically implemented by using CFDs in the expectation that they would not be found out.
Moreover, CFDs may allow exchanges to be used disseminate wrong information and to conceal their real intent. Large institutionis and corporations may make big purchases on the actual exchange (clear signal to buy) but may also open an opposite short position in the CFD market. Used in this way, the CFD market may be used to provide false signals to deceive others.
The lack of transparency affects all aspects of trading contracts for difference, however. Until the day comes when all CFDs are exchange traded, it is difficult to know who you are trading against and whether you are being charged and offered a fair price. In many cases, the counterparty to your trade is the CFD dealer himself, who aims to profit from your losses.
It’s true that the positions can be hedged by the dealer, taking on share ownership to cover the customers’ trades, but it is likely that many trades are not hedged, or only partially hedged, giving the dealer a vested interest in how well or badly you do. As the dealer can set the bid and ask prices without sticking to the quotes of the underlying securities, it is plain to see that the lack of transparency can lead to suspicions of fraud, particularly as many novice traders lose money and it is natural to want someone to blame rather than face your own failings.
Another factor which many novices fail to appreciate is that they have no good claim for their money if the dealer has financial trouble. There is no stock ownership, and the traders have to wait in line behind other creditors if the dealer is declared bankrupt. This is another aspect in which more transparency would assist in understanding the true risks of trading in CFDs.
One way in which transparency issues can be addressed is by the requirement for any substantial financial interest to be declared. For instance, in the UK the FSA now requires disclosure of holdings of 3% or more in any shares, whether by direct purchase or by derivatives such as Contracts For Difference.
The issue here is more than personal gain from insider trading. Any large interest in a financial security can be used to exert influence over the company, and it’s understood that hedge funds may have done this in the past using the leverage of derivatives and the size of their investments to dwarf the interests of the more traditional institutional investors.