Once upon a time, Contracts of Differences (CFD:s) was something utilized only by hedge funds and institutional traders. Today, the situation is very different, and CFD trading has become immensely popular among small-scale retail traders online.
In this article, we will explore what CFD:s are, how they came to be and why they have become so popular among ordinary hobby traders.
Short facts about the Contract for Differences (CFD)
A contract for differences (CFD) is an arrangement made in financial derivatives trading where the differences in the settlement between the open and closing trade prices are cash-settled.
In essence, the CFD is financial contract that pays the differences in the settlement prices between open and closing trades.
CFD:s are typically used for very short-term speculation and they are often bought with the help of leverage (money borrowed from the broker). When leverage is used, the trader only needs to put up a small amount of the contract’s notional payoff – the rest of the money required to purchase the CFD is lent out by the broker.
CFD:s can have a wide range of underlying asset types, but are especially common for Forex speculation and commodities speculation.
Background and development
In order to fully understand the nature of CFD trading, it is good to know a bit about their origins and development.
The Contract for Differences has its roots in a type of equity swap traded on margin in London in the early 1990s. Brian Keelan and Jon Wood of UBS Warburg are widely acknowledged as the creators of the first CFD. UBS Warburg, today known only as UBS, is a Swiss multinational investment bank and financial services company co-headquartered in Zürich and Basel. It is the largest of the Swiss banking institutions and it is active in all major financial centres around the globe.
A pet choice for hedge funds and institutional traders
Hedge funds and institutional traders quickly realized that CFD:s was a cost-effective way of gaining exposure to stocks on the London Stock Exchange (LSE). Instead of go through the effort of actually trading shares, huge investments could now be carried out using CFD:s. Not only was it easier, but it also cleverly circumvented the British stamp duty on share transfers since no shares were changing hands.
CFD:s and retail trading platforms online
As CFD trading platforms and inexpensive online brokers proliferated in the 21st century, the CFD moved from being a rather obscure financial instrument for the elite to becoming a favorite choice among many small-scale hobby traders.
In the United Kingdom, CFD:s appeared on retail trading platforms in the late 1990s, with Gerrard & National Intercommodities (GNI) as one of the trailblazers. From there, retail CFD trading gradually spread to other parts of the world – but not without controversy.
CFD:s and their relationship with financial spread betting in the UK
Around 2001, several CFD providers active on the British market realized that punters did not pay British Capital Gains Tax on money earned from spread betting, since spread betting was (and still is) considered gambling. To take advantage of this difference, most of the CFD providers launched spread betting operations that parallelled their CFD offering. A similar development has since occured on the Irish market too.
Why are CFD:s so popular among retail traders?
There are many reasons why CFD trading is so popular on retail trading platforms. Here are a few examples:
• With a CFD, you can gain exposure to an asset without actually owning that asset.
• With a CFD, there is no need to engage in the risky and complicated practise of short-selling assets. If you believe the price of an asset is going down, simply buy a CFD that reflects this belief.
• CFD:s makes it easy to speculate on index movements and other things that aren´t actual assets.
• Brokers and platforms that offer CFD trading are usually very generous when it comes to margin trading / leveraged trading. In essence, they will allow the retail trader to borrow money from the broker to make trades. This makes it possible for a small retail trader with a modest capital to engage in comparatively large trades. (Of course, trading with borrowed money also adds a new element of risk and the trader can end up losing more money than he or she ever had in their trading account.)
Is retail CFD trading legal in the European Union?
Yes, retail CFD trading is legal and regulated within the European Union.
In 2016, the European Securities and Markets Authority (ESMA) issued a warning on the sale of speculative products to retail investos, and this warning specifically mentioned CFD:s. After the warning, many financial regulators within the EU responded with tighter regulations.
A majority of the CFD providers for the EU market are based in Cyprus and regulated by CySEC. After the ESMA warning, CySEC limited the maximum permitted leverage for CFD:s to 50:1 and prohibited the paying of bonuses as sales incentives. These rules have been in place since November 2016.