Contract For Difference (CFDs) — Origins, Impact and Today

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Buzz words like Crypto, Commodities, Margin, Leverage, Trader or Investor, Broker (the list goes on) have been enjoying a popularity surge in global finance news for the past 2 years. These might scare you a bit if you have no idea what they are about, so the first thing you need to know is what they have in common… CFD, meaning Contract for Difference.

CFD is a contract that pays a retail trader the difference between the opening price and closing price of a trade. This includes Commodities (crude oil, gold), Crypto (Bitcoin, Ethereum), Shares (Google, Amazon), Indices (FTSE 100, NASDAQ) and Treasuries. Forex is technically a CFD due to its similar trade execution processes but is not wholly classified as such. CFDs trace back to the early 1990s but are gradually gaining the limelight along with traditional share trading. The reason for the surge is unexpectedly COVID, as it induced greater volatility in the global markets in 2020.

A daunting undertaking at the very least, hence thorough research and practice are strongly advised. CFD trading much like any other trading offer is profit/loss prone. The difference here is, that due to volatility, losses or gains are quick and can be massive. The major skill needed in the game is Speculation, on the upward or downward movement of financial instruments, although your trade decision must be backed up by chart monitoring and personal risk management because it is NOT gambling or a game of chance. So whether you bet on the market while in turmoil or tranquillity, you stand a chance to gain, you just need to know “WHEN”.

How CFDs Impact Retails Investors

This dwells more on what could go wrong so you are well-equipped as a beginner investor, but first, some good news.

Pros:

CFDs are virtual or handled digitally, so no physical goods or assets are traded or delivered. They require less capital, unlike traditional share trading. They offer access to major markets around the globe and are more short-term, favouring investors looking for quick wins. Profit is instantly realised so there are no settlement times. Also, they can be traded whenever and you do not have to be a full-time trader. Commanding global trade right from your phone or laptop in the comfort of your home, that is Power.

Cons:

Market volatility hugely affects the rise and fall in financial markets. A significant example is the Australian market report from 2020, reviewing a particular week: March 16-22nd. This was when the spread of COVID-19 was starting to peak globally. A whopping AU$234 million net (US$150.8 million) was lost which even led to many accounts going into negative balance to the tune of over -$4 million in aggregate. This meant that many retail investors lost their initial capital and further owed $4 million debt to the CFD Providers.

Another downside comes from Leverage. This refers to the use of borrowed funds to amplify earning power and gains from a trade but this also means if the trade fails, you lose more than you can afford.

Example:

Supposing the shares of Coca-Cola (KO) trade at $12 per share and you intend to buy 5,000 shares of KO, purchasing this would cost you $60,000.

Using leverage, you contribute only a fraction of the total purchase price as a margin on your trading account e.g 5% of the total value. This means that you have to put up $0.6 (60 cents) per CFD margin on your trading account. Therefore, 5% x $12 x 5000 is $3,000.

(Margin is the deposit required to open and maintain a leveraged position. So here, your margin is $3,000)

In this situation, you have leveraged 20 times (20:1) and if you record a loss, you lose totally, which could lead to a “Margin Call”. This is when a broker demands further cash or securities deposits from an investor to cover possible losses which can ultimately lead to account liquidation. Data shows that 70–80% of traders are unprofitable, their losses are Brokers’ wins. They also profit via commissions and spreads.

Restrictions & Regulations across the Globe; stricter over the years!

CFD is first developed in London, UK almost 30 years ago and is credited to Brian Keelan and Jon Wood. It thrives gradually and silently until 2002 when it begins to expand overseas, with Australia as its first adopter, South Africa in 2007 and it continues to garner a bigger presence with Europe catching on in 2013 and Kenya adopting it in 2018.

More than 15 years later, in 2009, UK’s Financial Services Authority (FSA) first implements a general regulatory framework for CFD trading due to some high-profile insider trading cases.

In 2016, the European Securities and Markets Authority (ESMA) issues a warning on the sale of what is called ‘speculative products’ to retail investors which naturally includes the sale of CFDs. This was after observation of increased marketing and brokerage of these products particularly out of Cyprus. In the same year, the Cyprus Securities and Exchange Commission (CySEC) takes a more aggressive stance on combatting illicit market practices by imposing administrative sanctions and disciplinary penalties on brokers, brokerage firms, and investment consultants.

On the heels of CySEC, Britain’s Financial Conduct Authority (FCA) 2017 cracks down on retail CFDs with 3 distinct measures; Enhanced disclosure requirements, Leverage limits (minimum margin requirements) and Prohibition of bonus promotions to ultimately reduce the total number of retail clients, particularly small and boutique traders who lack the necessary knowledge and/or money to trade.

2018: Here comes the introduction of leverage caps. The ESMA in a product intervention decides to temporarily restrict the marketing, distribution or sale of CFDs to retail clients in the form of leverage caps (maximum margin requirements) ranging from 30:1 to 2:1 across the different instruments. South Africa’s FCSA requires all Over-the-counter Derivatives Providers (ODP) to obtain a licence with reporting requirements to continue offering CFD products legally, to ensure transparency. While new licences are being issued, some are subsequently revoked for non-compliance.

2019: The FCA imposes further restrictions on 1 August for CFDs and 1 September for CFD-like options with the leverage cap being 30:1. To further curtail trade malpractices, Australia’s ASIC enforces the banning of the profitable cross-border sale of instruments, potentially severing ties with Chinese and South-East Asian IB networks for good. It’s no secret that Australian CFD brokerages are among the highest quality in the world, and they strive to hold up to that standard. ASIC has even gone as far as closing down companies for aggressive marketing practices.

Following the ASIC bombshell Consultation Papers (CP), brokers react by saying that the new restrictions are “overly stringent, considered a restriction on investors’ freedom of choice.. and will result in them seeking alternatives outside of Australia” like offshore islands where regulations are less rigid.

During the COVID pandemic in 2020, Kenya’s CMA releases regulations issuing clear warnings: brokers to cease advertising activities without a licence and its retail investors cautioned of trading via unlicensed brokers and risk losing money as its jurisdiction does not go beyond its borders.

The FCA now requires that CFD brokers carry warnings on their websites about trading losses to reduce the size and speed of CFD retail clients’ losses because of an over 70% loss rate and regulatory bodies around the world continue to fight for the interests of retail investors.

Meanwhile, in most parts of Asia & Africa with CFD presence, there are hardly any regulations due to the lack of recognition of Crypto CFDs as a legal tender and/or little to no regulatory coverage and the urgency of it. This flexibility makes these areas susceptible to fraudulent brokers and agents, domestic and foreign.

Even with the exploits of CFDs so far, not every country is very open-minded. A Contract for Difference is usually priced against the US dollar but ironically to date, CFDs trading is restricted for U.S citizens & residents by the Securities and Exchange Commission (SEC) because they are referred to as over-the-counter (OTC) products, meaning that they do not pass through regulated exchanges. It is also banned in Hong Kong.

Final Thoughts

A myriad of things is to be considered based on these facts. Can the CFD restrictions really protect investors? ASIC is currently deliberating extending its long-term restrictions on CFDs provided by financial institutions to retail clients until 2031. While regulations will always be in place, brokers and investors alike will always explore loopholes. Regulations might be able to curb certain excesses but not fully eradicate losses.

More than a few FCA-licensed brokers either have a licence or a branch in one or more of these island jurisdictions; Mauritius, Seychelles, Cayman Islands, The Bahamas, Vanuatu, Marshall Islands, Saint Vincent & the Grenadines, for the sole purpose of orbiting stringent leverage restrictions. It begs the question if there should be stricter onboarding requirements in all jurisdictions globally. If brokers can “colour outside the line”, there is a lack of transparency that affects all aspects of the trade. It may get better gradually if requirements for the declaration of substantial financial interests are enforced.

Every country has its own legal framework, however, brokerages and businesses incorporated in offshore jurisdictions enjoy lower initial capital requirements, loose regulations and sometimes get away with fraudulent activities such as money laundering more than anywhere else. There may be a need for international collaboration between regulatory bodies in implementing stricter standards that hold all parties equally accountable in the industry.

Written 1st May 2022.