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Friday, 19th April 2024
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A contract with a difference Back  
Contracts for difference (CFD) have shown a growing popularity in the Irish market and in some quarters this phenomenon as been described as a worrying development. In light of this popularity, we take a step back and examine more closely what CFDs are.
A contract for difference (or CFD) is an equity derivative that allows users to speculate on share price movements, without the need for ownership of the underlying shares. CFDs are traded over-the-counter (OTC).
Contracts for differences allow investors to take long or short positions and unlike futures contracts they have no fixed expiry date or contract size. Trades are conducted on a margined basis with margins typically starting at ten percent for CFDs on leading equities.
CFDs are currently available in listed and/or over the-counter markets in the United Kingdom, Germany, Switzerland, Italy, Singapore, South Africa and Australia. Some other securities markets have plans to issue CFD in near future such as Hong Kong. CFDs have varying brand names, depending on who issues them. In Hong Kong, they are referred as callable bull/bear contracts (CBBCs).
The product was originally devised by the derivative desk of Sharekhan an independent but hugely successful London based trading house - in the early 1990s. The advantage of CFDs was that they allowed the firm’s large hedge-fund clients to be able to easily short the market whilst being able to benefit from effective leverage as well as the same stamp duty exemptions enjoyed by members of the London Stock Exchange. It also obviated the need for clients to physically settle securities transactions and avoided the need to have a stock borrowing capability when shorting the stock.
Towards the end of the 1990s as the dotcom boom started to take hold, the product was adopted for the private client market by GNI Touch, the newly developed online trading arm of London based GNI (Gerrard & National Intercommodities, now part of Man Group plc). GNI offered the CFD product alongside an innovative trading system which in addition provided clients with the ability to trade via the internet directly into the London Stock Exchange order-driven trading systems.
For the first time, individuals trading their own accounts, as well as small institutions and investment funds who did not have the resources available to allow them direct connectivity to the London Stock Exchange, could trade the UK equity market on a level footing with the largest institutions.
They have now become widespread with some commentators suggesting that up to 25 per cent of UK stock market turnover is attributable to CFDs. Similar products were introduced in Australasia in 2002, and have now spread to Canada and some Far East markets such as Singapore.

The contracts are subject to a daily financing charge, usually applied at a previously agreed rate above or below LIBOR or other interest rate benchmark. Users pay to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.

Traditionally, CFDs are subject to a commission charge that is a percentage of the size of the position, usually between 0.2-0.25 per cent and is calculated on the size of the position; this charge is made on each trade, including disposal of the position.

When trading CFDs, you are required to maintain a certain amount of margin as defined by the brokerage/MM (as large as 20 per cent and as small as 1per cent). This means two things; 1) You can leverage your money further and expose yourself to greater profit/loss; 2) A position can move against you more before you are required to deposit further cash to maintain the margin. As with any leveraged product, you can of course lose more than you put in, however, you are able to place a stop loss order on your trades to limit your loss, and in the event that you are entering a risky position or are worried about economic change, you may be able to opt for a guaranteed stop loss, thus limiting your risk regardless of how badly the position moves against you.
Increased flexibility and leverage are other advantages of CFDs over more conventional forms of margin trading. All forms of margin trading involve financing charges, although in the case of CFDs and futures contracts these are embedded in the price of the instrument. Futures, whilst less flexible than CFDs, may offer more competitive pricing.

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