Contract for difference

Overview

In finance, a contract for difference (CFD) is a financial agreement between two parties, commonly referred to as the "buyer" and the "seller." The contract stipulates that the buyer will pay the seller the difference between the value of an asset at the time the contract was initiated and the current value of the asset. If the asset's price increases from the opening to the closing of the contract, the seller compensates the buyer for the increase, which constitutes the buyer's profit. Conversely, if the asset's price decreases, the buyer compensates the seller, resulting in a profit for the seller. Because no ownership of the underlying asset is transferred, CFDs allow market participants to speculate on price movements without buying or selling the asset itself.

Invention

Developed in Britain in 1974 as a way to leverage gold, modern CFDs have been trading widely since the early 1990s. CFDs were originally developed as a type of equity swap that was traded on margin. The invention of the CFD is widely credited to Brian Keelan and Jon Wood, both of UBS Warburg, during their Trafalgar House deal in the early 1990s.

Asset management and synthetic prime brokerage

CFDs were initially used by hedge funds and institutional traders to cost-effectively gain an exposure to stocks on the London Stock Exchange (LSE), partly because they required only a small margin but also, since no physical shares changed hands, they also avoided stamp duty; trades by the prime broker for its own account, for hedging purposes, are exempt from stamp duty. It remains common for hedge funds and other asset managers to use CFDs as an alternative to physical holdings (or physical short selling) for UK-listed equities, with similar risk and leverage profiles. A hedge fund's prime broker will act as the counterparty to the CFD, and will often hedge its own risk under the CFD (or its net risk under all CFDs held by its clients, long and short) by trading physical shares on the exchange. Institutional traders started to use CFDs to hedge stock exposure and avoid taxes. Several firms began marketing CFDs to retail traders in the late 1990s, stressing their leverage and tax-free status in the UK. A number of service providers expanded their products beyond the LSE to include global stocks, commodities, bonds, and currencies. Index CFDs, based on key global indexes including the Dow Jones, S&P 500, FTSE, and DAX, immediately gained popularity.

Retail trading

In the late 1990s, CFDs were introduced to retail traders. They were popularized by a number of UK companies, characterized by innovative online trading platforms that made it easy to see live prices and trade in real-time. The first company to do this was GNI (originally known as Gerrard & National Intercommodities). GNI provided retail stock traders with the opportunity to trade CFDs on LSE stocks through its innovative front-end electronic trading system, GNI Touch, via a home computer connected to the Internet. GNI's retail service created the basis for retail stock traders to trade directly onto the Stock Exchange Electronic Trading Service (SETS) central limit order book at the LSE through a process known as direct market access. For example, if a retail trader sent an order to buy a stock CFD, GNI would sell the CFD to the trader and then buy the equivalent stock position from the marketplace as a full hedge. GNI and its CFD trading service GNI Touch was later acquired by MF Global. They were soon followed by IG Markets and CMC Markets, which started to popularize the service in 2000. Subsequently, European CFD providers such as Saxo Bank and Australian CFD providers such as Macquarie Bank and Prudential made significant progress in establishing global CFD markets. Around 2001, a number of the CFD providers realized that CFDs had the same economic effect as financial spread betting in the UK, except that spread betting profits were exempt from capital gains tax. Most CFD providers launched financial spread betting operations in parallel to their CFD offering. In the UK, the CFD market mirrors the financial spread betting market and the products are in many ways the same; the FCA defines spread betting as "a contract for differences that is a gaming contract". However, unlike CFDs, which have been exported to a number of countries, spread betting, which relies on a country-specific tax advantage, has remained primarily limited to the UK and Ireland. CFD providers then started to expand to overseas markets, starting with Australia in July 2002 by IG Markets (first CFD provider to be licensed by ASIC) and CMC Markets. CFDs have since been introduced into a number of other countries. They are available in most European countries, as well as Australia, Canada, Israel, Japan, Singapore, South Africa, Turkey, and New Zealand, throughout South America, and others. They are not permitted in a number of other countries – most notably the United States, where the Securities and Exchange Commission and Commodity Futures Trading Commission prohibit CFDs from being listed on regulated exchanges and being traded on foreign or domestic trading platforms due to their high risk. At the same time, a number of trading apps with various usage scenarios operate on the market, including eToro, Freetrade, Fidelity Personal Investing (part of Fidelity Investments), IG, Pepperstone, CMC Markets, EBC Financial Group, and Trading 212. CFDs are treated as a gambling product in Hong Kong unless they have been permitted by the Securities and Futures Commission (SFC), which treats CFDs, where the underlying asset is a security, as futures contracts, that must be exchange-traded, effectively precluding their being offered in Hong Kong. However, the SFC has a separate regulatory regime for rolling spot foreign exchange contracts, which it terms "leverage foreign exchange contracts". These can be offered to retail clients as an over-the-counter derivative. Brokers in Hong Kong can also offer CFDs on the spot price of precious metals, which are not regulated as securities, using prices derived from contracts trading on the Chinese Gold and Silver Exchange Society. In 2016, the European Securities and Markets Authority issued a warning on the sale of speculative products to retail investors that included the sale of CFDs.

Attempt by Australian exchange to move to exchange trading

The majority of CFDs are traded over-the-counter using the 'direct market access' or 'market maker' model, but from 2007 until June 2014 the Australian Securities Exchange offered exchange traded CFDs. As a result, a small percentage of CFDs were traded through the Australian exchange during this period. The advantages and disadvantages of having an exchange traded CFD were similar for most financial products and meant reducing counterparty risk and increasing transparency, although costs were higher. The disadvantages of the exchange traded CFDs and lack of liquidity meant that most Australian traders opted for over-the-counter CFD providers.

Insider trading regulations

In June 2009, the Financial Services Authority, the UK regulator, implemented a general disclosure regime for CFDs to avoid them being used in insider information cases. This was after a number of high-profile cases where positions in CFDs were used instead of physical underlying stock to exempt them from the normal insider information disclosure rules.

Attempt at central clearing

In October 2013, LCH.Clearnet in partnership with Cantor Fitzgerald, ING Bank and Commerzbank launched centrally cleared CFDs in line with the EU financial regulators' stated aim of increasing the proportion of cleared OTC contracts.

European regulatory restrictions

In 2016, the European Securities and Markets Authority (ESMA) issued a warning on the sale of speculative products to retail investors that included the sale of CFDs. This was after they observed an increase in the marketing of these products at the same time as a rise in the number of complaints from retail investors who have suffered significant losses. Within Europe, any provider based in any member country can offer the products to all member countries under MiFID, and many of the European financial regulators responded with new rules on CFDs after the warning. The majority of providers are based in either Cyprus or the UK and both countries' financial regulators were first to respond. CySEC, the Cyprus financial regulator, where many of the firms are registered, increased the regulations on CFDs in November 2016 by limiting the maximum leverage to 50:1 as well as prohibiting the paying of bonuses as sales incentives. This was followed by the UK Financial Conduct Authority issuing a proposal for similar restrictions on 6 December 2016, and imposing further restrictions on 1 August 2019 for CFDs and 1 September 2019 for CFD-like options with the maximum leverage being 30:1. The German regulator BaFin took a different approach, and in response to the ESMA warning prohibited additional payments when a client made losses. The French regulator Autorité des marchés financiers decided to ban all advertising of CFDs. In March, the Irish Financial Regulator followed suit and put out a proposal to either ban CFDs or implement limitations on leverage. Beyond Europe, other regions have also set specific leverage limits. In Australia, the Australian Securities and Investments Commission has established leverage limits for retail CFD trading. In March 2021, they reduced the maximum leverage ratio to 30:1.

Electricity generation

Several countries aim to support low-carbon electricity generation with CFDs. In the United Kingdom, both nuclear and renewable contracts for difference were introduced by the Energy Act 2013, progressively replacing the previous Renewables Obligation scheme. A House of Commons Library report explained the scheme as:

Contracts for Difference (CfD) are a system of reverse auctions intended to give investors the confidence and certainty they need to invest in low carbon electricity generation. CfDs have also been agreed on a bilateral basis, such as the agreement struck for the Hinkley Point C nuclear plant. CfDs work by fixing the prices received by low carbon generation, reducing the risks they face, and ensuring that eligible technology receives a price for generated power that supports investment. CfDs also reduce costs by fixing the price consumers pay for low carbon electricity. This requires generators to pay money back when wholesale electricity prices are higher than the strike price, and provides financial support when the wholesale electricity prices are lower.

The costs of the CfD scheme are funded by a statutory levy on all UK-based licensed electricity suppliers (known as the 'Supplier Obligation'), which is passed on to consumers. In some countries, such as Turkey and France, the price may be fixed by the government rather than an auction.

One-sided and Two-sided CFDs

The terminology for CFDs in the renewables sector may differ from the finance sector. Some government-provided CFDs for supporting renewables are 'one sided' (i.e. a put option). If the spot price is higher than the strike price, no payment is made. Other CFDs for renewables are 'two sided', either with two strike prices (collar) or one (swap). In the case of two strike prices (collar), if the spot price is lower than a strike price, the government pays the generator. If the spot price is higher than a second strike price, the generator pays the government. If the spot price is in between the two strike prices, no payment is made between the government and generator. In the case of a two sided CFD with only one strike price (a swap, with no middle region) a payment is always made.

Quantity Component

The payment for a CFD equals the difference between the spot price and strike price, multiplied by a certain quantity. In most applications this entails a predefined quantity. For example, an airline may buy a CFD for ten million barrels of oil to hedge their expected consumption. If over the duration of the contract their planes actually consume 9 million or 11 million barrels, the contract payment will still be calculated using 10 million barrels. After signing the contract the number used for the quantity component of the calculation is independent of what the buyer and seller happen to physically consume or produce. These are known as "Production Independent", "Yardstick" or "Financial" CFDs. In contrast, government-provided CFDs for supporting renewables tend to use the output of each specific generator as the quantity component. If a generator produces more or less power than expected, the government will pay (or receive) more or less money than expected (for a given spot price). These are known as "Production Dependent" CFDs or "injection based" CFDs. These are similar to Power Purchase Agreements. (A Power Purchase Agreement is a production dependent swap).

CFDs difference from FTR

CFDs are different from financial transmission right (FTR) in two ways. First, a CFD is usually defined at a specific location, not between a pair of locations. Thus, CFDs are a tool principally for hedging temporal price risk – the variation in the nodal pricing or locational marginal pricing (LMP) over time at a specific location. Second, CFDs are not traded through regional transmission organizations (RTOs) markets. They are bilateral contracts between individual market participants.