CFDs: A Boon to Many, Highly Regulated in the United States

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In the sometimes eclectic world of stock exchanges, brokers and traders, a new kid on the block has come along and is taking much of the world’s financial markets by storm. Initially developed in England, traders and brokers from London to Sydney are looking at the United States as the next big market for this trading vehicle.

CFDs were originally conceived and developed in the early 90s in England as an equity swap based on margin trades. Brian Keelan and Jon Wood, both with UBS Warburg, are credited with their creation.

At first, CFDs were used by hedge funds to hedge cost effectively the exposure to stocks on the London Stock Exchange. Since CFDs require a small margin and no physical shares are swapped, CFDs managed to avoid the UK tax of stamp duty. Today, powerhouses like Iforex, and offer CFDs along with other popular shares almost globally.

During the late 90s, CFDs were introduced to retail traders. Popularized by several UK companies and characterized by online trading, live prices and real-time trades were possible. The first company to provide this was Gerrard & National Intercommodities, or GNI. Around the year 2000, retail traders started to realize that the true benefit of trading in CFDs was not the tax exemption but rather the ability to leverage the underlying instrument.

CFDs are available in about 26 countries, but are not permitted in others — including the United States. The restrictions imposed by the U.S. Securities and Exchange Commission have made the financial vehicle illegal for use in America.

What is a Contract for Difference? A CFD is a mutual agreement between two individuals or businesses to swap the difference between the opening and closing prices of a contract, which can be utilized for trade and speculation on which direction the prices of thousands of financial markets will move. An individual can “go long” (buy) and realize a profit when prices rise. An individual may also “go short” (sell) and reap the profit if the prices fall. CFDs are becoming popular because of the increased trading flexibility which allows a person to profit from financial markets — regardless of the overall price direction.

Pro – Lower Margins: CFDs give higher leverage than usual trading. The leverage in the market for CFD usually starts as low as 2 percent. Depending on the supporting asset, shares for instance, margin requirements may rise to 20 percent. Lower margin mean less cash outlay for the investor and bigger potential returns on investment.

Pro – No Shorting: Certain markets have rules which prohibit, or limit, shorting at certain trading times. The trader is then required to borrow before shorting or place different margin requirements. The CFD market usually does not have short-selling rules. A financial trade can be shorted at any time.

Pro – No Fee Execution: CFD brokers offer most of the same types of services as traditional brokers. The services include stops, limits and contingents, and some CFD brokers offer guaranteed stops. Very few fees are charged for trading a CFD with most brokers not sharing a fee to enter or leave a trade. The broker makes their money by making the buyer/trader pay the spread. Depending on how volatile the supporting, or underlying, asset is, the spread may be small or large.

Pro – Variety of Trading Options: CFDs can be found in stock, index, treasury and currency CFDs. The stock traders are not the only ones who benefit from CFD – traders in different financial tools can use the CFD as an alternative.

While CFDs look attractive, there are also some possible pitfalls. For instance, having to cover the price variation on market entries and exits wipes out the possibility to yield a return from minor market changes. The spread will continue to decrease winning trades by a small amount and will raise losses, also by a minor total. The CFD marketplace has a way of pruning returns through the use of bigger spreads.

Con – Not Highly Regulated: The CFD industry is not highly regulated. The broker’s credibility is largely based on reputation, financial position and how long they have been a broker. As with any financial decision, it is important to investigate who to work within CFD trading.

It is unknown if CFDs come to the American market. CFDs have often been compared to the bets sold by bucket shops which thrived in America during the late 1800s and early 1900s. The bets allowed speculators to place drastically leveraged bets on stocks typically not backed by actual trades on an exchange. The end result was the speculator begging against the house. Jesse Livermore wrote a colorful description of bucket shops in his autobiographical Reminiscences of a Stock Operator and the book tells the story of why CFDs are illegal in the U.S.

By Jerry Nelson

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