Why 'Contracts for Difference' Are Under Scrutiny: QuickTake Q&A

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Contracts for difference, or CFDs, have hastened the demise of an Irish bank, triggered Ponzi schemes in Chile and featured in a $100 million U.S. insider-trading racket. More recently, they’ve spooked European regulators because of the risks they pose to retail investors. There are proposals to cap potential losses and to ban advertising of CFDs, which are pitched via television commercials and sponsorships of soccer clubs from Real Madrid to Arsenal. They’re increasingly used to speculate on bitcoin and other cryptocurrencies.

1. What’s a contract for difference?

It’s a financial product that allows an investor to make a bet on the direction of stocks, currencies and commodities without owning them. There are hundreds of thousands of CFD traders across Europe. For a time, Australia elevated CFDs from an over-the-counter product to listing them on the Australian Securities Exchange. Things are different in the U.S., where regulators have largely banned them for amateur traders.

2. Isn’t that called a derivative?

Yes. But what’s different about CFDs is that they’re freely available to retail investors -- the amateur traders known in the U.K. as “punters,” who place bets in the market in the hope of a quick score.

3. How big is this market?

CFDs aren’t publicly traded. Still, Aite Group LLC, a research firm in Boston, estimates that daily trading volume is about $75 billion, compared with $22 billion in 2007, and is likely to climb to $94 billion by 2019. In the U.K., one of the biggest markets, the number of CFD firms has doubled since 2010, and they now hold about 3.5 billion pounds ($4.7 billion) of client funds, according to the Financial Conduct Authority, the markets watchdog.

4. So what’s all the fuss about?

While CFDs have been around for decades, regulators in Europe have begun clamping down on them because they’re concerned that the derivatives are too complex and too risky for retail investors. 

5. What’s the link with cryptocurrencies?

A number of CFD brokerages in the U.K. now offer retail investors the ability to go long and short sell bitcoin, Ethereum and other digital tokens. These newfangled cryptocurrencies are unregulated and ultravolatile. Using leveraged derivatives such as CFDs to trade cryptocurrencies compounds the risk for retail investors delving into the fledgling asset class. With trading volume in digital coins surging, this combination may pose a new challenge for the FCA.

6. Why are CFDs so risky?

Investors can use borrowed money, or leverage, to magnify the size of their CFD bets by hundreds and sometimes thousands of times. This can turn a $500 wager into a notional gamble of, say, $250,000. In such cases, just a slight market move in the wrong direction can wipe out an investor’s deposit. Punters lose money on CFDs more than 80 percent of the time, reports show. Common sense would indicate losses should be closer to 50 percent, but punters pay commission and so already start with a loss once a bet is made, while regulators have said clients may not understand the level of risk.

7. Haven’t CFDs always been risky?

Yes. But the industry has swelled in popularity since 2010, driven in part by the arrival of a wave of Cypriot-authorized, privately held online CFD brokerages that, in many cases, offer leverage not available elsewhere. Regulators such as the U.K.’s FCA have found increasing instances of poor conduct, with consumers being drawn toward gambling-style promotions with the offer of smaller minimum accounts.

8. So what are regulators doing now?

The FCA is considering banning the bonuses that some CFD firms offer to potential clients and also curbing leverage. CySEC in Cyprus has introduced rules that ban bonuses and limit client losses while attempting to reduce leverage. Spain’s National Securities Market Commission is requiring brokers to expressly warn investors of the risks and have proof that customers are aware of the complexity of the products. The European Securities and Markets Authority is mulling whether to introduce its own rules in 2018. Germany’s Federal Financial Supervisory Authority late last year announced restrictions on marketing and sales of CFDs. In Poland, leverage has been capped. The Irish are considering banning CFDs altogether. The Belgians already have.

9. Is this the first time CFDs have bothered regulators?

Absolutely not. In Ireland and the U.K., wealthy CFD investors often used the derivatives to amass clandestine stakes in publicly traded companies without having to declare their interests. Regulators have since stopped this practice, although not before the instruments contributed to the fall of Anglo Irish Bank Corp., which helped drive Ireland into an international bailout. In Chile, the products triggered a spate of alleged Ponzi schemes and a congressional investigation. Some individual investors made big losses when the Swiss National Bank abandoned a peg against the euro in 2015, leading to wild currency swings. Later that year 32 people were charged by the U.S. Securities and Exchange Commission for trading on information gained by hacking news releases and making more than $100 million with the use of CFDs.

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