In an FX context, a contract for difference (CFD) is an agreement between two parties to exchange the difference between the opening price and closing price of a currency.
The person making the trade does not physically – or virtually – possess the bought currency and does not have to deliver the sold currency.
A number of European regulators have expressed concern about the leverage aspect of CFDs. In August, Belgium’s Financial Services and Markets Authority (FSMA) banned CFDs amid concerns over excessive leverage – although the ban does not apply to derivatives that are traded on regulated exchanges or on multilateral trading facilities.
Earlier in the summer, France’s Autorité des marchés financiers banned the advertising of CFDs that have a leverage greater than five.
The FSMA’s move came just weeks after the European Securities and Markets Authority (ESMA) sounded the alarm on the aggressive marketing of speculative instruments to retail investors, identifying binary options and CFDs as particular areas of concern.
Since mid-2015, ESMA has coordinated a group of national regulators focused on issues relating to a number of Cyprus-based investment firms that sell CFDs and binary options throughout Europe.
Despite these warnings, CFDs are gaining traction with traders looking to exploit market volatility, and brokers are inevitably keen to cash in.
“Traders want to access as much trading product as they can and FX brokers are trying to capitalize on this trend by offering multi-market, multi-products via the CFD route,” says Vinay Trivedi, FlexTrade’s vice-president, strategic initiatives.
“The ease of accessing multi-markets via a common vehicle helps capture trading opportunities, and CFDs are also being used by some investors to hedge their long-only portfolios.”
In addition to leverage and the ability to place short trades, volatility is the third component that makes this market attractive to traders, according to Luis Sanchez, CEO of FX broker BMFN.
“Investors who have switched from traditional trading to CFD trading are looking for higher return opportunities,” he says.
“When events that affect the market occur, you can immediately see that trading volumes increase – the event can cause the price to move up or down, but it doesn’t matter since investors can place a trade in both directions.”
The easiest way to play volatility in FX is through currency pairs, and CFDs enable traders to jump in and out of markets, explains Chris Beauchamp, senior market analyst at IG Group. The appeal of being able to move in and out of markets quickly is accentuated by the trend towards automated placing of trades, he continues.
FlexTrade’s Trivedi suggests demand for CFDs will continue to grow, adding: “Most brokers are selling CFDs more than FX as they see this product as a door opener to investors and traders to whom they can upsell their FX offering.
“Some brokers are recycling/distributing CFD prices from the top market makers, while others are building their own hedging engine with the help of technology providers. We have experienced an increase in requests for our CFD engine from FX brokers.”
IG’s Beauchamp reckons it is too simplistic to suggest CFDs are only effective in periods of heightened volatility, saying: “You can still find a function for CFDs in a broader hedging approach during quieter market periods.”
CFDs are priced to mirror the market, resulting in a neutral market position. A short position is replicated to hedge fully or partially the initial opposite position.
BMFN’s Sanchez explains: “Because of this, retail investors are attracted to CFDs to hedge their investment portfolio.”
According to Trivedi, CFDs have become a differentiating factor for the heavily crowded FX broking space, a point taken up by Sanchez, who says investors want to trade stocks, indexes, commodities and currencies in one place with one broker.
“Investors realize that trading these assets in a CFD format gives them higher trading opportunities compared to the traditional brokerages,” adds Sanchez. If a broker doesn’t have the capability to offer multi-asset services, they can enter a white-label partnership.
When asked how CFDs have affected the trend towards multi-asset brokerage, Beauchamp concludes their use has heightened demand for specialist providers.
“Some clients will find the full service brokerage is the place to go; others will feel more comfortable building relationships with different brokers in different areas of their business,” he says.