The Contract for differences (CFD) more commonly known as a buyer and seller contract is an agreement between two parties. The contract states that the buyer will pay the difference between the current value of the assets and the value at the time the contract was signed. If the current value is in negative, the difference will be paid to the buyer by the seller. The benefit of the Contract is that it provides the advantage to the investors as they can make the best use of the fluctuating prices to speculate the status of the market.
The United Kingdom, The Netherlands, Poland, Portugal, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, Norway, France, Ireland, Japan and Spain are the nations where the Contract of differences is applicable. In Hong Kong, a few of the securities markets are considering to introduce CFD soon whereas due to the restriction of U.S. Securities and Exchange Commission and over-the-counter (OTC) financial instruments the contract of differences(CFD) is not permitted in the United States of America.
Though CFD is beneficial for the buyers, seller and investors, it also has its share of risk. Market risk, liquidation risk and counterparty risk are the three main categories of risks involved in CFD. The problem with market risk is that the contract is driven for the disparity of the opening and closing price of the principal asset as CFDs are traded on margin, the leveraging effect increases the risk radically. A small amount of money can be used to hold a large position as margin rates are normally minute. Hence it can be misused in financial markets to either speculate on movements or evade existing positions elsewhere, in effect to which if the market moves against the users of CFD there is probability of losing money.
In the liquidation risk, an additional margin can be required to maintain the margin level if the market moves against the open CFD position. Due to this, an additional amount of money would be required to be paid to the CFD provider by the party. When the party refuses to pay the money, there is a possibility that the CFD provider might liquidate the position at loss. The party will be liable for this move. When it comes to counterparty, the risk is associated with the financial stability of the counterparty to the contract. In this situation, the CFD investor can potentially sustain relentless losses even if the underlying instrument moves in the preferred direction.
Like any other contract, CFD also has its advantages and disadvantages.
The advantages available are market independence, transparency and counterparty risk. With market independence, the customer gets the option to choose who would prefer to execute their business as per the separation of responsibility between the broker and the exchange. The separation of responsibility means there would be one standard contract for all. When it comes to transparency, Australian Securities Exchange (ASX) reports all ASX CFDs transacted, open positions, bids and offers with the volumes.
The customer’s order is directly entered through a participant into the ASX CFD central market order book, which is easily obtainable by all. With counterparty risk, the benefit one gets is that all settlement obligations are not only dealt and guaranteed by SFE Clearing Corporation but also resolved with absolute fair and efficient amenities.
A higher charge fee as well as the broker fee has to be paid as the clearing house and the exchange need to make money. To fulfill exchange and clearing requirements, the broker’s administration fee is also high. Only small number of CFDs is offered by the Australian Securities Exchange. The prices are based on CFDs’ orders as a result of the separate order book in the exchange.