What Are CFDs?
CFDs, short for Contracts for Difference, are direct contracts between traders and their brokers. When you take a position with a CFD trade, your CFD broker is essentially taking the other side of the trade, somewhat similar to what a market maker does, although there are some important differences.
When you trade positions with a conventional broker, the broker acts as a financial intermediary in many cases, although they may fill your order to buy from their current inventory, or borrow from this inventory to lend to you in the case of short selling.
In all cases with traditional brokers, whether they fill the order themselves or send it to an exchange or dealer, you do hold a real position in the market, in other words you are in possession of the securities you bought or borrowed.
With CFD trades, no securities ever change hands, you never possess any. While this may seem to be disconcerting to many, where they believe that they are better off possessing the security than merely placing a bet that is covered by the CFD broker, provided that the CFD broker is reputable and solvent, owning the security or not doesn’t really make any real difference, and there are several very prominent advantages to trading directly with brokers this way.
This does of course require that the broker be able to cover their losses in a trade, but it’s not as if they take on the full risk of the positions they take with their clients single handedly. CFD brokers manage their own risks well, and they will ensure that they have positions in the market to hedge the risk they take on with the trades placed with them sufficiently enough.
CFD brokers may or may not offset a trade that you place with them in the so called real market, although they can and do when they deem this is warranted, and losing money or taking on too much risk isn’t an objective of theirs. CFD brokers make plenty of money from functioning as market makers as well as lending money to clients to support the higher leverage they offer to need to take on any market risk that they are not comfortable with.
CFD brokers are also regulated in the countries where they operate and in the countries where they take on clients, and clients also enjoy the same solvency protection as with other investment institutions.
CFDs Are Like Bucket Shops Properly Regulated
In the late 18th and early 19th century, operations known as bucket shops were very popular with the investing public. This was during a time where investing was much more elitist, where for the most part only fairly well to do men were welcome to open and maintain brokerage accounts.
This was also at a time where futures trading started to really take off, and trading in futures was something that was even more out of reach of the public.
Once the ticker tape become invented, this allowed for people to monitor prices from remote locations, from traditional brokerages as well as elsewhere. Private establishments started opening up where anyone could take positions in stocks or futures, and although the operators weren’t set up or licensed to place actual trades, one could place trades with the operators directly, who would cover their bets out of their own pockets.
Sometimes the operators would place trades in the real market to offset the positions they took on, and sometimes they would not. Since many traders lost, especially because the spreads and prices offered by bucket shops weren’t exactly trader friendly, often times they were happy to just take the action on themselves, and many did well.
Bucket shops were completely unregulated though, and this allowed for a lot of shady operations to flourish, and if they couldn’t cover their losses they often just shut down the bucket shop and opened another one elsewhere.
In spite of all the grim stories about bucket shops, many were reputable enough, and while these trading establishments were a far cry from today’s much higher standards, they certainly did fill a need in the investment and trading community.
Bucket shops become popular enough that major exchanges such as the NYSE became concerned about how much business they were losing to them, and started lobbying to have them shut down as well as taking other measures against them. The influence of the bucket shops was no match, and they eventually became outlawed.
The experience with bucket shops taught us a few things, not the least of which is the importance of at least a minimally acceptable degree of regulation. We also got a taste of the limitations of traditional trading and investing brokerages, who did improve access due to all this but to this day don’t serve the trading and investment public as well as they could.
Derivatives and the Futures Market
The idea of placing bets on something without actually owning anything comes from the futures market, and futures trading is in itself contracts for difference. This was always the case, even back in the early days of futures trading, predating even the bucket shops.
Trades in the futures market involve contracts to buy or sell commodities at some future date, and although in some cases the actual commodities change hands, in most cases they don’t, and the parties just settle the difference between the contract price and the spot price at expiration in cash.
One may also close their positions in these contracts at any time prior to expiration, where the trade gets settled by the difference between the contracted price when the position was entered and where it is when it was closed.
Positions can also be rolled over should the trader desire, where their positions are closed prior to expiration and a new position is entered with a longer expiry date.
At no time is anything bought or sold during the life of the contract with futures trading, as traders just put up deposits on the overall value of the contract as a means of good faith and as a way to cover any losses. Positions are marked to market each trading day, with cash added or subtracted from the trader’s account based upon daily price movements in the contract.
Futures contracts are called derivatives because they just consist of what are essentially bets on the direction of another asset, called the underlying. This is the case with all derivatives, including things like options, swaps, forwards, and so on, in which traders make financial bets on the movement of something else, or just exchange these cash flows between them in the case of swaps.
CFDs Take Derivatives a Step Further
CFDs are essentially cash swaps between traders and brokers, where the difference between the value of an underlying security is settled in cash. These sort of transactions go on all the time and the derivatives market overall is simply gigantic, having hundreds of trillions of dollars worth of trades active at any one time. The overwhelming majority of derivative contracts settle in cash, just like CFDs do.
What makes CFDs different is that instead of bringing parties together to trade, CFDs essentially consist of traders trading directly with their broker. CFDs don’t really provide brokerage, they are parties themselves to the transactions they take on, just like the bucket shop operators were.
There are actually several significant advantages to a setup like this. While this may seem to increase what is called counterparty risk, the risk that the CFD broker won’t make good on their end of the bargains they enter into, there is always counterparty risk in derivatives trading. Proper regulation can manage this with CFD trading quite well, to the extent where one can achieve a level of protection quite similar to other forms of derivative trading, ones that involve trading with other traders or institutions.
The idea of trading against financial institutions is certainly not unique to CFD trading, as institutions are heavily involved in trading and will often be on the other side of the trades placed by retail investors.
Having your broker be a primary in your trades allows for more efficiency and access though, and while most of this does benefit the broker primarily, more efficiency does get passed along to traders though things like tighter spreads and other benefits.
One of the mechanisms that does benefit the brokerage and their traders overall is the fact that brokers have the means but not the obligation to place the trades in the market. Brokers can and do make money by taking on trades themselves, for instance trades placed by traders who aren’t skilled enough and lose money, and that’s quite a few traders.
Is Trading With Your Broker A Good or Bad Thing?
If the broker can handle the risk of these trades themselves, and end up making trading profits from taking the other side of bad trades, this money stays within the system so to speak instead of ending up in the pockets of other traders in the market or other counterparties. This allows brokers to be able to charge less for things such as spreads and margin as well as being able to offer free perks such as free robust software, data, and education.
Even the losing traders benefit from this, as their losses are reduced by the lesser spreads and other savings that this all results in.
With the trades that do get placed in the market, brokers trading their own accounts, especially the very large CFD brokers, can place these trades more efficiently than individual traders can due to their much higher volume and access. They also can offset positions from their own order book, with the utmost of efficiency, like a large bank does with internal debits and credits.
When you are just dealing with a broker, this can actually serve to reduce their counterparty risk, because with internal trades, the only counterparty is the trader. This is all of minimal impact, as counterparty risk tends to be generally, although keeping all the money in the house means you don’t have to worry about other parties.
The trader does need to worry about counterparty risk though, by seeking to only have accounts with reputable and solid CFD brokers, but todays’s CFD brokers do tend to be very trustworthy, although some are better set up than others. Provided one selects a top CFD broker, counterparty risk should not be a concern at all actually.
There’s only been one case of a CFD broker becoming insolvent, and traders got back 93 cents on the dollar from the principal, and this doesn’t even account for country specific coverage of losses. Investment firms going under certainly isn’t unique to CFD brokers of course, and if anything, the business setup and risk management of CFD brokers may be more stable than other types of investment firms.
Like the bucket shops, one can place trades through CFD brokers that you never could elsewhere, and this is one of the biggest advantages of CFD trading to new traders. Many have no minimum deposits or trade sizes, and you could literally buy and sell $1 worth with thousands of different financial products, many of which cannot be accessed through other means.
CFD trading has grown enormously over the past few years and has really made its mark already, and is set to grow a lot more as more people become familiar with all of the advantages this new form of trading offers.