Contracts for Difference

Many years ago, when financial trading became to catch on in popularity with the public, it wasn’t anywhere near as easy to place trades as it is today. Nowadays, one can access the markets easily from a computer or mobile device. Before that, people would place their trades over the phone with their broker, and prior to that they could visit a storefront location of a retail broker.

In the early days though, the market was quite underserved, and the public had a bigger appetite for security trading than the traditional mechanism could satisfy. Once stock tickers were put into place, allowing for the transmission of stock market information by telegraph, this opened the doors for establishments to open up which offered the public the opportunity to place trades of sorts.

These establishments became known as bucket shops, with the name being taken from the practice of street people draining discarded kegs from drinking establishments and take the loot to an abandoned establishment and drink it. The connection with the trading bucket shops came from the fact that these small amounts of beer were too small to sell but when collected and brought to a location, the beer could be enjoyed.

The financial bucket shops were entirely unregulated, and offered access to all, in stark contrast to securities markets of the day, which catered to the elite. This is much less the case today but this still plays a role, where people may not have the larger amounts that typically are needed to open a normal brokerage account and end up being unserved.

Since bucket shops did not have representation on exchanges like normal brokers do, the trades placed at them tended to be pure bets against the house so to speak, although in some cases the bucket shop operators did secure actual positions in the stock market or whatever market was traded, to hedge their risk when needed.

Bucket shops did vary in quality, with some being more reputable than others, and the natural flow of the market did manage to regulate them somewhat, as if one bucket shop developed a reputation for being less fair or developed other negative views, people would tend to take their business elsewhere.

Contracts for Difference Take Side Bets on Markets

As access to the markets improved, bucket shops became less needed, but it was the regulators cracking down on these establishments that greatly diminished their impact. The securities industry is a very highly regulated sector, especially in the United States, and eventually bucket shops became illegal.

This was supposed to be in the interests of the public, and we may wonder why they just didn’t seek to regulate them like they do with other types of brokerages, and this decision may have indeed been influenced by the established brokerages exerting their political power, and they certainly would have had more power than these small bucket shops.

Bucket houses are still illegal in the U.S., and since contracts for difference is seen as a method of bucketing, it is illegal for a broker to offer a contracts for difference arrangement to Americans, in their pure form at least.

Contracts for difference are offered to residents of a number of other countries though, by a number of different online brokerages, some of which have become quite large and successful.  Bucket shops have certainly come a long way since the old days, especially with the availability of technology.

In the old days, the derivatives market was much more limited, and when one bought a contract on the futures market for instance this amounted to a real contract, and when you bought stock you of course presumably owned the stock and didn’t just place a bet on its movement with a third party.

Bucket shops were criticized for creating the illusion of ownership of real futures contracts and real stocks, when this wasn’t really the case, and operators of bucket shops were actually offering what we now call derivatives.

The futures contracts that they sold were already derivatives, so what they sold were derivatives of a derivative, essentially placing side bets with the operators which the operator would pay out or collect depending on the outcome of the bets.

This is exactly what contracts for difference do, they take side bets on a number of different securities and market valuations, and pay them out of their own pocket. This includes actual stocks and bonds as well as futures.

The Need for Regulation with Contracts for Difference

The risk that one of the parties in a contract may not be able or willing to fulfill their end of an agreement is called counterparty risk. Counterparty risk is a issue to various degrees depending on the type of financial agreement involved, and this is one of the benefits of for instance trading futures on an exchange versus forward contracts over the counter, as the counterparty risk is lower with exchange traded contracts.

Regulators are primarily concerned that parties do not get cheated out of what they are due, especially by underfunded or even fraudulent brokerages. With today’s online brokerages offering contracts for difference type trading, we have evolved to the point where they all have some sort of regulatory oversight, although the degree of this will differ depending on the country they are regulated in.

The online forex trading market has grown into a pretty large and popular one these days, and all forex trades placed through these brokers are on a contract for difference basis, or at least are subject to being so. Forex trading isn’t considered to be contract per difference trading per se though, and therefore aren’t subject to the same restrictions.

When you place a forex trade with one of them, the broker may or may not go into the market and place your trade, although they are on the hook for it whether they do or not. Since they have the luxury of doing so or not as they choose, they will often pass on this with the expectation that most traders lose money on their trades and they then look to be on the other side of this type of losing trading to make even more money.

They still will look to hedge their risk as they see appropriate, and they are not looking to become too exposed with a certain currency or other asset traded with them, and if a trader has proven to be a skilled one, not only may they cover the position, they may even piggyback it in the market.

Given the fact that you are trusting your forex broker to come good on all of your trades, if we didn’t have regulation, who knows how that would all come out. Trading is risky enough without very high counterparty risk from shoddy run online brokerages.

When choosing between them though, it does pay to do your homework, and traders are better suited with going with more trusted and reputable ones, especially those who have enough assets aside from the brokerage side of things to be able to reduce the risk of them not being able to cover their positions close to zero.

How Contracts for Difference Trading Works

One of the things that some smaller traders find so appealing about trading contracts for difference is that this is just like the old bucket shops, you can trade with as small an amount as you wish. In many cases, you could literally open a trading account for a single dollar and actually place real trades with this amount of money, even taking multiple positions with it.

With other means of trading, you would never be able to do this, and many people of very modest means do not even have the opportunity to trade. Contracts for Difference trading completely overcomes this, where people with a hundred bucks and people with several million dollars trade alongside each other on the platform.

Another big advantage with contracts for difference is that in many cases there are no fees involved aside from paying the spread. While the spreads here are wider than you would usually see if you traded the actual assets yourself, and there’s never a free ride when it comes to trading, what this serves to do is to not have trading costs require a big enough position to justify them.

If you’re paying $10 a trade in commissions for instance, it wouldn’t make sense for you to trade $100 worth of anything as the commission would be 10% on each side of the trade. In order to make sense of this, you have to trade pretty large, but not having fees levels the playing field for all.

Brokers differ quite a bit in what they charge for spreads with certain things though, and it certainly does pay to shop around. The more often you choose to trade, the more important this is. Some brokers offer what amount to be excellent spreads, while others may have elevated spreads.

Aside from forex, which isn’t considered to technically be a contract for difference trade even though it usually is treated that way, people can trade a wide variety of things with contracts for difference.

You can trade both cash and futures markets in a wide variety of indexes and commodities. Many brokers also offer stocks on a contracts per difference basis, as well as bonds and treasury bills, where there may be a commission in addition to the spread, but one need not worry about position sizing or odd lots, or shorting rules, as this is all pure bets between you and your broker so normal rules do not apply.

There are people who trade with huge sized accounts in this market, ranging into the millions, and there are also people with just a few bucks. At some point, if your account is large enough, it may be worth looking at trading the actual futures contracts yourself, or buying the stocks itself, but there are some very competitive brokers out there who will get you pretty close to what you could get on your own even with some pretty big accounts.

Contracts for difference also allow for a lot of leverage, and depending on the broker, you can get up to 1000:1. That’s simply a ridiculous amount of leverage though, as even a small move against you at this level will result in your losing your entire balance and then some, but those who are looking for extra leverage can find plenty with these products.

Contracts for difference trading is much more about allowing greater access to the markets than the markets normally provide, much like the old bucket shops did. These days it’s much more regulated and organized and much safer though.