What are CFDs?
A contract for difference (CFD) is a derivative product that allows a buyer to try and predict the value change of an underlying asset without owning the asset. Specifically, any profits or losses are calculated by the asset's value movement between trade entry and exit. Traders can trade on either increases or decreases in value, depending on their predictions of the asset’s underlying value at contract expiry.
CFDs were first used by institutional traders and hedge fund managers in the UK to hedge exposure to stocks. To many investors, the CFD market most resembles the futures and options market, with a few key differences:
- No expiry date on contracts;
- Trading is conducted over-the-counter with CFD brokers or market makers;
- The contract is normally one-to-one with the underlying instrument;
- Low entry threshold, with small contract sizes as low as a single share;
- Wide variety of underlying instruments available due to ease of creating new instruments, and no exchange or jurisdictional boundaries;
- Not available to residents of the US or Hong Kong.
CFDs were introduced to retail traders in the late 90s. Their features made them quickly popular, which was amplified by innovations in trading technology that allowed traders to see live prices and conduct transactions online and in real time.
Worldwide expansion has been rapid since 2002, and CFD online brokers like capex.com, for example, are now available online to traders from many countries including Spain, UK, Italy and Germany Due to regulations, CFD trading is not permitted in a number of countries like the United States & Hong Kong.
Along with the proliferation of new brokers, this explosion of CFD trading around the world has also created a huge traders user base for these services. This has resulted in increased scrutiny and regulation by authorities. Regulatory bodies have recognized the need for consumer protection and responded by creating specific regulations and imposing restrictions on brokers around the world and specifically in Europe.
CFD Regulation in Europe
Most CFD brokers who operate in Europe are regulated by The Cyprus Securities and Exchange Commission (CySEC). Brokers who operate in the UK are also regulated by The Financial Conduct Authority (FCA) in the United Kingdom.
Regulations imposed by these regulatory bodies are mainly aimed at increasing traders awareness and knowledge, reducing the high-risk nature of the trading activity and protecting traders funds and privacy.
Some restrictions imposed by the CYSEC and the FCA in relation to retail traders include:
- Strict leverage limits per account
- A standardized margin close-out per account
- A negative balance protection per account – preventing retail clients from losing more than the funds in their trading account
- Prohibition of cash or other inducements that encourage retail trading
- A standardized risk warning informing potential or existing clients of the risks involved in the trading activity and presenting the percentage of the broker's retail client accounts that suffer losses.
In addition CFD brokers must meet strict capital and fiscal requirements, work with top-tier financial institutions and keep their client funds in separate accounts.
As CFD trading continues to expand, increased regulations are likely to appear offering increased protection to traders, promoting a fair trading environment and more confidence in the industry.
