Contracts for difference

Contracts for difference (CFDs) have been in the news recently following a call from the Association of Investment Companies (AIC – formerly the Association of Investment Trust Companies) to recommend changes in disclosure regulations. The association argues that these products are being used by some investors to build stakes in companies in a less than transparent manner.

CFDs are part of a growing trend of complex equity derivatives products that are gaining popularity among investors because they offer the potential to make money from stocks for a fraction of the price of buying them.

What are CFDs?

CFDs, or swaps, are equity derivatives that give investors exposure to a company’s share price without requiring them to buy the stock. The investor can gain returns on rising share prices but has no voting rights in the company.

Investors can take out a CFD on a wide range of financial instruments such as shares, bonds and even portfolios of different assets.

Typically a contract is drawn up between an investor and an investment bank which holds the underlying assets. The agreement states that if shares in the company in which the investor holds CFDs move in his or her favour, the investment bank will pay the investor. If the share price goes against the investor, the investment bank is owed money by the investor.

At the end of the contract the two parties exchange the difference between the opening and closing prices of the asset.

How much do they cost?

CFDs cost much less than shares. The investor generally pays between 10 and 20 per cent of the face value of the share. This amount is known as a margin.

How do they work?

CFDs technically have no expiry date, but they may cost more the longer they are held. CFD investors trade on margins. If the share price moves in their favour, they can make large amounts of money from a small margin.

If investors think the value of shares underlying the contract are going to rise they can “go long” on the stock by buying a large number of shares. If a share costs 100p and the investor thought the price was going to rise, he might want to take out a CFD on 100 shares. The margin of the shares could be 10 per cent of their value: 100 shares would be worth £1,000 but the margin would cost £100. If the share price then rose by 20p, the investor could close his CFD position and take a profit of £200. But if the price fell 20p he would lose £200.

It is possible to limit financial exposure by applying a “stop loss”: setting a price at which the investor no longer wants to hold the position. When this price is breached, the investor’s position is automatically sold at the next best price. It is also possible to apply a guaranteed stop loss to guarantee a return of a set price if the stock price moves against the investor.

Why do investors like them?

In the late 1980s, CFDs were traded as a niche product offering investors the returns of equities but without the costs of stamp duty (0.5 per cent on share purchases).

Now they are far more commonplace and commission fees on opening and closing trade have dropped as competition has increased. The commission fee is expressed as 20 basis points, so on a £1m position, it would be £2,000.

Investors should also be aware that their position affects dividends. If an investor “goes short” on a stock and there is a dividend payout while he holds the position, he must pay this to the CFD provider. If he holds a long position, he will be credited with a percentage of the payout.

CFDs also provide anonymity because the asset on which the CFD trade is based is registered with the CFD counterparty, usually a financial institution, rather than with the investor.

Why are they controversial?

The anonymity of CFDs leaves them ripe for potential abuse. The UK requires disclosure of large stock positions on the grounds that the market deserves to know if an investor is increasing his influence over a company.

Because CFDs do not have voting rights as ordinary shares do, they were deemed to carry no influence and so are not subject to the same disclosure rules. However it can be very easy to turn a CFD into an ordinary voting share. If an investor has CFDs from an investment bank, the bank may be willing to sell actual stock to the CFD investor.

What does the AIC want to see happen?

The AIC is calling for improved disclosure of CFDs to protect investors and maintain a fair and orderly market. It proposes that the Financial Services Authority (FSA) conducts research into the potential problem of investors using CFDs to build up stakes.

What is happening now?

The UK Takeover panel decided early in 2006 that investors should disclose CFDs relating to stock positions of 3 per cent or more if a bid discussion was entered into.

The FSA then launched a three-month regulatory consultation to examine whether this needs to be extended. It says that forcing CFD holders to disclose their identity may be expensive and complex. A final decision is expected in 2007 following the FSA’s review of the Takeover Panel rules.