CFDs are not available in the U.S. to retail investors because of Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) regulations. However, they are widely available in the U.K., Europe, and Asia. Learn how CFDs work, and what similar derivatives are available here in the U.S.
Definition and Examples of Contracts for Difference
There are always two parties to a CFD, a “long position” (the buyer) and a “short position” (the seller). CFDs are offered by brokers who may act as one of the two parties. CFDs are different from options and futures available in the U.S. because there is no expiration date, there is no standard contract size, and contracts are individually negotiated. CFDs are a tool for traders to speculate on the short-term price direction of thousands of financial instruments and money managers to hedge their portfolio positions. CFDs are “leveraged” derivatives which means investors only need to deposit 3.3%-50% of the trade value depending on the contract. The CFD broker loans the balance to the investor at interest. CFDs are available for:
CurrencyGlobal financial indicesBondsStocksCommoditiesSectorsCryptocurrencies
Spread bets are similar to CFDs; they’re leveraged derivatives and a speculation tool for traders. The key difference between the two is that in most cases spread betting has an expiration date and CFDs do not. Spread betting is popular in the U.K. and Ireland because it is tax-free for most residents.
How a CFD Works
CFDs are traded in units equal to the “ask” or “bid” price of the financial instrument used, depending on the trade. The bid price is the price you sell. For example, opening a $10,000 CFD buy trade for the fictional ABC company would look like this: If our bullish investor is right, and one week later the ABC bid rises to $10.50, the position is now worth $10,500. The loan is repaid to the CFD broker and the investor’s profit looks like this: What if the investor thinks ABC stock is on its way down? The bearish investor could open a sell or “short” trade. One-thousand CFD units would trade at the “bid” of $9.95 for a total of $9,950. In a short trade, the investor deposits 5% or $497.50, and the account is credited with the full value of the trade, or $9,950. If the bearish investor is right, and one week later the ask price of ABC is $9.45, it looks like this: If our bullish investor was wrong about ABC and the bid price falls to $9.00, the loss is $1,000 on a $500 deposit. Nonetheless, the 2021 meltdown of Archegos Capital illustrates how leveraged derivatives can still pose a threat to the markets and small investors. Archegos Capital is a family office, which means that it is a money management firm owned by one individual—in this case, billionaire trader Bill Hwang—or family and manages only its money. Family offices are exempt from the Investment Advisers Act of 1940, and the rules governing money management firms According to a Bloomberg report, Archegos capital negotiated swaps and CFDs for billions of dollars, making highly leveraged bets on Paramount (formerly Viacom) and other stocks with investment banks such as Morgan Stanley, Credit Suisse, Nomura, and Goldman Sachs. Those bets went awry when those stocks saw a sell-off in March 2021, and Archegos did not have enough cash to meet the margin requirements. The investment banks, reportedly, arranged to sell off large holdings of Archegos, including Paramount to raise cash. These large trades, known as block trades, further drove down the price of Paramount and other stocks. After the dust settled, Archegos and Bill Hwang reportedly lost $20 billion. The investment banks also reported big losses: Morgan Stanley $900 million, Credit Suisse CHF 4.4 billion (approximately $4.7 billion), and Nomura approximately $2 billion. Retail investors and funds holding Paramount also bore the brunt of the stock’s decline. In April 2022, Hwang was arrested on fraud and racketeering charges. The SEC and CFTC both filed civil complaints. Hwang was released after paying a $100 million bail.
