Contracts for differences, also known as CFD, is an arrangement between the investor and the provider to exchange differences in the value of a financial products or index between the time the contract opens and closes. UK Financial Conduct Authority (FCA) found that there is a “clear information asymmetry” between firms and retail investors in the CFD market.
High level of leverage and volatility
CFDs have high level of leverage. According to the research of FCA, some firms offer the leverage over 200: 1, which means the clients just need to pay a small fraction of the total value and the CFD provider covers the rest. It is true that this is attractive, but owing to the high leverage, the volatility of CFD is greater than other financial products. That is to say, you may lose much more than your initial deposit. Some people even compare CFD trading to “borrowing money to gamble”.
To avoid large-amount loss, many firms use auto account close-out. If you do not have sufficient funds to cover your total margin requirement (the balance of your account falls below a certain level), your CFD account will be closed out by the firm without consulting you. Then there would be liquidity risk. Even if some time later, the price of the underlying asset recovers and shows a profile to you, you cannot trade and you have to meet the loss.
The firms’ gambling-style promotion and bonus for opening accounts also contribute to the high risk. In practice, many clients are not well aware of the risk (the firms never tell them) and trade the products they do not have enough understand, unlike the financial products sold in the market. Actually, CFD is so volatile that even the most educated and experienced investors could have totally wrong predictions, no mention the inexperienced retail ones.
Conflict of interest: both the referee and the always-win athlete
Hedging against the clients is common and reasonable—few people can find their relevant clauses concerning conflict of interest hiding in a long and full-of-terms contract. Especially when your trading amount is large or the position on one trend is much larger than the opposed trend, to manage the risks, they have plenty of ways to be the clients’ competitors like getting exposure to that asset or index with partner companies to get the broker’s desirable result. The brokers sometimes hedge entirely or partly into the market, when the risk management models ask them to do so.
The client’s CFD trade could be close owing to the broker’s benefit. When the “risk management league” fails to produce the results that they want, the CFD provider may close the client’s trade without warning or paying any profit or money. There are also liquidity risks. If there are not enough trades being made for an underlying asset, the investor may be unable to trade over that asset. Imagine a sports game, the CFD provider or broker is acting both the referee and the athlete so they always win. Sometimes the retail investors do gain something because the winners want to keep them in the field and continue to play the game.
On December 6th last year, FCA published the consultation paper on “enhancing conduct of business rules for firms providing contract for difference products to retail clients”. In the consultation paper, FCA said the internal analysis found that 82% of CFD investors lost money on it and every client lost £2,200 at average. For consumer protection, FCA is going to tighten regulation of CFD trading.