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OTC CFD providers are required to segregate client funds protecting client balances in event of company default, but cases such as that of MF Global remind us that guarantees can be broken. Exchange-traded contracts traded through a clearing house are generally believed to have less counterparty risk.
Ultimately, the degree of counterparty risk is defined by the credit risk of the counterparty, including the clearing house if applicable. There are a number of different financial instruments that have been used in the past to speculate on financial markets. These range from trading in physical shares either directly or via margin lending, to using derivatives such as futures, options or covered warrants.
A number of brokers have been actively promoting CFDs as alternatives to all of these products. The CFD market most resembles the futures and options market, the major differences being: Professionals prefer futures for indices and interest rate trading over CFDs as they are a mature product and are exchange traded. The main advantages of CFDs, compared to futures, is that contract sizes are smaller making it more accessible for small trader and pricing is more transparent.
Futures contracts tend to only converge near to the expiry date compared to the price of the underlying instrument which does not occur on the CFD as it never expires and simply mirrors the underlying instrument. Futures are often used by the CFD providers to hedge their own positions and many CFDs are written over futures as futures prices are easily obtainable.
The industry practice is for the CFD provider to ' roll ' the CFD position to the next future period when the liquidity starts to dry in the last few days before expiry, thus creating a rolling CFD contract.
Options , like futures, are an established product that are exchange traded, centrally cleared and used by professionals. Options, like futures, can be used to hedge risk or to take on risk to speculate. CFDs are only comparable in the latter case.
An important disadvantage is that a CFD cannot be allowed to lapse, unlike an option. This means that the downside risk of a CFD is unlimited, whereas the most that can be lost on an option is the price of the option itself. In addition, no margin calls are made on options if the market moves against the trader.
Compared to CFDs, option pricing is complex and has price decay when nearing expiry while CFDs prices simply mirror the underlying instrument. CFDs cannot be used to reduce risk in the way that options can. Similar to options, covered warrants have become popular in recent years as a way of speculating cheaply on market movements. CFDs costs tend to be lower for short periods and have a much wider range of underlying products.
In markets such as Singapore, some brokers have been heavily promoting CFDs as alternatives to covered warrants, and may have been partially responsible for the decline in volume of covered warrant there. This is the traditional way to trade financial markets, this requires a relationship with a broker in each country, require paying broker fees and commissions and dealing with settlement process for that product. With the advent of discount brokers, this has become easier and cheaper, but can still be challenging for retail traders particularly if trading in overseas markets.
Without leverage this is capital intensive as all positions have to be fully funded. CFDs make it much easier to access global markets for much lower costs and much easier to move in and out of a position quickly. All forms of margin trading involve financing costs, in effect the cost of borrowing the money for the whole position. Margin lending , also known as margin buying or leveraged equities , have all the same attributes as physical shares discussed earlier, but with the addition of leverage, which means like CFDs, futures, and options much less capital is required, but risks are increased.
The main benefits of CFD versus margin lending are that there are more underlying products, the margin rates are lower, and it is easy to go short. Even with the recent bans on short selling, CFD providers who have been able to hedge their book in other ways have allowed clients to continue to short sell those stocks. Some financial commentators and regulators have expressed concern about the way that CFDs are marketed at new and inexperienced traders by the CFD providers. In particular the way that the potential gains are advertised in a way that may not fully explain the risks involved.
For example, the UK FSA rules for CFD providers include that they must assess the suitability of CFDs for each new client based on their experience and must provide a risk warning document to all new clients, based on a general template devised by the FSA. The Australian financial regulator ASIC on its trader information site suggests that trading CFDs is riskier than gambling on horses or going to a casino.
There has also been concern that CFDs are little more than gambling implying that most traders lose money trading CFDs. There has also been some concern that CFD trading lacks transparency as it happens primarily over-the-counter and that there is no standard contract. This has led some to suggest that CFD providers could exploit their clients.
This topic appears regularly on trading forums, in particular when it comes to rules around executing stops, and liquidating positions in margin call.
Although the incidence of these types of discussions may be due to traders' psychology where it is hard to internalise a losing trade and instead they try to find external source to blame. This is also something that the Australian Securities Exchange, promoting their Australian exchange traded CFD and some of the CFD providers, promoting direct market access products, have used to support their particular offering.
They argue that their offering reduces this particular risk in some way. If there were issues with one provider, clients could easily switch to another. Some of the criticism surrounding CFD trading is connected with the CFD brokers' unwillingness to inform their users about the psychology involved in this kind of high-risk trading.
Factors such as the fear of losing that translates into neutral and even losing positions  become a reality when the users change from a demonstration account to the real one. This fact is not documented by the majority of CFD brokers. Criticism has also been expressed about the way that some CFD providers hedge their own exposure and the conflict of interest that this could cause when they define the terms under which the CFD is traded.
One article suggested that some CFD providers had been running positions against their clients based on client profiles, in the expectation that those clients would lose, and that this created a conflict of interest for the providers. A number of providers have begun offering CFDs tied to cryptocurrencies. The volatility of the cryptocurrency markets and the leverage of CFDs has proved a step too far in some cases with Coindesk  reporting that UK based Trading was forced to suspend trading of Bitcoin Cash CFDs in November resulting in significant losses for some clients when trading recommenced and the market had moved against them.
CFDs, when offered by providers under the market maker model, have been compared  to the bets sold by bucket shops , which flourished in the United States at the turn of the 20th century. These allowed speculators to place highly leveraged bets on stocks generally not backed or hedged by actual trades on an exchange, so the speculator was in effect betting against the house. If you are incorrect and the value rises, you will make a loss. This loss can exceed your deposits.
If you have already invested in an existing portfolio of physical shares with another broker and you think they may lose some of their value over the short term, you can hedge your physical shares using CFDs.
By short selling the same shares as CFDs, you can try and make a profit from the short-term downtrend to offset any loss from your existing portfolio. You could then close out your CFD trade to secure your profit as the short-term downtrend comes to an end and the value of your physical shares starts to rise again. Using CFDs to hedge physical share portfolios is a popular strategy for many investors, especially in volatile markets.
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