Better education and more informed choices - helping to bring CFDs in from the cold

Traditionally, Contracts for Difference (CFDs) have been seen as a financial derivative class best suited to be used by very experienced and semi-professional traders, as opposed to the majority of retail FX market players. However, as Heather McLean discovers, that opinion is changing, as more retail traders decide to try out CFDs.

First Published: e-Forex Magazine 62 / Retail FX trading / October, 2015

CFDs offer interesting opportunities for those with the experience to work with them, says Luis Sanchez, CEO at BMFN. He explains how the system works: “A CFD embodies a specific kind of agreement between a client (trader or retail investor, for example,) and a broker regarding a particular asset, but it does not involve ownership of that particular asset itself. So, from the viewpoint of a retail investor, investment and trading in CFDs can be attractive because of the way CFDs use leverage, ie, a CFD requires the trader to put up less cash (margin) than would a similar traditional trading transaction that involves the movement or exchange of a traditional asset. When retail investors lack leverage-centric opportunities like CFDs, the best way to invest is to enter into traditional investments vehicles such as deposits in banks, mutual funds, or maybe some insurance investments linked to returns.”

Exciting sometimes means dangerous

However, Sanchez adds that CFDs are not for everyone: “Some retail investors may hesitate to trade CFDs because some such investors are adverse to risk, in part based on perceived lack of knowledge, or memories of money lost due to traditional investments that went wrong. These retail investors may have lost faith in trying out new kinds of investments. In some cultures such as Latin America, CFDs are not well known or well developed. Brokers may feel that the knowledge base among traders (or themselves) is not yet strong or deep enough for players to comfortably enter the field. However, other brokers are poised to do a lot of homework and education (of themselves, traders, and investors) to make the retail segment understand that there are new ways to invest their assets, including with a kind of controlled risk in a high risk market,” he says.

Exalting the value of CFD trading, Jeff Grossman, COO at Squared Financial Services, says: “CFDs are among the most flexible of all the instruments regulated under MiFID. With CFD’s clients can take on exposures to any number of underlying markets and or asset classes without the costs or obligations of accessing the market directly. Client’s keep all the benefits of regulation and gain a more granular and versatile access to financial markets.” Yet he adds: “This flexibility creates a lot of variation in trading conditions. Settlement methods, Contract specs, required margins, and overall liquidity are determined independently by the counterparty. That means, as a client, you need investigate all these aspects before you trade.”

On how CFDs can offer exciting trading opportunities for more sophisticated and experienced retail investors, Cyril Tabet, partner and CEO at JFD Brokers and JFD Prime, agrees: “Designed to address the lower end of the retail market, CFDs enable retail traders to open relatively large leveraged long or short trading positions in the worldwide Stock, Commodities, Bonds, or ETFs markets with a very low initial investment.” 

However, Tabet warns that CFDs come with challenges for those with less experience: “A type of OTC-based derivative, very speculative in nature as the slightest price movement will have a major impact on the investment, CFDs carry a high level of volatility which obviously translates into opportunities but also into significant risks,” he cautions.

“If retail traders holding small deposits can easily diversify their market exposure trading a significant variety of asset classes through CFDs, they remain clearly exposed to great risks due to both their relatively low level of trading sophistication coupled with the highly volatile nature of the CFD product,” explains Tabet. “In fact, sophisticated and experienced investors holding larger deposits will always favour exchanged traded futures and stocks products, which by nature do not suit investors holding smaller deposits, as exchange traded products will always be less expensive in terms of trading costs and far more transparent to trade compared to over the counter traded CFDs.”

Benefits of trading CFDs

As to the major benefits of CFDs, Sanchez comments that: “In the past, when you wanted to buy meat you went to the butcher; when you wanted to buy medicine, you went to the drugstore; and, overall, whatever you wanted to buy, you needed to go to a very specific venue to make your purchase or conduct your business. Today, you go to one unified supermarket and you find everything that you need, in one place. Keep that analogy in mind as you contemplate this: even today (in places like Latin America, for example), if you are a family office and you want to invest in stock, you need to open an account with a stock broker; if you want to then trade currencies, you need to open another account with a specific kind of bank, and maintain the same kind of specialised and separate relationships to manage trades of commodities and other financial instruments.”

“But ‘one stop shopping’ is increasingly available,” notes Sanchez. “Today, the main obstacle is the time and energy it may take to effectively assess potential credit risk and stability of a particular one stop shop kind of broker, but once that obstacle is overcome, some brokers may be able to offer you the entire menu of multiple investments products from a single platform, meaning that you open an account with the one broker and you have multiple options in which to invest, making it, indeed everything, much easier to manage and control. In this case, from one computer or phone screen you can see and control all of your positions, reduce your administration work, and cut fees and cost,” he explains.

On the key benefits of trading CFDs, such as access to a wider choice of products across the financial markets and ability to trade a range of instruments from one trading platform and brokerage account, Grossman notes: “CFDs can be designed to reflect any underlying capital market, combination of markets, or even relationships between markets. With this instrument clients can construct and scale their own multi asset portfolios and strategies across global markets in one account. This gives a consolidated view of the portfolio exposure and greatly simplifies risk management.”

Cyril Tabet“If trading costs are always a key decision making factor, full transparency and exclusion of any potential conflicts of interest must also be seriously considered whenever selecting a broker of choice.”

Cyril Tabet

“If trading costs are always a key decision making factor, full transparency and exclusion of any potential conflicts of interest must also be seriously considered whenever selecting a broker of choice.”

While Tabet points first to diversification as the major benefit of trading CFDs. He says that as traders concentrating their exposure across a narrow number of FX pairs will systematically be prone to suffer from any abrupt market move, CFDs are now more important than ever. “This year’s CHF-related black swan came in as a clear indicator, demonstrating that traders diversifying their exposure across a large variety of instruments and asset classes and brokers offering multi-asset class capable platforms have both been far less impacted by the SNB debacle.”

Accessibility is the second major benefit of CFDs, says Tabet. “If there is a significant growth of interest towards Index CFDs such as the Dow, the DAX, the FTSE or the CAC, backed by an interest for the most commonly traded stocks, it simply is because retail traders can easily relate to these, both from a purely emotive perspective, ie, they know and like these brands, as well as from a trading perspective, ie, they have access to a vast amount of financial research and analysis published on these, based on which they can in turn decide to long or short securities with a small initial investment.”

“In that light, offering a single and hassle-free access to a wide variety of asset classes becomes a must have for any serious retail broker willing to match and exceed the retail market expectations,” continues Tabet. “Indeed, in 2012 we at JFD addressed this opportunity by deploying a comprehensive multi-asset solution comprising FX, Indices, Commodities, Metals, Stocks, Bonds, ETFs and Rates on the popular MT4 retail trading platform. With nowadays a solid half of our revenues sourced from CFD trading versus FX trading, we have emerged as a solid proof of concept and are now actively supporting all kind of retail brokers in clearing, integrating and deploying CFDs within the MetaTrader environment via JFD Prime, our Institutional Sales division.”

Further positives

CFDs can also provide an excellent alternative to suit a variety of trading styles or methods. Focusing on Latin America, Sanchez says that normally in traditional financial markets, an investor in stocks and commodities can only go long, for example; perhaps in currencies, not all are available, with only the G7 currencies open to trade, “So what if you, an investor, want to go short?” he questions. “Let’s say that you want to go short on Apple stock; how do you do it? You need to borrow this stock from or via your counter-party, a centralised mechanism, or a provider lending securities, and after that you can sell in the spot market and wait to re-purchase the stock in the future at a lower price. And all of this comes with a complicated matrix of administration and fees.”

Sanchez continues: “As an alternative, with a broker trading CFD, you can go short without having any of the aforementioned complications. And this is the beauty and simplicity and centralised approach or facility that some brokers can now and will increasingly offer investors.”

Meanwhile, Grossman adds something else: “CFDs are not subject to the usual fee overheads involved in exchange or MTF trading. This is ideal for the short term trader if pricing and liquidity is competitive with the underlying. For the long term multi asset investor, the same applies with added savings on market access and technology costs.

Picking the right CFD provider

Various factors should influence a retail FX trader’s choice of provider. Tabet states that if FX has been the retail trading industry’s favourite asset class until recently, things are beginning to change thanks for CFDs. He explains that, “We are seeing a number of online retail brokers starting to expand their offering with CFDs in response to an increase in popularity amongst retail traders,” however he adds that these are “most notably the least experienced ones of these traders,” so retail traders still need to be wary.

Tabet comments that historically, CFDs have been disbursed by non-bank market makers such as IG, CMC, Saxo, or Gain, that created both the product and the marketplace, systematically acting as a direct counterparty to all retail traders’ trades. He adds: “As such, the CFD marketplace appears to be less optimsed than the aggregated interbanking FX marketplace, so for instance, any single market making broker’s exposure on CFDs is highly sensitive.”

Continuing, Tabet says: “Each retail trader’s position goes straight into a single market making broker’s internal book where hedging all clients’ positions onto the real underlying futures or stock exchange traded market would cause unwanted additional trading costs due to the larger negative dividends or swaps that exist on at least one side of the position, as well as, most importantly, the inability to earn from retail traders’ losses. In short, trading with, or in fact against, a CFD market maker sustains a systematic conflict of interest.”

“As a reminder, Take Profit and Stop Loss levels are fully disclosed to the CFD market making counterparty as all clients’ orders are sitting within the broker’s servers, which translates into the ability for the broker to Stop Hunt any of its clients’ trades,” Tabet says. “In fact, some of the largest market making FX and CFD brokers have been repeatedly fined by American and European regulators against the conduct of such practices.”

Tabet states that it is therefore business-critical to ask oneself the following: is my broker executing trades against me or passing them on as an agent protecting my trading anonymity, ie, without disclosing my limit and pending orders to the ultimate counterparty?; are my trades hedged on the real market?; and do irregularities in the pricing appear often with my stop loss and take profit levels? He says the best approach to resolve any possible conflict of interest remains to trade with a 100% DMA/STP agency only broker. “JFD stands for Just Fair & Direct and as such does not hold any positions, hence no exposure against its clients; rather we transfers all clients’ trades to a pool of CFD liquidity providers in complete trading anonymity, thus preventing any possible conflict of interest with direct retail clients,” remarks Tabet. “If trading costs are always a key decision making factor, full transparency and exclusion of any potential conflicts of interest must also be seriously considered whenever selecting a broker of choice.”

“As another indicator, this time from any FX retail broker’s perspective looking into adding CFDs into its offering, the exact same principle applies at the institutional level whereby sourcing CFDs from a Prime of Prime which will aggregate a variety of CFD liquidity providers into one pool rather than sourcing liquidity from one single market making CFD broker acting as the direct and sole counterparty, is becoming a new industry standard to avoid any possible conflicts of interest while guaranteeing best execution and adding a significant level of market depth to the equation,” says Tabet. 

When choosing a  provider Grossman states that: “Traders also need to ensure that their provider is a MiFID compliant firm. They also need to thoroughly research the contract specifications and trading conditions that will apply as well as investigate the pricing, and liquidity constraints. This is critical for managing the risks associated with CFD trading as variations are unlimited and clients need the full transparency available under MiFID.”

Meanwhile, quantifying it further Sanchez says what should influence a decision are: a) for 50% of total influence, regulation (its content and effects) and the credit risk of the broker; b) for 40% of total influence, assurance that the broker provides the instrument(s) that you need. For example, in Latin America, the broker would need to offer local stock and currencies in order for you to consider them as an option; and c) for up to 10% of total influence, the suitability and comprehensive nature of the platform that is being offered.  Sanchez notes this is particularly, even the only, important point for expert retail investors.

Luis Sanchez“Some retail investors may hesitate to trade CFDs because they are adverse to risk, in part based on perceived lack of knowledge, or memories of money lost due to previous investments that went wrong. These retail investors may have lost faith in trying out new kinds of products. So Brokers are poised to do a lot of education to make the retail segment understand there are new ways to invest their assets, including with a kind of controlled risk in a high risk market.”

Luis Sanchez

“Some retail investors may hesitate to trade CFDs because they are adverse to risk, in part based on perceived lack of knowledge, or memories of money lost due to previous investments that went wrong. These retail investors may have lost faith in trying out new kinds of products. So Brokers are poised to do a lot of education to make the retail segment understand there are new ways to invest their assets, including with a kind of controlled risk in a high risk market.”

Moving onto the next generation 

Next generation CFD trading platforms are now starting to appear on the market but Tabet says that these are just one piece of the equation; he adds that, “What will always make a difference remains the execution model used behind these”. 

Tabet notes: “The absence of any conflict of interests between the broker and the client is paramount to guarantee an optimal trading experience. That being said, I strongly believe in the provision of added value services such as multi asset class trading tools, ie, correlation matrixes or heatmaps, combined with multi-asset class market research and analysis to facilitate retail clients’ trading decisions. With JFD Research for example, we provide our clients with free proprietary institutional-grade research and tools adapted to the retail audience, and in that sense we equip them with solid insights to maintain their positions on the market.” 

He adds: “Under an agency model based on charging commission fees rather than benefiting from client losses, a trader’s burnout translates into a loss of trading income for an agency only broker as commission based revenues are strictly generated from clients’ trading volumes, hence our heavy investment into such solutions.”

On what features and functionality are now available via next generation desktop, web, and mobile CFD trading platforms, Sanchez comments: “Today, brokers must develop, and have been launching, multiple trading channels, paying much attention to mobile trading, including different operating systems (particularly in iOS and Android). In some cultures like those within Asia and Latin America, individuals use mobile devices and apps for nearly everything, from ordering a taxi to arranging their meals by ordering food, to paying bills, and even to trading. [Therefore] if a broker does not provide multiple trading vehicles and platforms to such consumers in a technically and culturally attuned way, he will never reach the next level of consideration and success.”

“Successful brokers will ensure that the mobile versions of the platform mirror the majority of the features found on the desktop version,” Sanchez adds. “In Peru, for example, smartphones are not cheap compared to the average income, yet people prefer to have them and use them ubiquitously (as a cultural and economic priority).  Peruvians have come to use smartphones to reduce overall expenses in ordering needed goods and services.  Trading is and will be no exception. Brokers must be attuned to this and ensure adequate platform development.”

Early days on education

While educating your client may seem paramount in running a good business, Tabet says many traditional CFD brokers are more interested in making a quick buck than helping their new, unsophisticated retail clients: “Historical CFD market making brokers have naturally been targeting unsophisticated traders who will eventually fault one way or the other, thus generating losses translating into revenues for the market making broker. In that light, I do not believe such players have any legitimate interest in seriously educating their clients.” 

He provides tips on how to spot the warning signs that a CFD broker is ready to sacrifice their client for fast cash: “Here is a typical indicator; some market making CFD brokers will urge their retail clients to manage their risk by placing Stop Losses. If this seems a sound advice, in fact as Stop Losses will sit into the market making broker’s servers, no trading anonymity will ever be guaranteed, leading straight into the various manipulations, such as Stop Hunting, all of which have been condemned by the financial regulators,” notes Tabet. 

“Again, in my opinion, retail CFD trading should not be made available to beginners as it carries a high degree of risk whereby losses may exceed the investors’ initial deposits, but rather to experienced traders holding smaller deposits” adds Tabet. “The real focus should instead be placed on the provision of solid market research and trading tools covering the wide panel of instruments and asset classes offered under the CFD product. That is the reason why at JFD we have no interest in targeting beginners, hence do not offer any particular educational services.”  

Sanchez believes it is still early days when it comes to actively educating retail traders and investors about managing the risks associated with CFDs, helping them to capitalise on their trading potential, and assisting them to make more informed choices when using these instruments. 

He explains: “In some cultures, such as those within Latin America, this industry is in an early stage of development.  For this reason the brokers that want to pioneer and to penetrate this region must have a strong educational business plan, one that encompasses and even extends beyond constant online webinars, seminars, presentations, and a team that is available to give private classes. In addition, these pioneering brokers will offer tutorial videos and e-books written in the native local languages, along with sending a daily email to clients, highlighting a daily market summary; even though such daily market information is available to clients on a web page, many clients expect or will hugely benefit from an efficient summary email or text message that arrives pro-actively in their inbox or on their phone.”

While Grossman states: “Most brokers offer education materials with clear specifications and actual trade examples on their websites. If clients take the time to fully digest the materials they will be able to manage the trading risks properly. For many clients who want a true multi asset account, CFDs are the only option so it largely a matter of selecting the right broker.”

Sanchez believes that all educational communication must be rendered to clients and prospective clients without the pressure to open an account immediately.  “In [the Latin American] region, people do not invest in something they don’t understand. For example, imagine you give a car to someone who doesn’t know how to drive; they will expect you to provide them a driver to teach them in real time how to drive. BMFN is investing a lot in this region via all of the aforementioned mechanisms because we understand the intersection of this industry and the local culture very well. For example our weekly webinars containing fundamental news and technical-level information for more advanced users, are all a part of our increasing efforts to educate and engage individuals who are ready to stretch into a new comfort zone, with much new opportunity ahead.”

Jeff Grossman“CFDs are not subject to the usual fee overheads involved in exchange or MTF trading. This is ideal for the short term trader if pricing and liquidity is competitive with the underlying. For the long term multi asset investor, the same applies with added savings on market access and technology costs.”

Jeff Grossman

“CFDs are not subject to the usual fee overheads involved in exchange or MTF trading. This is ideal for the short term trader if pricing and liquidity is competitive with the underlying. For the long term multi asset investor, the same applies with added savings on market access and technology costs.”

Still a forbidden fruit for some

Despite widespread use around the world, CFDs still remain illegal in some jurisdictions. Tabet comments: “Not only CFDs are distributed over the counter with less control and transparency than exchange traded products, they also remain under the monopoly of a limited number of historical CFDs market making brokers that are entertaining a constant conflict of interest with their direct retail clients, the vast majority being inexperienced. That is one of the reasons why regulators tend to incentivise the access to the exchange traded futures and stocks market, which remain by nature more suitable to the higher end of the retail market. In effect, some regulators such as the NFA and CFTC chose to clearly prevent CFD market making brokers to address the lower end of the retail market, protecting the end client from any potential abuse.I believe that one of the most realistic transformation levers would reside in regulating the enforcement of a 100% DMA/STP agency-only execution model whenever addressing the retail market with any type of OTC product, including CFDs, thus repositioning all historical CFD market making brokers towards the strict provision of liquidity to financial institutions rather than to retail clients,” states Tabet. “As a result, retail clients would benefit from a direct and transparent access to a wide variety of products via agency only brokers and conduct their trading activity and fulfil their passion for the financial markets within a conflict free trading environment.”

In conclusion Grossman notes that: “CFD trading is not authorised in numerous jurisdictions for many reasons. In general the regulatory overhead of supporting foreign derivatives is very high, so the CFD is just too flexible to control. However, even in the US there are domestically traded equivalents although these are subject to more uniform trading and clearing structures.  “In many ways the CFD reflects the classic contradictions seen in the development of financial markets. Often the most interesting feature or innovation is the aspect that makes it a regulatory challenge,” he says. “As I see it the best way to promote a wider acceptance is for intermediaries to maintain a forward looking approach and ensure that adequate safeguards and controls are in place at all times so that instrument itself is not brought into disrepute.”