Tuesday 06 December 2016 2:47 pm

Contracts for difference: What are they and what’s the FCA’s problem with them?

By: Oliver Gill

It's been a tumultuous day so far for spreadbetting firms after financial regulators announced plans to clamp down on the retail trading of contracts for differences (CFD) products.

Platform investors ran for the hills in the wake of the news: the likes of IG Markets, Plus 500 and CMC Markets have had between a quarter and a third wiped off their share price so far today.

But what actually are CFDs? And why does the Financial Conduct Authority feel they are so dangerous to retail investors that it has decided to tighten governing rules?

Read more: City watchdog to tighten rules around spreadbetting

Getting more for less

Buying shares in a conventional way is quite straightforward. You pick the stock you like, notify your broker (whether online or over the phone), they will take your money and ta-dah: you own shares in your elected company.

Critically, when buying shares in this "normal" way you must stump up the full amount of cash for the shares. 

CFDs are both a nifty and popular way of getting round the necessity to use your savings to fund the full amount of the shareholding you want to buy.

Like most stuff, the clue is in the name. A CFD is a contract to either receive or pay the difference between the current value of a share, index or other financial instrument; and value at a future point in time.

For example, if Vodafone shares are (hypothetically speaking) priced at 100p and I think they are going to go up in value, I could go to my broker and ask him to buy 100 shares for 100p. I'll hand over my £100 (100x100p) and if they go to 110p and I've had enough I'll sell them, netting £10 of profit.

Read more: Spreadbetters' shares tumble on news of FCA crackdown

Alternatively, I can do the same trade by buying a CFD. I go to a provider, and say I want to buy a CFD for 100 Vodafone shares. I will have to post a minimum amount of collateral, let's say £5, but it will likely be considerably less what I would need to pay to get the same exposure if I was buying the stock outright.

If I agree to close out the CFD at 110p, then in the above example I'll have netted £10 after only ever laying down £5 of capital. Whereas on traditional trading I have had to lay down £100 of capital to get the same return.

You can't lose on what you don't own, right?

So far in our example we have only assumed the price of shares increase. But it's when they fall that investors can be caught out. 

Because you are betting on the price of a share by not fully stumping all the cash for your exposure with a CFD, investors can get into a real pickle if the bet moves against them. If (and let's be clear, this is purely hypothetical) Vodafone's share price fell to 70p, then for a £5 CFD stake, you could be liable to owe £30 – or six times your original investment.

Of course, spreadbetting firms put measures in place to prevent huge losses. Extra collateral may need to be posted and/or trades may need to have a limit put on them so they automatically close out when losses exceed a certain level.

The other thing to stress is with CFDs you can bet on the price of a financial instrument or index going down as well as up.

Read more: Spreadbetters respond to the FCA's new rule proposals

So what is the FCA proposing?

The amount of leverage – in other words the number of times you can ratchet up your exposure – is a focus of attention for regulators.

The key focus for the FCA is restrict the amount the average Joe can lose without realising.