By John Wasiliev
With the exception of the CFDs offered by the Australian Securities Exchange (ASX) most of the CFD activity today is still in products offered by providers who trade directly with clients.
Even though they have been around since late 2007, only about three per cent of CFD traders nominated exchange traded or listed ASX CFDs as their main trading choice in the mid-2009 CFD survey by financial markets researcher Investment Trends.
- that the five year head start that over-the-counter (OTC) CFDs – the name given to products where trading happens directly between providers and traders – has been enough to keep them well out in front. They have the market momentum and most of the estimated 32,000 regular CFD traders;
- that the focus that listed CFDs have on a limited number of prominent Australian shares, foreign currencies, a couple of indexes and gold share hasn’t seemed that exciting compared to the hundreds of potential trading choices that OTC promoters offer;
- that listed CFDs are seen as a totally new market with features that many traders still have to come to grips with. In other words, it is still early days for listed CFDs. Furthermore market conditions since the launch of listed CFDs have not exactly favoured new trading products.
Whatever the reason, exchange traded listed CFDs are still very much the new kids on the block, although their strongest supporter, major online broker Commsec, reckons that during 2009 more new people have been signing up to trade listed CFDs than for the OTC product it also offers. At the same time, Commsec acknowledges that more trading is still happening in its OTC CFDs. Those signing up for listed CFDs have so far been slower to get off the mark.
Since their launch in November 2007, the main message about listed CFDs promoted by their developer, the Australian Securities Exchange has been that trading listed CFDs is better because the action happens in a public regulated market which is safer from a counter-party perspective.
A counter-party is the other trader, the broker or the CFD provider in each CFD transaction. While no OTC CFD provider is known to have lost client money by going broke – a testament that providers have run tight ships during a very challenging market environment – Australia’s corporate regulator, the Australian Securities & Investments Commission (ASIC) has been taking a greater interest in OTC CFDs.
There is concern that OTC CFDs operate in a largely unregulated market environment. ASIC does require all OTC providers to hold a financial services license which carries certain responsibilities like belonging to an independent dispute resolution scheme that hears any complaints from clients. ASIC is also moving towards introducing stricter measures on the handling of client money in trading accounts.
In a recently released consultation paper that deals with how client money is handled by CFD providers, ASIC expressed concern that many clients may not aware of their risk they are taking with the money they are depositing with CFD providers.
Compared to listed CFDs, providers of OTC CFDs have considerable regulatory freedom. They organise the collection of initial margins from client account, the creation of CFDs and the daily settlements and money management required to ensure all traders have the funds to settle their daily positions.
Providers also calculate margins for traders who wish to hold their positions for longer than a day. In some instances they are also active participants in their own trading platforms, encouraging trading by taking the opposite side in many trades, a role described as market making.
The arrival of ASX CFDs in late 2007 introduced the ASX as a provider offering CFDs in a more regulated market. While trading listed CFDs offers a similar experience from a trading perspective, the big difference is the involvement of the ASX in the trading process.
While listed CFDs have focused attention on how different areas of the CFD market are regulated and whether traders need to be concerned about this, a very important point worth noting is that from a trading perspective the same risks apply to listed CFDs as OTC CFDs. Like their OTC counterparts, listed CFDs follow the same broad principles. A trader buys or sells CFDs using a smaller proportion of their capital.
The aim is get the same return from investments for a lower capital cost. The trade-off of course is that you could suffer the same capital loss as being a direct investors but this will represent a greater proportion of the capital you have committed to CFDs.
The broad risks and rewards associated with trading listed CFDs are exactly the same as for trading OTC CFDs. Therefore broadly the same trading basics apply. The same requirement to deal with trading risks and have a money management plan are also essential.
ASX listed CFDs have features that can be found in many OTC products with some extra aspects. The ASX product, for instance, has market makers – known as designated price makers – who have been organized by the ASX. Their role is to offer prices and be prepared to trade ASX CFDs in a way that will encourage other traders to be involved.
While market maker OTC providers also perform this function they are the only market maker on their platforms. The ASX platform offers multiple price makers, a feature the ASX claims should see quite competitive prices being offered.
ASX price makers are professional traders who are generally in the business of making markets. As well as CFDs many also perform the same role for other financial products like exchange traded options, exchange trade warrants and futures contracts.
While they do participate in trading, most ASX price makers are not involved for the trading. Where they hold any positions these are generally hedged to minimize any trading risk. Hedging a position means neutralising any trading risk.
ASX price makers are in the CFD business for the spreads they can earn – the difference between the trading prices they quote to allow a CFD position to be either opened or closed. They are also involved for a share of an incentives pool created by the ASX from the daily interest charge levied on each CFD.
This charge of 1.5 per cent per annum of the position value of investments over which CFDs are created is used to finance the ASX CFD business and pay for such expenses as the involvement of price makers. From this pool comes special incentives to reward price makers who offer the smallest or tightest spreads between offer and buyback prices.
Although buyers and sellers of CFDs pay only a percentage of the cost of the investment over which the CFD is created, prices are quoted on the investment price. A tight spread is considered one where there is very little difference between the investment market quotes (for example share price quotes on the share market) and quotes for the shares on the CFD market.
When they were launched in late 2007, ASX listed CFDs were promoted as a world first derivative product capable of delivering a different style of trading CFDs.
Like all CFDs they are financial products based on a range of investments that are traded in financial markets, in this instance shares in 50 prominent Australian companies traded on the ASX. There are also two share price index contracts – one of them the S&P.ASX 200 – as well as eight foreign currency contracts and gold CFDs.
Compared to OTC providers, the ASX offers a fairly restricted list of choices, although it is argued that what is offered are the most active investment likely to be traded using CFDs.
ASX listed CFDs are derivatives of these investments where rather than buying and selling the investments directly, traders pay an initial margin that covers the likely risk of adverse price movements over a day. This allows them to trade the daily price differences that occur which are then settled each day in cash with money being moved between the accounts of individual traders. With listed CFDs, the provider and CFD manager is the ASX.
ASX CFDs are certainly different from their OTC rivals in that they are traded on a regulated public market supported by professional price makers as well as a network of ASX approved and supervised brokers. The listed CFD market is a transparent market with daily reports of activity including bid, offers, open positions and volumes.
With the ASX platform, the system of multiple brokers and professional price makers means that orders from different sources go into the one electronic order book where they are matched in the order they are received in the same way that orders for other derivative contracts are traded. At the same time it is a separate market with different market pricing and activity. Individual orders are anonymous and orders from one broker are just as likely to be matched against those of others or the quotes posted by market makers.
Like all derivatives that are listed on exchanges, ASX CFDs have standard features and standard costs. While most OTC CFDs have similar features and costs, there can be differences between the various products, particularly when it comes to initial margins.
ASX CFD initial margins are set at levels designed to cover reasonably foreseeable losses between the close of business on one day and the next. The daily price volatility of the investment is also a major consideration.
While the bottom-line responsibility with CFDs lies with the traders on either side of the contract, with ASX CFDs there is an extra security feature. After a trade has taken place, the link between the two sides is broken through a process described as novation. This process sees an ASX subsidiary, the SFE Clearing Corporation; take over the role of the other party – the counter-party - in each trade.
The clearing house becomes the buyer to the CFD seller and the seller to the CFD buyer. At the same time it guarantees that all contracts will be settled according to the rules. This change of counter party from traders to the exchange is a major part of ASX involvement in the listed CFD regulation process.