Responsible Leverage: CFD Trading and the Current State of Regulations
By: Marcus Tan
Tags: Trading, Forex, Finance, Bitcoin, Cryptocurrency

Responsible Leverage: CFD Trading and the Current State of Regulations

How should forex and cryptocurrency brokers adapt to the latest changes in FCA, ESMA, and ASIC regulations?

Historically, professional traders are subject to ever-shifting regulatory climates, especially traders with a preference towards leveraged products. It has always been a battle of two sides: brokers vs regulators, where the brokers are looking to offer products that their traders want the most, and regulators are looking to protect said traders from disproportionate risks.

One of the most popular trading products globally is the Contract-for-Difference.

What is a Contract-for-Difference?

Contract-for-Difference (CFD) trading is increasingly becoming one of the most popular forms of derivative trading. The instrument allows traders to speculate on the rise and fall of prices of underlying assets such as forex, stocks or commodities.

More recently, the cryptocurrency community in particular has shown growing interest in derivative trading:

“The crypto trading industry doesn’t have much experience [in] margin trading, but it’s something that traders demand.” Source: Finance Magnates

CFD trading does not involve the actual buying or selling of the underlying asset. Instead, it is a tool to speculate on the future price of the asset and generate profits from the price movement.

This has especially generated interest in the cryptocurrency trading community for the simple fact that it allows traders to mitigate unnecessary risks that result from private/public key mismanagement.

“The safest way to trade [cryptocurrencies], without the need to bear the risk of storing digital assets, is to opt for crypto CFDs.” Source: Bitcoinist

Why Trade CFDs?

CFDs offer tremendous advantages to all types of traders and that has contributed to its growing popularity in the financial world. Some of the advantages include:

Leverage

Leverage allows traders to work their initial capital to the fullest, by allowing them to trade with a fraction of the trade’s full value. Traders have to only place an initial deposit (a fraction of the full value) which is referred to as margin. The margin amount depends on the size of the position and the underlying asset being traded.

Ability to Short Sell

CFD trading is one of the few avenues for traders to generate profits in a falling market. If the trader can make an accurate prediction regarding the direction of price movement, they can profit in a rising as well as a falling market. The flexibility makes CFDs an attractive proposition for traders.

Hedging

Hedging is one of the key mantras for financial success. CFDs allow traders to hedge their physical portfolios. For instance, traders who have an existing stock portfolio with a broker can open a short position using CFDs if they believe that the stock market is in a downturn. If they are correct, they can earn a profit and offset the loss in their physical portfolio. Even if the prediction is inaccurate, traders can close the CFD position and offset the losses against future gains.

Some other benefits of CFD trading are the ability to access a wide variety of markets, low costs, liquidity and tax efficiency.

What are the Inherent Risks with CFDs?

Just like any advanced trading instrument, traders have to be careful with some of the inherent risks associated with CFD trading:

Overtrading

CFD trading, with its low-cost structure and low initial capital investment, makes it very easy for traders to get into the overtrading trap. This essentially means that they expose a major share of their portfolio to the market, more than their capital can cover for in the eventuality of a loss. Traders can lose a significant share of their capital if their positions turn out to be wrong.

Overnight Financing

Overnight financing refers to the swap interest rates that kick in daily for each trading day that traders maintain their open positions. If the open positions are held for a long time, these costs can eat up a significant share of profits or contribute to the losses. Simply put, CFDs are best thought of as a short-term instrument with some exceptions.

Lack of Ownership

As we mentioned earlier, CFD trading does not give traders ownership of the underlying asset. With CFD, there is no intrinsic value to the instrument itself. While this can be handy purely from a trading standpoint, it makes sense to hold on to an asset to beef up portfolios in the long term so as to not incur swap interest rates.

For instance, traders who would have held Bitcoin in the depths of the 2018 bear market, would have generated good returns from the recent recovery in the cryptocurrency market that would otherwise have been reduced from overnight financing fees associated with CFDs.

What Do Regulators Have to Say?

Due to the inherent risks with CFDs and leveraged trading in general, regulations are constantly evolving. Traders and brokers need to keep a tab on regulations to ensure that they are not caught on the wrong foot. Let’s look at some of the approaches taken by regulators across the globe:

FCA

The Financial Conduct Authority (FCA) is the regulator of UK’s financial markets and financial service firms. Its strategic objective is to ensure that regulations protect both consumers and the markets, along with boosting competition in the country.

The FCA took a hardline stance on the CFD industry initially by placing temporary restrictions. However, it has now placed caps on leverage available for CFD trading. The maximum leverage available on all financial products will be between 30:1 and 2:1, depending on the asset class.

CFD traders were expecting new rules in April 2019, but the FCA has delayed the publishing of the new rules. As things stand, the current rules are temporary and renewed every three months.