Where are CFD's traded and what are the pros and cons when compared to exchange traded derivatives?

Contracts for difference (CFD) are financial derivative products that are traded “Over the Counter.” They are very similar to exchange traded derivatives where you can speculate on rising or falling prices on securities such as equities, commodities, currencies, indices and treasuries etc. Since CFD’s are OTC products, they are bilateral contracts between a client and a broker where the client places bets on securities without owning the underlying asset, although prices closely track the value of the asset traded on an exchange. Since CFD brokers generally act as market makers, they hedge their risk by placing trades on the underlying asset traded on the corresponding exchange.

Example: If a client purchases 1000 CFD’s in Boeing, the broker will simultaneously hedge his short risk by purchasing an identical number of shares on the New York Stock Exchange where shares of Boeing (BA) are traded.

CFD’s are often compared to futures contracts traded on an exchange. Although there are quite a few positives, the negatives of CFD trading outsize the pros, atleast in the current regulatory environment. Highlighted below are some of the key pros and cons of trading in CFD’s

Pros-

  • Easy access to global markets from a single platform.
  • CFD’s are highly leveraged products with margins as low as 2 percent for certain securities, beneficial to small clients.
  • Brokerage is either nil or very small, CFD’s brokers mostly earn form the spreads.
  • Rules are very flexible when it comes to day trading and going short.
  • No limits or restrictions on the minimum initial margins or maximum position size.
  • The trading platforms offered by CFD’s brokers support multiple order types, similar to brokers in exchange traded markets.

Cons-

  • CFD markets are not highly regulated, unlike exchanges. While an exchange acts as an intermediary in the event of a dispute between clients and brokers, CFD markets have high counterparty risks.
  • Possibility of execution risk during sharp moves in the underlying due to time lag in CFD’s.
  • The bid-ask spreads in CFD’s are much higher when compared to exchange traded derivatives, which is a major disadvantage when prices are moving in a tight range.
  • The high leverage offered by CFD’s will magnify losses in volatile markets and wipe out all the margins from the client account.