The long and short on 'contracts for difference'

FEW investors here have yet to encounter 'contracts for difference' (CFD), but they are one of the hottest financial products around in markets like London.

By some estimates, CFDs now account for about one-third of all share trading activities in Britain.

They have attracted keen interest here as well, despite the sluggish stock market conditions.

One CFD provider, IG Markets, says the number of new accounts it attracts has doubled every year since it set up shop here four years ago. It currently has about 12,500 accounts.

CFDs are essentially 'bets' between a trader and the investment bank that sells him the contract, and they are not traded on the Singapore Exchange (SGX).

The biggest attraction of a CFD is that it works like a share margin trading account.

When a trader buys a CFD on a blue chip like DBS Group Holdings, he needs to put up only 10 per cent of the costs of owning the stock.

The CFD price then tracks the stock movements. If the price rises by 10 per cent, the trader doubles his initial outlay.

But if the price drops, he will have to top up the account with more cash or risk having his CFD sold to settle the loss.

One attraction is the lower trading cost, compared with stock transactions. A trader pays a 0.2 per cent commission on the face value of the contract and saves on clearing fees, since his CFD trade is not cleared by the SGX.

CFDs allow traders to build both 'long' and 'short' positions. If a trader thinks a certain stock is going to rise, he can 'go long' by buying the CFD. Likewise, if he believes the stock may fall, he can 'short' by selling the CFD.

Unlike a covered warrant - which offers an option to buy into a stock at a fraction of the costs - a CFD has no maturity date.

This means a trader can keep his CFD position open as long as he pays a finance charge, and tops up the margin if the value of the contract drops.

Besides shares, a CFD allows an investor to trade foreign currencies, commodities such as crude oil, and stock indexes like The Straits Times Index.

So it is no surprise to find lots of players - local houses like Phillip Securities and foreign outfits such as IG Markets - jostling for a slice of the action.

But there is no way to gauge traders' interest in the CFD market. The market is fragmented among a dozen or so players and data like daily CFD turnover is not disclosed publicly.

In February last year, the SGX launched a product - the extended settlement (ES) contract - which works in a similar way as CFDs. In the seven months since its launch, only about $103 million worth of ES contracts have been traded. This is a tiny amount compared to the average value of $1.46 billion worth of stocks traded daily last year.

Market observers say stiff competition from CFDs is one reason for the lacklustre interest in ES contracts.

'A brokerage would rather promote to its clients the CFDs it offers than the ES contracts,' one trader said.

It is worthwhile highlighting some differences between ES contracts and CFDs.

In trading CFDs, a trader should consider the counterparty risks involved. If the investment bank or brokerage at the other side of the contract goes bust, a trader's CFD is worthless.

CFD issuers argue that since they are required to put clients' money into a separate bank account, such a risk is minimised.

Still, considering the spectacular collapse of giant investment banks such as Lehman Brothers and Bear Stearns - which were far bigger than any of the CFD players here - traders should be aware of the counterparty risks involved.

Trading ES contracts on the SGX offers better protection. As the SGX is an established clearing house with a central counterparty facility, it is in a far better position to manage any counterparty risks involved in trading stock derivatives.SIT to offer industry-focused Degree Programmes to Poly Grads

The other big problem is the risk which unhedged CFDs pose to the rest of the market.

Some CFD issuers assure traders that all their outstanding CFD positions are fully hedged. This means that each time a trader buys a CFD, the issuer will immediately buy the underlying stock to hedge its position.

But doubts persist.

'If a CFD issuer hedges all its positions, it will have little profit to speak of. It makes the big bucks by taking the bet against you when you open a CFD contract,' one trader noted.

CFDs remind some brokers of a highly popular stock derivative known as 'delayed settlement contracts', which were highly popular here before the collapse of fridge maker Pan-Electric in 1985.

'Twenty-five years dims many memories and even heals wounds,' recalls retired stockbroker Narayana Narayana, 82.

But the massive fraud linked to the trading of such contracts triggered a crisis which was so serious that it caused an unprecedented three-day closure of the local bourse and sent five brokerages belly-up.

While the probability of a crisis caused by over-trading of CFDs is remote, the global financial crisis has taught us that we should leave nothing to chance.

What is needed is a central clearing house for CFDs to minimise the counterparty risks and prevent an implosion in unhedged CFD positions causing grief to the local bourse.

Perhaps, the SGX would like to explore the possibility of extending its clearing house facilities to the CFD market.

Paying a small clearing fee may add to the trading costs of the CFD trader but it sure makes the market rest easy, knowing that a risk has been licked.

So...one of the way to get around this counter-party risk is to open an account for DMA_CFD at MF Global. And being a Direct Market Access system...it is clear thru the central clearing house SGX. Understand Interactive Broker has a pretty good commission thingy of 0.08% vs 0.35% ( MFG ) for HK market trades and I will be considering to fund an account with them soon for that purposes as I traded quite often and paying about near to 5 figures every month for the past few months to MF Global.