A Contract for Difference (CFD) is a contract between two parties (the buyer and the seller) where one party commits to pay the difference between the current value of an asset and its value at contract time.
Before you enter into a Contract for Difference, it is important to read and understand the terms and conditions of that specific contract to avoid surprises.
Contracts for Difference used to be strongly associated with big institutional investors and hedge funds, but have in the 21st century also become immensely popular among retail investors. Today, many trading sites online offer CFD:s that can be purchased for a very small amount of money – and they also offer leverage.
Examples why small-scale retail traders like CFD:s
- With a CFD, you do not need to buy an entire share to gain exposure to the share price. For small-scale traders, this is especially important when it comes to high-priced shares. At the time of writing, the share price of Apple exceeds 140 USD, Tesla hovers above 810 USD, and buying just one Amazon share will cost you more than 3 255 USD.
- Even when shares do not cost much individually, making a noticeable profit from buying and selling them can require a trader to buy a large number of shares. When price fluctuations are small, many shares are required to make a substantial profit. Using Contracts for Difference makes it possible to profit from small price movements without taking on ownership of a large number of shares.
- When prices are going down, Contracts for Difference are considered both easier and less risky than short-selling.
- Brokers that offer CFD:s tend to also offer large leverage.
- CFD:s makes is very easy to speculate on non-tangible things, such as the movements of an index.
- With CFD:s, you can gain exposure to a wide range of cryptocurrencies without having to own and transfer cryptocurrency. CFD:s are available for both crypto-crypto pairs and crypto-fiat.
Contracts for Difference emerged in London in the 1990s and their creation is typically credited to the investment bank UBS Warburg, and more specifically to Brian Keeland and Jon Wood who worked at the UBS Warburg office in London. Back then, the Contracts for Difference were a type of equity swaps traded on margin.
After becoming popular among big and mid-sized traders, the CFD:s eventually trickled down to the online trading platforms utilized by small-scale retail traders. Among the pioneering companies that helped making CFD trading mainstream we find Gerrard & National Intercommodities (GNI), IG Markets and CMC Markets.
By the early 00s, CFD:s were as popular as financial spread betting in the United Kingdom. Financial spread betting had arose chiefly as a way to gain exposure to share prices without having to pay the British stamp duty on share transfers, and the CFD:s offered that same advantage to British traders. There was a big difference though: financial spread betting was considered betting, not trading or investing, and was thus not subject to capital gains tax on profits.
The UK Energy Act of 2013
One example of how well-known and accepted CFD trading has become is the UK Energy Act of 2013. The UK Energy Act of 2013 stipulates that Contracts for Difference (CFD:s) is to progressively replace the British Renewables Obligation scheme. The aim of these new CFD:s is to support new low carbon electricity generation in the United Kingdom (bot nuclear and non-nuclear).
In the new system, CFD reverse auctions are carried out to give investors the opportunity to easily invest in low carbon electricity generation. CFD:s are also agreed on a bilateral basis, such as the Hinkley Point C nuclear plant agreement.
The CFD:s fix the prices received by low carbon generation, to ensure that eligible generation will have a dependable income flow. The aim is also to reduce costs by fixing the price consumers pay for low carbon electricity.
The CFD scheme is funded by the Supplier Obligation, a levy on all UK-based licensed electricity suppliers.