How to Mitigate Counterparty Risks When Trading CFDs

In comparison to the futures market, beginning in 1710 at the Dojima Rice Exchange in Osaka, Japan, contracts for difference, or CFDs, are still very much in their infancy.

Much credit goes to UBS Warburg’s John Wood and Brian Keelan for their work with CFDs in the early 1990s initially traded among financial institutions. However, nobody could have foreseen the immense popularity CFDs have since gained, particularly among retail investors.

Retail clients can access CFDs in a number of countries, including Australia, Canada, Japan, and also in several European countries. Yet, CFD trading is not permitted in the US.

CFDs are leveraged products, financial instruments that deliver a unique and cost-effective method of trading the financial markets. A contract for difference represents an agreement between two parties to exchange the difference in value between the opening and closing price of a new CFD trade. Like all investment vehicles, though, CFD positions carry a risk – think liquidity risk, leverage risk, execution risk, and, in particular, counterparty risk.

 

Derivatives

Derivatives are financial vehicles that derive their value from the performance of an underlier, such as stocks or commodities. A derivative transaction is based on two parties, referred to as counterparties, either through an organised exchange or over-the-counter (OTC).

Counterparties in exchange-traded derivatives are the holder and the exchange, while OTC derivatives are bespoke contracts with specific terms and conditions agreed by the buyer and seller – forward contracts, swaps, foreign exchange (Forex – currency pairs) and CFDs are common OTC derivatives.

CFDs, on the face of it, appear similar to traditional investments such as stocks. However, they differ significantly as CFD contracts are based on agreements, a contract between the trader and CFD provider, meaning you never own the underlying asset. CFDs work by mirroring the price of the underlying asset.

 

Mitigating Counterparty Risk

Counterparty risk refers to the risk that a counterparty in a derivatives transaction may default, failing to meet obligations. Regarding CFDs, this is the risk the CFD provider issuing the CFD fails to meet their obligations. Counterparty risk gained prominence during the financial crisis in 2007/8, also referred to as the credit crisis or global financial crisis.

Generally, the buying and selling of CFDs do not come with trading advice – CFD traders are responsible for their initial investment and any potential losses that may occur, regardless of market conditions (market risk). Before investing in CFDs, or any investment product, therefore, educating yourself is crucial.

Before committing, traders are encouraged to research the following:

• Traders are urged to fully read the agreement between the CFD provider before opening a live trading account and executing trades. CFDs are complex financial products and are not suited to all investment styles.

• Check your chosen CFD provider is regulated. Regulatory bodies license and supervise financial institutions. Their key purpose is to ensure clients are subjected to the impartial financial practice. Well-known regulatory bodies are the Financial Conduct Authority (FCA) in the UK, Australian Securities and Investment Commission (ASIC) out of Australia, the Commodity Futures Trading Commission (CFTC), and the National Futures Association (NFA) in the United States, as well as the Cyprus Securities and Exchange Commission (CySEC).

• CFD providers (or CFD brokers) may offer trading bonuses to entice new clients. This is often a marketing strategy to entice clients to open retail investor accounts, frequently with strict terms and conditions that most traders will not read through.

• Ensure you understand the margin requirements set by your CFD provider. It is also worth understanding what happens to trading positions if held overnight. What are the commissions?

• Does the CFD provider state whether they can change or requote market prices once you place an order?

• Confirm funds are segregated. This is important. A CFD provider that faces financial difficulties with funds that are not segregated poses a risk you may lose your entire investment.

 

Why FP Markets?

• FP Markets has a risk management policy which sets out how we monitor compliance with the Australian financial services (AFS) license financial requirements.

• We do not offer introductory bonuses, only free educational material.

• We work with tight spreads and offer fast execution, usually under 40 milliseconds.

• FP Markets does not work with a dealing desk and does not requote price movements.

• In addition, FP Markets also segregates client money and conducts stress testing to ensure it holds sufficient liquid funds to withstand significant adverse market movements.