CFDs: Why are exchanges warning investors about them?

The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) in a statement on August 23 said that it has come to their notice that certain unregulated platforms were offering unregulated derivative investment products called Contracts for Difference (CFDs) and Binary Options.

The NSE’s statement read, “Investors falling prey to the promises of high/ exorbitant returns by these websites/platforms may eventually lose money heavily. Hence, investors are advised to refrain from dealing/investing in unregulated products such as Contracts for Difference (CFDs) / Binary Options offered by such unregulated internet-based trading platforms.”

The NSE accounts for India’s largest derivative trading volumes.

So, what are CFDs?

In a CFD, investors don’t hold the actual investment in the underlying asset, but enter into a contract with the CFD broker. The CFD broker buys the asset on behalf of the investor. Depending upon the difference between the opening and closing price of the asset when the CFD is opened and closed, the investor profits or incurs losses on such transactions.

Investors are required to pay up an initial margin for such transactions and also pay a certain interest to the broker, as the latter purchases the asset on behalf of the investor. Essentially, the broker is funding the investment.

While it sounds good that the broker buys the asset for the investor, remember, the investor is in a private financial contract with the broker. There is no regulatory oversight. Such contracts are also called over-the-counter (OTC) contracts, as these transactions are not executed on recognised exchanges.

“The biggest risk of trading CFD is that it is an OTC product and that there is no exchange or clearing corporation involved. If the CFD platform goes bankrupt or rogue – so will all your positions and cash lying with them with little legal recourse,” said Nithin Kamath, founder of Zerodha -- India’s largest brokerage -- in a note.

Low to almost zero trading costs add to the attractiveness of such platforms. Investors are also lured by the notion of getting access to international markets and assets, which otherwise may be restricted or limited.

How a CFD fraud might take place?

A CFD broker might not actually buy the underlying asset. At the same time, it would allow the investors to take much larger positions with higher leverage (i.e. borrowing funds from the broker).

Now, even with a small change in price against your position, it would be difficult for you to hold the position due to the high leverage involved. Any move against the position can quickly force the investor out of the position.

In his note, Kamath pointed out that there have been allegations against several CFD brokers for “rigging market prices on their platforms against the customers for a fraction of a second to cause enough loss, so the customer is forced out of the position.”