Contracts for Difference (CFDs) are a relatively new derivative “product” in the financial market place. You can get a better understanding of what they are and how best to trade them by getting some idea of the place that CFDs, hold and the financial world they are part of.
A financial system consists of an intricate network of markets and institutions that facilitate the flow of funds between the various sectors of the economy. This flow of funds can take many forms, including money, financial assets and securities (both debt and equity). CFDs, being a derivative are part of the securities/financial market.
Primary and secondary markets
The term “primary market” refers to the new issue of securities such as a company offering shares or the government offering bonds. The term “secondary market” refers to the subsequent buying and selling of securities, i.e. traded. Where there is a significant number of active buyers and sellers in a market, that market is regarded as a deep market. This offers the trader the benefit of liquidity, i.e. they are able to liquidate, sell, without undue delays.
Within the financial system there are numerous market participants who facilitate the flow of funds between the various sectors of the economy. These participants can be broadly classified into borrowers and lenders, capital raisers and investors. The participants interact through the financial markets and generally have intermediaries to assist them.
An economy is made up of a number of sectors, each owning, producing or purchasing the resources, goods and services flowing through the system. These sectors include the following:
Producers of goods and services
Federal, state local and semi-government institutions
Finance sector including financial intermediaries such as share markets and CFD providers
The economy and money flows
The finance and investment industry is continually evolving as technology and trends influence markets and change the way businesses operate. The best way to keep abreast of everything is to read current financial material, including newspapers and finance magazines. The Australian Financial Review, business magazines and the business sectors of state newspapers all contain a large amount of investment information. Websites also provide current market updates.
History of CFDs
Contracts for Difference (CFDs) have been used in the UK stock market for a number of years,(Equity Swaps) mainly by institutions seeking to extract the performance of a stock rather than owning the actual share itself.
The application of CFDs first became widespread in the UK equity market in the early 1990s, the driving force being a requirement by non market-makers to be able to short (selling to open) stock.
At that time only market makers, most of whom were integrated within big investment banks were able to do this. So the investment banks became natural CFD providers, while typical users included hedge funds, arbitrageurs and funds pursuing market-neutral strategies. As no actual stock transfer took place no stamp duty was payable on these transactions and demand evolved to encompass long contracts as well as short. Although CFDs confer no ownership rights such as a shareholder vote, they do reflect the full performance of the stock including dividends and corporate actions such as share splits and for many users (including short-term traders) these are the features that are paramount.
With the introduction of the SETs (electronic trading system) system to the UK market in 1997, stamp duty exemption was widened to recognised liquidity providers who were members of the Stock Exchange and it is these members who now provide the retail CFD product.