Explaining why increasing numbers of institutional firms and FX brokers are looking to trade and expand their product range with CFDs, Simon Smith, chief economist at FXPro, states that although CFDs are not a new phenomenon, having been developed in the early 1990s and employed by institutional traders since those days as an easy way to hedge against exposure in other instruments, they are now truly mainstream.
He says that: “As far as retail trading goes, CFDs started being offered in the late ‘90s, or the wild west days as they are affectionately termed in the industry. The earliest adopters of CFDs in the retail space are true pioneers and are largely responsible for the online trading industry we have today. They had to contend with forbidding barriers to entry in terms of capital, margin requirements and a user experience that was extremely far removed from what traders enjoy now. The real explosion in retail trading took place in the mid 2000s and this was the push into the mainstream that many FX businesses were hoping for.”
Smith believes that the popularity of CFDs comes down to several key points. He says the overwhelming majority of speculative traders are not interested in taking physical delivery of the instruments they trade, “but rather to profit from differences in value over time; CFDs are ideal for this”. He notes that, “this flexibility is also apparent owing to the fact that CFDs do not have expiry dates like traditional contracts, but are rolled over each day, their expiry being continually deferred until a position is closed”.
He states that: “The fact that CFDs are traded on margin allows traders to take command of very large positions that would be prohibitively expensive if they were traded outright, which is also why they were historically reserved for large institutional trading desks and high net worth individuals. Finally, CFD contracts allow traders to access all manner of underlying instruments, which is one of the main reasons why you’re seeing this push towards multi-asset brokerage in our industry. With a single margin account a trader can effectively jump between markets with a fluidity that was unheard of in previous decades.”
Increase in demand
Brandon Mulvihill MD, global head of institutional sales at FXCM PRO, observes that Retail FX and CFD traders are intraday traders, meaning they seek short term yields. He says that “the most obvious reason we see the increase in demand for CFDs relates to the increased volatility in the market and thus that potential for higher yields. US and European indices have been increasingly volatile in the past two years. DAX alone has not only been volatile over the last year but has provided such volatility during pockets of time when EURUSD was relatively flat.”
“Moreover, FX brokers’ appetite to add CFDs as a product offering also stems from increased regulatory oversight,” says Mulvihill. “Regulations in western markets have significantly increased the cost of doing business. This comes at a time when brokers have engaged in a global pricing war on FX instruments. Thus, the cost to operate a retail FX brokerage has increased just at a time when profit margins on retail FX are at an all-time low. CFDs present one way to hedge against this business risk.”
Nearly every CFD product runs on a profit margin much higher than FX while the increase in cost to offer CFDs adjacent to FX is marginal, explains Mulvihill. Of all the CFDs available, about 20 or so represent the vast majority of volume across all CFDs and to add 20 CFDs to an FX platform is not difficult, he states. Mulvihill adds: “In fact, nearly every FX platform already comes with CFD instruments available. Similarly, from a marketing standpoint, the added instruments offer a way to maximise efficiency of spend. If an FX broker is spending several million dollars a year to attract FX traders, adding CFDs provides an additional way to monetise that spend. As a result, when considering the recent volatility in US and European indices, adding CFDs to an FX offering is a no brainer.”
Jeff Grossman, Managing Director of Squared Financial comments that the CFD can be a very efficient, flexible, and powerful instrument. He explains: “It allows brokers and liquidity providers to create MiFID-regulated tradeable products derived from virtually any underlying market or combination of markets. This enables an unlimited scope for innovation, and end user driven solutions.”
Originally CFDs were exclusively OTC instruments developed to help large corporates execute market neutral or risk reducing strategies on listed securities, observes Grossman. “The real cost benefit was simple but significant as it eliminated all the overheads in physical delivery and settlement of the underlying. The big innovations were triggered when this product type gained traction with market segments that were interested in speculation as well as hedging and active on a broader range of underlying markets,” he says.
Grossman states that today, most CFD transactions still take the OTC form, but recently exchanges and MTFs have successfully entered the space. “This shows that the growth in CFDs is not just about the cost or ‘more favourable’ OTC conditions. From the smallest professional to the largest institution all CFD traders will tell you cost is a factor, but the main driver is flexibility, and more often than not that also includes convenience. Undoubtedly, the increasing sophistication of the High Net Worth (HNW) retail trader and the small capital management firm is an unseen driver here. Many of today’s sophisticated HNW traders and start up firms have worked in the industry and have significant portfolios of their own or substantial direct trading experience. These traders are now demanding the same low cost, multi asset, Direct Market Access as the institutional traders from not so long ago.”
Crucially, says Grossman, these client segments are also engaged in equally sophisticated strategies. He notes that the CFD is, “their obvious instrument of choice now and going forward this is unlikely to change”. He adds: “That is particularly so as it applies to the growing interest in copy trading systems and advanced technologies which enable clients to construct and or hedge their own portfolios across diverse asset classes.”
New trading opportunities
Meanwhile Luis Sanchez, CEO at BMFN, comments that while trading traditional stocks is still a very popular option today, and that some cultures are actually restricted to trade only them, many people are, “looking for new trading products and opportunities”. He explains: “Stocking their money in the bank without having any interesting return (and in some countries banks even offer negative interest rates,) is no longer an option. So what happens now is investors, in this search for a diversified trading option, find out about CFDs and all the opportunities they present.”
On why a CFD is attractive for investors, Sanchez says there are two main reasons; leverage and the ability to place short trades. He explains: “The use of leverage requires investors to put up less cash (margin) than they would on a similar trading transaction that involved the movement or exchange of a traditional asset. They can find at some brokers high leverage (1: 200/400) even though the higher the leverage, the higher the risk, but they also get higher returns on the opposite side. If there is no leverage, the best way to invest is via traditional investment vehicles, like in the past (deposits, mutual funds, stocks, etc.)!” He continues on short trades stating that with a broker trading CFD, you can go short without having any of complications, “and this is the beauty and simplicity and centralised approach or facility that some brokers can now, and will increasingly, offer to investors.”
Sanchez observes: “Brokers must expand their CFDs, because investors will demand more and more CFD trading products and if they want to remain competitive, their CFD offerings must become more diversified. Increasing numbers of new investors are learning what a CFD is, even in frontier markets, (such as parts of Latin America). Brokers are therefore utilising more educational materials, webinars, seminars, videos, and the like, so that their future client prospects will become more educated about using and trading CFDs.”
CFD liquidity issues
On what key liquidity issues need to be addressed in trading CFDs, and how these may vary and differ amongst client sectors, Grossman comments: “When assessing the risks of trading any particular instrument, market liquidity is always a major factor. The institutional and professional segment will always as a rule have one or more alternative liquidity sources for every instrument they trade. As we move down the chain toward retail this is less common but becoming much more frequent today. Sourcing alternative liquidity for OTC traded CFDs tends to be more complex than sourcing alternative liquidity for derivatives that are traded on exchanges or MTFs. In the latter case, fungible off exchange OTC trading is frequently available via clearing members. However, this is not the case with many CFDs which are counterparty specific pure OTC derivatives and clients need to be particularly careful in this regard.”
He warns that, “Because the CFD is so flexible many iterations based on the same underlying are not compatible and their liquidity cannot be aggregated in a straight forward manner.” He states that, “CFD traders need to ensure that they fully understand the contract specifications and trading conditions in detail, in order to arrange alternative liquidity which is on demand and compatible from a risk management perspective. And in all cases, traders especially those in the advanced retail segment need to ensure they are up to speed on the lost art of voice trading.”
Additionally, Grossman believes that all client segments need to ensure that they have a solid understanding of the underlying market and precisely how a CFDs pricing is derived and any overnight charges that apply. Accurate information on the contract’s notional size and the use of any multipliers are critical for calculations of actual leverage relative to the underlying, Grossman says. “Most Institutional and professional traders will have direct access to pricing and or trading in the underlying so these aspects can be calculated independently. Even for the advanced retail trader this type of independent verification versus the underlying is quite difficult,” he continues. “However it really is essential to foresee the liquidity and liquidity related issues which may develop. For these reasons, although the CFD can be highly efficient and cost effective, traders in the retail segment need to have advanced trading experience and dedicate significant resources to benefit from the leverage that is usually available.”
While Smith states that: “Obviously, your typical retail trader is not going to have the same liquidity requirements as an organisation does. Most of the larger retail brokers are more than able to cater to the needs of retail traders, even those with very large accounts. Now, if you’re a hedge fund or a company attempting to hedge segments of your portfolio’s exposure, or to inoculate yourself from future currency risk, not all CFD brokers are going to be able to service you at the volumes and prices you require.” He adds: “An interesting trend since the 2008 crisis, however, is that now many smaller firms with existing Prime Broker relationships are able to aggregate liquidity in ways that make it extremely cost effective, even for those trading larger volumes.”
Catching up with FX
Mulvihill says the CFD market needs to catch up with FX: “We believe that the CFD market is where FX was back in the mid 2000s. The lack of central clearing for index and commodity CFDs explains why CFD brokers are all market makers or are simply passing their flow to one market maker. In the words of my CEO Drew Niv, “all of us CFD market makers suffer from the same disease, we just treat the disease differently.” Some brokers offer a fixed spread but requote trades during times of illiquidity such as news releases. Other brokers, such as FXCM offer a no requote system, thus the spreads move dynamically with the underlying market. Either way, market making comes with trading restrictions and that means some client types are not well accommodated. Take automated traders for example. An automated trader in retail FX has a plethora of choices regarding APIs, platforms, charting packages, and historical data. In contrast, an automated trader in CFDs has extremely limited choices and in fact, there are more brokers not offering an API for CFD trading than there are those who do.”
Restrictions exist in CFDs predominately because, “each broker is offering a price that is good for a quantity known as the maximum contract size”, notes Mulvihill. He says this quantity is normally a multiple higher than what is available on the underlying exchange. For example, a CFD broker may offer a price on GER30 (or some other abbreviation for DAX) similar to the EUREX DAX price. At the same time however, this broker will allow upwards of 3,000 contracts available at this price whereas the underlying exchange is offering only 500 contracts, says Mulvihill, who adds: “Obviously, this presents a risk so brokers utilise restrictive tools such as re-quotes, or manual intervention to mitigate their risk. Some client segments, due to their inherent style of trading, cannot trade effectively with these restrictions in place.” On the latter point, he refers to automated traders, latency arbitrage, and large ticket sizes, all of which create risk for CFD brokers.
He adds: “A market maker’s primary role is to net customer trades so as to generate a profit with as little risk as possible. Thus, a broker ideally wants customers buying and customers selling the same instrument so that their book remains flat. When this occurs the broker does not have to place a ‘hedged’ trade in the market. Hedging costs money as the broker pays the inherent spread. As a very generalised rule of thumb, the more a broker has to hedge, the higher their trading costs, and subsequently the lower their profits.”
Concluding on the issue of liquidity, Nenad Naumovic, BMFN chief dealer, comments that: “CFDs are traded Over The Counter (OTC) and that makes it difficult to determine who has the best liquidity. Thanks to today’s technology the CFD market is one of the most liquid in the world, even though it is not traded on a centralised exchange. Most FCMs have a relationship with the biggest liquidity providers so it’s not unusual if the customer uses different brokers but still trades with the same banks.”
Due to this OTC nature he says that it is difficult to define the real liquidity and states that “Liquidity for each CFD is different. Liquidity for DAX 30 CFD is much smaller than liquidity for Gold CFD due to the trading volume of these respective CFDs. The best indicator of liquidity and spread is the average daily volume. Instruments with lower volume usually have higher percentage moves due to the lack of liquidity.”
“If you are looking for a more conservative approach, trade CFDs that have a higher average daily volume, which will insure better trading conditions and much better spread,” he recommends.
Platform choices today are a dime a dozen, says Mulvihill. This offers little edge to an institutional partner, he notes, adding, “the edge lies in innovation at the liquidity and execution level; having said that I can agree that this point is not yet necessarily accepted unanimously”.
He comments that: “Every tier one retail broker offers a white label version, including FXCM, Saxo Bank, IG, and Gain Capital to name a few. Independent platforms such as MT4, PF Soft, and C Trader can accommodate CFDs. We are even seeing a pick up in traditional FX aggregators now accommodating CFDs, such as Flextrade and First Derivatives.” Yet he adds that, “very few platform enhancements are unique these days.”
Mulvihill says that while until about 2010 most brokers white labelled a proprietary platform from a tier one provider, now in Spain, Portugal, France, Germany, and the UK, institutional momentum has, “shifted drastically in favour of institutions building their own platforms or buying a third party platform, versus white labelling a competing brokers’ platform”. He notes that, “at FXCM for example, we have received about 15 times more requests for distribution of CFDs via API than we have for a white label product”. However, he says that: “Accessing CFDs via an API is an awfully revealing story. If you were to take the top 10 FX/CFDs brokers (sans Japan) in 2014, you would find that less than half offered CFD trading via an API. Once again, we arrive at the fundamental challenge in CFDs, the execution model behind them.”
He goes on to say that, “Automated traders or anonymous traders who trade via a single API connection within an Omnibus account present significant risk to CFD brokers. This type of trading is generally not welcome for the simple reason that CFD brokers struggle to monetise this business, or worse off lose money altogether. In the past 18 months, IG and CMC have finally launched an API, while Gain Capital went public, citing they are no longer accepting Omnibus partners. This paradox reveals a simple truth; there exists conflicting interests between the style of trading an API promotes, and the execution model on offer by principle, market making brokers. Therefore, as institutions demand API access versus traditional white labels you can rest assured this story line is not going away anytime soon.”
More trading options
Today brokers must offer multiple trading options for their clients. The old fashion trading style is gone and no longer valid, states Sanchez who says that: “We are in a fast and constantly changing world, where the brokers that quickly adapt to new environments and needs will be the only ones that will survive and succeed. And these new needs and demands are coming from clients within entirely different markets; Asia has a different demand than Latin America and Europe, but all have the same common demands of technology and simplicity.” Sanchez states that multiple trading solutions that need to be deployed include desktop, web, mobile and white label.
On white label solutions, Sanchez notes that this, “allows traders to use a broker’s technology within another broker”. He continues: “For example, BMFN holds a unique technology called Unitrader that we white label to many brokers, facilitating the entire trading process for them. Remember there are hundreds of brokers in the world but only a few that have their own proprietary trading platform and solutions.”
Firms looking to enter the CFD trading space have all manner of options open to them, says Smith who notes that whereas historically a Prime Broker relationship was required in order to source liquidity, “this has changed in the wake of the last financial crisis as the big banks became more risk averse and started making it more difficult for newcomers to meet their criteria”.
Smith continues saying that: “Today there are many lower tier institutions able to offer sound liquidity solutions, as well as Prime-of-Primes (PoPs) who have sufficient capital behind them and existing liquidity relationships with the big boys to service the needs of smaller start up brokerages. Many of these PoPs are also able to white label their platforms, be they desktop, mobile or web, as well as providing consulting services to help new brokers ensure they have all their bases covered before entering the market.”
Looking ahead towards new CFD product offerings and more advanced functionality Smith comments that algorithmic trading has yet to make the impact many were predicting a decade ago. “The explosion of HFT use on exchanges is a different story as those algorithms play a different game for different ends. Algo trading in the retail space has hit several hurdles, mostly due to the fact that programming algorithms is an extremely specialised skill that requires all of the trading chops we associate with seasoned veterans, as well as the ability to turn those chops into something a computer can understand and execute without human intervention. At FxPro we launched Quant, one of the first algorithmic strategy-building platforms for retail traders, which does not require the use of a scripting language, but rather, allows traders to formalise their trading strategies in a visual way, by connecting different technical indicators and mathematical functions in a drag and drop interface.” He continues by stating that, “It’s an extremely powerful product that has been very well received, but even in this much more user friendly guise, most traders are still going to find it challenging to turn their trading hunches into something more formal. There is an enormous amount of potential here though, and I think it’s just a matter of time before more and more traders start experimenting with these things. There are already a number of very vibrant algo trading communities out there; I just think we haven’t hit that wider mainstream adoption yet.”
Whilst Mulvihill says that FXCM is constantly innovating. “At FXCM, our single largest initiative is what we dubbed ‘enhanced CFDs’. This initiative focuses on how we both price and execute customer orders. Our quest to offer an enhanced CFD is a quest to aggregate prices and execute trades against a best bid offer system, the way we have done in FX. This is no easy task and requires many steps to reach our ultimate goal, but we have taken step one, which has been to license pricing and execution from a high frequency market maker.”
“Today, every broker offering CFDs suffers from a singular point. Their market data is slow. As a result, CFD brokers offering an API are subject to being “picked off”, which is one of many reasons why those brokers invoke trading restrictions. In contrast, we have found that the HFT market making community has the technology resources to be faster than the fastest retail customer. As a result, we can price API users without the fear of latency arbitrage users picking us off, an advantage nearly no other retail broker offers. In turn, this has allowed us to offer a CFD product with ‘no trading restrictions’. While this is just step one, it is a monumental step to take in a world that has not advanced even this far since its inception nearly 16 years ago,” concludes Mulvihill.