The Rise of CFDs and Spread Bets

by Mike Estrey

The rise of contracts for differences and financial spread betting over the last decade has naturally impacted on the extent of trading in physical shares using a traditional stockbroker. There is no doubt, whatsoever, that the internet has altered the share trading process to the advantage of private investors in terms of cost and ease of access to market information, and this coupled with broadband and efficient streaming makes for a big boost for those looking to capture small real-time movements using online trading.

Originally, what now appears to be a very cumbersome system, trading involved phoning a broker with the client having to wait for a dealing report from the stock broker, and this would be followed up with a paper based settlement and certification system. The advent of nominee accounts and the crest settlement system helped to simply the process, and in terms of stock market deals carried out for investment purposes, rather than trading, the system still works well.

But for stock market traders, this reduction in certification has gone hand in hand with the biggest shift in the financial industry, the explosive growth of CFDs and financial spread betting, which have in practice have three major benefits over traditional share dealing.

First and foremost, there is no stamp duty to pay under current tax legislation which means an immediate saving of 0.5% on UK based stock market dealings. This is because with a CFD, the trader is simply agreeing to pay the difference between the open and closing price of an instrument. Delivery never materialises and there is no definite expiry date on the CFD - therefore there is no stamp duty. On the other hand, spread bet are treated as bets so are likewise not subject to stamp duty.

Secondly, clients are able to go long (profit from rising prices) or short (profit from falling prices) on the underlying stock, commodity or index. Being able to profit from a falling asset price is an additional benefit that many stockbrokers still disallow, and is useful both as a speculative mechanism and for hedging share portfolios. CFDs and spread bets offer an effective and straightforward way to protect against adverse price movements in the stock market, without having to sell stocks in a portfolio and then having to buy them back.

Thirdly, traders are often able to utilise generous margin rates, which by using gearing, enable large trade sizes to be entered into using a relatively small capital outlay. It goes without saying that this cuts both ways and there is a level of risk which mirrors the amount of leverage, but for advanced traders this to some extent bears some similarity to traditional physical trading for extended settlement. For CFD traders, margin rates of as low as 1% are possible, which again is very attractive from a hedging perspective.

For traditional share trading it is normal for investors to place funds on margin, but positions still have to be closed within the trade settlement period, or the full cost of the shares purchase has to be borne. The investor usually pays an extra premium for not having to settle for up to 25 working days. But even here, the extended settlement option is not offered by all stock brokers, and contracts for difference solve this problem, as they have no time limit, which makes them much more flexible. Spread bets can also be taken out with a wide range of expiry dates - so again it increases the choice for clients.

Given these benefits, and the perceived cost advantages it makes you wonder why clients would still wish to make use of a traditional stock broker at all. The answer of course lies in the extra value services offered by a stock broker, which include portfolio analysis and management, advisory and taxation services as well as other financial products. For clients with a longer term perspective on investments, and for buying and selling shares on a longer term horizon, stockbrokers will continue playing an important role. Moreover, buying securities outright provides investors with the benefit of shareholder voting rights, which is not the case for CFDs and spread betting contracts, although holders of long CFD positions are still eligible to receive corporate dividends, and short CFD positions are debited with dividend amounts on the ex-dividend date.

It is for day trading and longer term hedging that CFDs and spread bets have a definite edge, and both instruments are cost-effective from a trader's perspective. This benefit can be quantified in terms of the period of time each trade is open.

With contracts for difference, the extra cost of holding a long CFD trade over a traditional purchase is the financing cost (i.e. interest). The interest incurred on a long CFD trade is usually at a premium to LIBOR (London Interbank Offered Rate), typically LIBOR plus 2.5%, but it should be noted that if a client takes a short position, then interest is actually credited to the CFD position at a comparative discount to LIBOR. The amount the investor lodges in terms of margin is held as a guarantee and is not available to be set off against the contract value.

It is worth noting that a conventional shares purchase incurs stamp duty at 0.5%. The crossover will happen at the time that the interest charged on the long CFD matches the savings made against stamp duty, and this point is usually reached on or around 30 days after the position is opened (however in practice with the prevailing low interest rates this period can be extended to 3 months or more). Consequently, for stock market trades held for lesser periods it makes economical sense to hold the CFD or spread bet position rather than buy the underlying stock outright. For traders going short of a stock or index, there may be extra benefits as interest is received on a daily basis while the position is left open, so time is not a factor (although again with the current very low interest rates no providers will pay on short positions).