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Contract for difference (CFD)
European Union Electricity Market Glossary

  

Financial contract for difference (CFD) is a derivative product that gives the holder an economic exposure, which can be long or short, to the difference between the price of an underlying asset at the start of the contract and the price when the contract is closed (characteristics used, for example, by ESMA in the Addendum Consultation Paper, MiFID II/MiFIR of 18 February 2015, ESMA/2015/319).

 

According to the Notice of 22 May 2018 of ESMA’s Product Intervention Decisions in relation to contracts for differences and binary options (ESMA35-43-113) CFD is a derivative other than an option, future, swap or forward rate agreement, the purpose of which is to give the holder a long or short exposure to fluctuations in the price, level or value of an underlying, irrespective of whether it is traded on a trading venue, and that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event.

 

Economically, a CFD is an agreement between a buyer and a seller to exchange the difference between the current price of an underlying asset and its price when the contract is closed.

 

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ESMA’s product intervention measures in relation to CFDs and binary options offered to retail investors, 27 March 2018, ESMA71-98-125, p. 3

 

 

What are CFDs?

 

- CFDs are complex financial instruments, often offered through online platforms. They are a form of derivative trading.

 

- CFD trading enables you to speculate on the rise or fall of the price, level or value of an underlying, including such asset classes as currencies, indices, commodities, shares and government bonds. You do not need to own the underlying asset.

 

- CFDs are typically offered with leverage which means you only need to put down a portion of the investment’s total value. However, financing costs and transaction costs (such as bid-ask spreads) are typically based on the investment’s total value.

 

- Leverage also multiplies the impact of price changes on both profits and losses. This means you can lose money very rapidly. Leverage can contribute to losses being so rapid that people have ended up owing large sums of money to the product provider.

 

- A recent market event underscoring the importance of a Negative Balance Protection was when the Euro fell suddenly and dramatically against the Swiss Franc in January 2015. As a result of this event, in the absence of Negative Balance Protection, some retail investors ended up owing very large sums of money to providers, often much more money than the investors could afford.

 

 

From this point of view, CFDs can be perceived as flexible financial derivatives, suitable to give exposure to a variety of different underlying instruments: shares, currencies, commodities, indices, etc.

 

Broadly, there are the following CFD classes, defined at the type of underlying level: i. equity; ii. bond; iii. futures on equity; iv. option on equity; v. commodity; and vi. currency (FX).

 

CFDs having an equity instrument as underlying represent around 72% of the notional amount traded, followed by contracts on currencies.

 

CFDs are listed as financial instruments in the Annex I, Section C(9) of MiFID II (which means no change to status quo established under MiFID I).

  

CFDs are mostly, if not exclusively traded OTC.

 

In general, such instruments offer exposure to the markets while requiring to only put down a small margin (‘deposit’) of the total value of the trade.

 

The above mechanism allows investors to take advantage of prices moving up (by taking ‘long positions’) or prices moving down (by taking ‘short positions’) on underlying assets (if an investor speculates on the price of a given commodity going up, a CFD provider, who acts as the contractual party in this CFD and does not hedge against market risk, speculates on the price of this commodity going down).

 

When the contract is closed the investor will receive or pay the difference between the closing value and the opening value of the CFD and/or the underlying asset(s).

 

If the difference is positive, the CFD provider pays the investor, in turn, if the difference is negative, the investor must pay the CFD provider.

 

CFDs might seem similar to mainstream investments such as shares, but they are very different as the investors never actually buy, trade or own the asset underlying the CFD.

 

On 28 February 2013 the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) issued warning for investors in CFDs underlining the risks involved wiith everaged products.

 

In the said document regulators recommend that investors trading in CFDs carefully analyse the following:

- the costs of trading CFDs with the CFD provider,
- whether the CFD provider will disclose the margins it makes on the trades,
- how the prices of the CFDs are determined by the CFD provider,
- what happens if the position is held open overnight,
- whether the CFD provider can change or re-quote the price of an order,
- whether the CFD provider executes orders even if the underlying market is closed,
- whether there is an investor or deposit protection scheme in place in the event of counterparty or client asset issues.

 

Also the German financial regulator BaFin in its comments of 8 May 2017 underlines that in CFDs:

- the client's risk of loss is not limited to a particular margin payment but instead may encompass the entirety of the client's assets,

- if the clients’ loss exceeds the balance on their account for the purpose of CFD trading, they must pay for the loss from their other assets (additional payments obligation).

 

According to the BaFin, German legislators treat CFDs as a subgroup of derivatives.

 

In the said notes of 8 May 2017 BaFin also refers to the US example, where, similarly to Europe, CFDs are not traded on the stock exchange, however, in the US:

 

- over-the-counter CFD trading is prohibited for retail clients unless the investor has a minimum investment capital of USD 10 million or USD 5 million solely for hedging purposes in CFD trading;


- for other products which are economically similar to a CFD with a currency pair as the underlying asset (e.g. leveraged forex products), a leverage limit of 50 applies;


- on behalf of the Commodity Futures Trading Commission (CFTC), the National Futures Association (NFA) has additionally limited the permissible leverage for forex products with particularly volatile underlying assets to 20.

 

 

CFDs costs

 


The main CFDs’ cost may potentially be the loss incurred on the contract.

 

Moreover, CFDs’ providers charge commissions, which can take the form of a general commission or a commission charged on each trade (i.e. on opening and closing a contract).


Additional costs related to CFDs’ trading may also include:

 

- bid-offer spreads,

 

- daily and overnight financing costs,

 

- account management fees, and

 

- taxes (depending on the jurisdiction in which you and the CFD provider operate). 

 

There is the need for careful analysis of the respective offer as the costs linked to transactions in CFDs can be complex to calculate and, in principle, may outweigh the gross profits from a trade.

 

 

 

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Key support elements of RES in Europe: moving towards market integration, CEER report, C15-SDE-49-03, 26 January 2016, p. 38 - 40

 

 

Case study on the "Contract for Difference" scheme in the UK

 

The Contract for Difference (CfD) renewable support scheme is one of three major policy interventions introduced under the Electricity Market Reform (EMR) under the Energy Act 2013. It aims to overcome the limitations of the RO (discussed in section 2) by achieving the following:

 

- provide greater revenue certainty to investors of RES generation;

 

- reduce the borrowing costs of financing RES generation projects; and

 

- encourage competition both within and between generation technologies to deliver cost-efficient RES capacity and improve the affordability of low carbon energy to consumers.

 

Basic functionality of the CfD scheme

 

The CfD scheme places an obligation for RES generators to sell electricity. The CfD acts as a contractual agreement between the generator and a Government owned counterparty - the Low Carbon Contracts Company (LCCC). This agreement guarantees that the generator will be paid a set price, 'the strike price', for each unit of electricity produced for the duration of the agreement (15 years). RES generators bid the strike price they are willing to receive for a specified capacity (MW) in a competitive auction. Funding is awarded to RES generators based on these bids, with cheapest strike price bids always accepted first. Once the successful bidders sign their CfD agreement, they have one year to provide evidence of substantial commitment to investment in a project, or the contract will be cancelled and the funding recycled. Once projects are operational, CfD holders have two main sources of revenue from RES generation:

 

- Direct revenue from electricity: In the short term, the generator will gain revenues from electricity sold in the wholesale market; and

 

- Compensation from CfD: Typically, the strike price will be set at a higher price than the average market price for electricity. This 'premium' allows generators to recover the additional costs generally associated with RES technologies. When the strike price is higher than the 'reference price' – a measure of the average electricity price in the GB wholesale market - the generator is compensated the difference.

 

RES generators under the CfD scheme will be subject to the same standard balancing responsibilities as defined by UK national regulation, i.e. they are responsible for settlement costs associated with deviations from their delivery commitments.

 

Key lessons learnt

 

As of December 2015, none of the successful projects have started generating. Therefore, only the following indicative lessons learnt can be drawn:

 

- Value for money: Strike prices established by the first auction cleared at a level significantly lower (on average 17% lower) than the administrative strike price, for almost all RES technologies, in all years. The administrative strike price, set by Government was determined to be a 'fair' return on investment should the competitive auction not result in a cleared strike price. This provides early evidence that the auction process is delivering better value for consumers, whilst still supporting new RES projects.

 

- Transparency: For the first time in any GB renewable support mechanism, the CfD auction provided advance prices of RES technologies made available in the public domain. This process has revealed industry determinations of the actual costs of providing RES, for a large number of RES technologies. This level of transparency on the cost of RES generation has been missing from previous schemes, and should help to inform better auction design in the coming years of the CfD scheme.

 

- Technology competition: Onshore wind dominated the CfDs in the Pot for established technologies, with offshore wind dominating the Pot for less-established technologies. The auctioning process balances the need for cost effective support schemes for RES generation, whilst recognising that less-established technologies will need further support. The domination of wind projects in both pots may mean that other technologies may find it hard to compete for funding through the CfD scheme, leading to a convergence of new capacity to a small number of generation technologies (ie the most efficient technologies in each Pot.

 

 

 

 

 

 

 

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    Documentation    

 

 

 

 

 

ESMA to renew restriction on CFDs for a further three months, 28 September 2018, ESMA71-99-1041

 

Questions and Answers Relating to the provision of CFDs and other speculative products to retail investors under MiFID, 31 March 2017, ESMA35-36-794

 

Questions and Answers on ESMA’s temporary product intervention measures on the marketing, distribution or sale of CFDs and Binary options to retail clients, 28 September 2018, ESMA35-36-1262

 

Notice of ESMA’s Product Intervention Decisions in relation to contracts for differences and binary options, 22 May 2018, ESMA35-43-1135

 

ESMA’s product intervention measures in relation to CFDs and binary options offered to retail investors, 27 March 2018, ESMA71-98-125, p. 3

 

ESMA's Addendum Consultation Paper MiFID II/MiFIR of 18 February 2015, ESMA/2015/319

 

Key support elements of RES in Europe: moving towards market integration, CEER report, C15-SDE-49-03, 26 January 2016, p. 38 - 40 

 

Investor warning, Contracts for difference (CFDs), ESMA, EBA, 28 February 2013

 

 

 

 

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    Links    

 

 

 

 

 

Electricity Market Reform: Contracts for Difference

 

Feed-in Tariff with Contracts for Difference: Operational Framework, DECC, November 2012

 

Feed-in tariff with contracts for difference: draft operational framework

 

BaFin, Guidance notice on the general administrative act of 8 May 2017 regarding contracts for difference (CFDs)

 

BaFin, General Administrative Act regarding CFDs, 8 May 2017

 

 

 

 

 

 

 

 

 

Last Updated on Saturday, 20 October 2018 09:58
 

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