Are CFDs over the counter derivatives?
Yes, CFDs (Contracts for Difference) are over the counter (OTC) traded derivatives, meaning they are not traded on major exchanges such as the Australian Stock Exchange (ASX). Over the counter in the case of CFDs basically means that the financial instrument is traded between two parties, for example between you as the trader or speculator and your Contracts for Difference provider. So, in answer to the question are CFDs OTC derivatives, yes, in most cases they are.
An exception to this rule is the case of exchange-traded CFDs. In Australia, you have the option of using exchange-traded CFDs, which have the benefit of having standardised fees and spreads (offered through the ASX.) However, as mentioned earlier, most CFDs are offered through OTC (over the counter) means.
With over the counter, you close out your trade with the same broker that you placed it with, rather than leaving it to an open market for buyers and sellers to compete. This is the big difference between over the counter provided financial instruments and exchange traded financial instruments.
OTC transactions can definitely be more tailored to the exact need of both parties – with CFDs, this means agreements can be created that meet your trading goals specifically.
OTC (over the counter) CFDs carry inherent risks that exchange traded financial instruments do not. Also, they can offer significant leverage (though this is a risk in itself). Some of the inherent risks of OTC trading are that the transaction is private and lacks the protection of a central exchange. There is also liquidity risk and fraud risk, in that the counterparty to your Contract for Difference can abuse the market maker system (effectively counterparty risk).
With such possible risks, it’s no surprise that CFDs (Contracts for Diffference) are heavily regulated and have strict rules to comply with. In Australia this is performed by ASIC (Australian Securites and Investments Commission.) Many CFD providers are publically listed companies and as such have to be subject to the audit and due diligence requirements as such, depending where their company is registered.
Check out my article on are CFDs legal in Australia? for more information on the regulation and regulatory framework surrounding CFDs in Australia. Whatever you do, make sure you consider if the risks and rewards of contracts for difference are suitable for your needs. Check out other articles on this website for more information about Contracts for Difference.