You’ve come across Contracts for Difference (CFDs), but they sound just a bit too good to be true. So much so, you are concerned as to whether they are legal. This post sets out to demystify some of the myths and truths about CFDs. Certainly there is very volatile risk and reward available through this product type.
Yes, CFD trading is definitely legal in Australia, but as one might expect, it is heavily regulated. ASIC (Australian Securites and Investment Commission) is the relevant regulator for this market in Australia. ASIC has seven disclosure benchmarks to assess the risks in trading Over-the-Counter (OTC) Contracts for Difference. (Even though these benchmarks may help you understand the risks, they don’t actually mitigate them directly – remember there are always risks involved in CFD trading.)
Is CFD Trading taxable in Australia?
In short, yes they are, most likely as assessable income (or deductible loss). It’s a complicated subject and I extend on this answer in my article here. There is differentiation depending on if you are trading as part of carrying on a business, engaging in profit making activities or gambling.
How do I trade CFDs in Australia?
To break into the CFD market, there are many online platforms clamouring for your business. Check out this example review here of one such platform – Plus500.
Is CFD trading safe?
CFD trading is definitely risky but is legal in many countries and jurisdictions. In Australia, it is regulated by ASIC (Australian Securities and Investments Commission). It all depends what you mean by the term ‘safe’.
Definitely the leverage that is available through CFDs is massive and can lead to greater losses than the capital involved. It is not an instrument for traditional investors but the leverage can be attractive to traders.
The disclosure benchmarks are:
An OTC CFD provider needs to have a written policy setting out the minimumcriteria that an investor needs to meet before opening a CFD account. Also, they should not open an account for you if you don’t meet these criteria. Criteria may include a qualification assessment, tests, or phone interviews. A record of these assessments needs to be kept by the OTC CFD provider.
Basically a OTC CFD provider should not accept any monies that are not cash or cash equivalents. They may accept up to $1000 of other securities, anything over this and why needs to be explained in the PDS. As CFDs are already heavily leveraged products, borrowed money may increased your risks even more substantially.
Counterpart Risk – Hedging
To meet this benchmark, an OTC CFD provider must have a policy in writing describing how they manage their market risk (can be known as ‘hedging’). It’s important to know this as the CFD provider may bear a too much risk themselves, causing your risk to be increased.
Counterparty Risk – Financial Resources
OTC CFD providers should have policies on how they maintain adequate financial resources, and ow they ‘stress-test’ their ability to withstand significant market movements. If they cannot meet their obligations at any point in time, it may increase your risk as an investor.
OTC CFD providers should clearly state their policy on the use of client money, and if it is used to meet the margin or settlement requirements of another. If client money is pooled it could result in loss of funds in adverse situations.
Suspended or halted underlying assets
If trading in underlying securities such as shares has been halted, the PDS of the OTC CFD provider should clearly state their policy on if new CFD positions can be opened. Risks can be substantially increased in such situations.
A provider’s PDS should clearly state the use of CFD’s can result in losses significantly greater than your initial investment. A pre-agreed method of notification of margin call should be available before the provider closes out your positions. It’s critical you understand your providers stance on margin calls, and how they do them should be readily available information.
The above is a quick summary of the ASIC framework around how you can tell if a OTC CFD provider is offering a genuine service. I’ve included a link to this reference here.
Is CFD trading legal everywhere?
One of the interesting truths of CFD trading is that it is not legal everywhere. For example, the United States does not endorse or regulate Contracts for Difference. This post is concentrating on Contracts for Difference in Australia.
What can I do to learn how to trade CFD’s?
Do your due diligence on the CFD provider you choose, and make sure it meets all of the guidelines listed above as a minimum. Thankfully, most online CFD trading providers offer a demo or practice trading account so you can get a feel for how CFD trading works and educate yourself in the process. Typically these trials are cost and obligation free and are a great way to help you understand the process of trading Contracts for Difference. Don’t forget it’s just a trial however, and you are likely to behave differently when you have real money on the line. Also, past results are no indication of future results.
Also remember that trading CFDs is not a light undertaking in terms of the time, research and concentration that is required to trade, maintain your account and watch active trades.
Make sure you understand the PDS supplied by the CFD trading provider and always ask questions on what you do not understand. The risks, especially those of losing more capital than you put in, are real and should be respected and known.