Weaknesses of CFDs

We know they are useful, but what are the weaknesses of CFDs

Contracts for difference (CFDs) were introduced to the retail market in Australia about 6 years ago. At that stage two providers, CMC and IG markets, were the only choice for most traders. CFDs rapidly replaced Exchange Traded Options as the most popular derivative, offering high leverage on the commonly traded stocks. They are now offered by a multitude of providers over an increasing range of stocks. The time and money CFD providers have spent (advertising and) developing user-friendly platforms that make them easier to trade have made many traders feel comfortable utilising them in their trading strategies.

Despite their widespread usage and acceptance and the positives that they have bought to derivatives trading in Australia, it is crucial that anybody who trades derivatives understands that there are some weaknesses with CFDs. We will examine these today.

They were developed in the UK - The UK has particular tax situations that are not applicable in Australia and most importantly, there are no franking credits in the UK, so if you hold a CFD in Australia the franking credit is not applicable to you.
CFDs are an 'Over The Counter' (OTC) derivative - This means that the contract is between the trader and the CFD provider. This is different to shares that are traded on an exchange as the CFD trader does not own the stock. These contracts are written by the providers and ultimately favour the provider to the detriment of the trader. For example; many CFD providers will have vague conditions on entry and exit prices, some terms that we have read even state that the provider is able to lump together stop losses from individual traders into a single order and give an average price to everybody. The CFD provider is acting as a financial spread better. Additionally, there is no protection afforded to the trader if the CFD provider goes out of business due to poor management. As most providers have 'pooled' trading funds your money may be lost along with everybody elses.
Prices 'aint prices - We constantly highlight the difference between Direct market access and market makers. We have become increasingly aware that certain CFD providers are muddying the waters, claiming direct market access when they deliver a hybrid product, or attach other terms such as 'average' stop loss prices as detailed above. Make sure you read and understand the terms and conditions from your prospective CFD provider.
Interest payable on the whole transaction - Unlike marging lending (or any shares gearing) the CFD trader is paying interest on the total transaction amount, regardless of the margin that they have contributed. Interest cannot be prepaid so tax management is not as easy as margin lending.
Inflexible leverage levels - The CFD provider sets the leverage (margin) level applicable to each stock. The trader has to accept this level and try and formulate risk management strategies around the level. This leverage level can be amended as the provider sees fit, therefore if the CFD provider increases the margin required mid-trade the trader has to contribute more money (margin) to the transaction to avoid being closed out.
CFDs are restricted to around 600 ASX shares - Although the CFD trader is able to trade on far more shares than the Options or Warrants trader there are still many shares that are unavailable.
CFDs for Index, currency and commodity trading - CFDs seem to offer an easy path into trading commodities, currency and indices. However, it is important that the trader is aware of exactly what they are trading. For example, whilst the ASX200 index (XJO) is used as the benchmark index for Australian shares there is no CFD provider that offers the XJO index. They can claim to be 'based' upon the index levels, but at 100 to 1 leverage, this can be far too much difference and leverage for an average trader. This also carries over to futures - the Sydney Futures Exchange (SFE) charges a huge amount of money for quoting the SPI200, therefore most CFD providers cut costs by providing a product that 'reflects' the SPI200.
CFD accounts are 'stand alone' - With the exception of the 'Macquarie CFD' platform, all other CFD platforms were developed in Europe and are 'white labelled' by local offices in Australia. Therefore CFD providers have not had the ability to integrate their CFD platforms into legacy share brokerage platforms (if they possess them).

So in summary, after 6 years CFDs have been instrumental in bringing high levels of leverage to the retail trader market. However, as described above there are weaknesses and in addressing these Macquarie have released the 'Prime' account which was developed for the local market. It encompasses Shares, CFDs, shares gearing and cash in one platform, more details on this can be found on this page.