The Investment Dealers Association of Canada has published a regulatory study examining a new retail derivative product known as Contracts-for-Difference.

A CFD is a derivative product that allows investors to speculate or hedge on the underlying security movements, without the need for ownership and physical settlement of the underlying security. They are generally traded over-the-counter and mirror the economic performance of the underlying security based on its price movement. The underlying security is typically common shares listed on a stock exchange, but may also be foreign currencies, bonds and indices where there is market transparency of price and traded volumes.

CFDs allow investors to take long or short positions on the underlying security, but unlike futures contracts they have no fixed expiry date or contract size. The contract is generally closed out by the end of the trading day and the settlement of profit and loss, less commissions, is paid in full. Contracts may be rolled overnight subject to a financing charge on the leveraged amount of the position.

The IDA notes that, “CFDs are marketed as high leverage products that can generate large profits, but losses as well for the investor. They represent a short term trading strategy and not a long term investment. As such, for retail investors they are speculative investment products and do not usually serve any significant hedge or risk management function. As a result, the distribution to investors is based on suitability waivers and account opening documents that consist of risk disclosure statements and written acknowledgements by the investor before an account is accepted and opened.”

In Canada, CFDs are a relatively new product and unknown to most investors and investment dealers, the IDA says, adding that there are no known IDA members currently engaged in the trading of CFDs with their customers. “That is expected to drastically change with strong interest expressed by current and prospective IDA member firms that are affiliates of foreign CFD providers that want to introduce the product into Canada,” it says.

CFDs are currently marketed and sold to accredited Canadian customers by a firm that is currently registered in Ontario as a limited market dealer and in other provinces. The IDA says that the firm has applied for IDA membership and intends to expand its target market by product offerings to non-accredited retail customers. The CFDs will be sold under a proposed base shelf prospectus to both retail and institutional investors. The regulator explains that its paper was researched and prepared in response to the pending new member application.

In the current regulatory environment, the IDA notes that LMD registrants do not have specific capital and margin rules, and there is no required minimum regulatory margin for open client CFD positions or leverage restrictions. “It is another example of regulatory arbitrage between rules that are applicable to investment dealers as opposed to LMDs for the same product offering, albeit limited to accredited investors,” it says. It also notes that customer documentation and marketing literature provided by the LMD to accredited investors includes risk disclosure stating that the customer may sustain losses greater than the margin deposit required to establish and maintain the CFD position; and that the customer is required to seek its own independent financial, legal, taxation and other professional advice to determine whether CFDs are an appropriate investment.

In addition to its analysis, the IDA says that firms should also consider the final report of the Commodities Futures Act Review Committee which was tabled in the Ontario provincial legislature in March, calling for a principles-based approach to derivatives regulation. “It would be expected that OTC products such as CFD and FX spot involving retail investors will be captured under the proposed principles of regulation. This would be a significant step forward in resolving regulatory arbitrage that currently exists in Ontario by unregistered entities engaged in FX spot retail trading with Ontario residents and IDA member firms that engage in the same activity with defined standards of regulation that are set out in this Study.”