So-called “contracts for difference,” a new way to bet on price movements of financial assets, have existed on many foreign markets for some time. CFDs have recently been available to sophisticated investors in Canada, and they now appear headed to retail investors as well.

The derivative products allow investors to speculate on price movement without actually owning the underlying security. Essentially, they function like swaps. If investors wants to bet that a given stock’s price is going to rise, rather than going out and buying and holding that stock, they can enter a contract that gives them exposure to the capital gain, or the loss, over the duration of the contract.

The underlying securities used in the contracts are typically listed equities, but CFDs can also be used to speculate on other assets such as commodities, currencies, bonds and indices. The contracts are generally traded over the counter and, unlike other types of derivatives, they typically don’t have fixed expiry dates or contract sizes.

The appeal for investors is flexibility. The contracts are often highly leveraged, so investors can maximize their bets. The products also provide the ability to make both long and short bets, and CFDs have relatively low transaction costs.

CFDs are currently available in one form or another in various parts of Europe, Asia, Australia, New Zealand and South Africa. In Canada, they aren’t yet widely sold, but at least a few firms that are registered as limited market dealers in Ontario are selling them to accredited investors via offering memoranda.

So far, the products haven’t been available to the average retail investor, but that is expected to change. The Investment Dealers Association of Canada reports that one firm has applied for IDA membership, which would allow it to offer the products to the average investor by prospectus.

Paul Bourque, the IDA’s senior vice president for member regulation, says that for a firm to sell CFDs to non-accredited investors, it must first become a member of a self-regulatory organization. “We will not permit IDA members to sell CFDs unless they comply with certain margin requirements and other internal control and account-monitoring requirements.”

An IDA report states that, as far as it is aware, no existing members are currently trading CFDs. The Mutual Fund Dealers Association of Canada also says it isn’t aware of any members trading the products.

The IDA expects the situation to change “drastically,” however, as current and prospective IDA member firms that are affiliates of foreign CFD providers have expressed “strong interest” in introducing the product into Canada for the average investor. In response to the application for membership, the IDA recently published a regulatory analysis of CFDs, which underpins the requirements the IDA will impose on firms intending to trade CFDs with retail investors.

The Ontario Securities Com-mission says it is also reviewing the prospects for retail CFD trading and is discussions with the IDA on the matter.

The IDA report notes that there is some uncertainty as to whether OTC derivative contracts such as CFDs should be considered securities. It adds that “based on existing case law and the securities legislation in most provinces, it is likely that retail CFD products [that] represent a speculative investment contract are securities for the purposes of the legislation.”

Indeed, there is uncertainty around the overall regulatory sta-tus of the derivatives market in Canada. Regulators haven’t taken a consistent approach in the markets, and derivatives regulation is in the midst of an overhaul in both Ontario and Quebec.

Earlier this year, Ontario’s commodities futures act review committee delivered a report calling for a principles-based approach to derivatives regulation. It suggested that there is a role for securities regulators in the retail OTC derivatives market.

That report focuses, however, on reforming the exchange-traded side of the market and recommends that, in the meantime, the government provide either legislative or policy guidance to the OSC regarding regulation of the retail OTC arena. The OSC reports that it has yet to receive any such guidance.

In the meantime, CFDs remain the preserve of so-called “sophisticated investors” and offered by the lightly regulated LMDs. The IDA paper notes that in the LMD world, there are no specific capital and margin rules, and no minimum regulatory margin requirement for open 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,” the IDA report says.

@page_break@Margin requirements are one of the biggest factors affecting the appeal and utility of CFDs. The IDA paper compares three hypothetical trades: a CFD at 5% margin; a CFD at 20% margin; and an ordinary stock trade with a discount broker in a security that requires 30% margin, the lowest possible rate. While the total transaction costs are effectively equal for all three trades, the greater the leverage, the greater the return on capital.

In the IDA’s hypothetical example, the imaginary security’s price rises 8.3% over three days. As a result, the discount brokerage client sees almost a 27% return, the trader with a 20% margin gets a 40% return and the trader with just a 5% margin enjoys a 158% return.

Of course, the power of leverage cuts both ways, and investors that find themselves on the wrong side of a heavily leveraged trade can soon sustain massive losses. Yet it is the ability to use a great deal of leverage that has popularized CFDs in other parts of the world.

In Britain, where CFDs were developed and are now estimated to account for as much as 30% of trading volume, regulators do not impose minimum margin rates.

The Monetary Authority in Singapore recently set CFD margins at 10% for stocks that are index constituents, 20% for non-index components, 5% for indices, 2% for foreign exchange contracts and 20% for all other contracts.

In Australia, the Sydney Futures Exchange is expected to launch the world’s first exchange-traded market for CFDs in August. Margin rates have not been announced, but the IDA paper indicates they are expected to be in the 4%-5% range. The local affiliates of larger firms such as Merrill Lynch, Credit Suisse and UBS have all been named as market-makers for the business.

In the Canadian market, the IDA indicates the margin requirements it expects to use are ones that apply to similar products that already exist in Canada. For instance, the IDA reports that margins for its blue-chip stocks are generally in the 5%-10% range, with rates as high as 25% for illiquid or very volatile stocks.

“The development of listed single-equity futures by the Bourse [de Montreal] provides a good start in establishing margin rules applicable to CFDs [for which] the underlying [security] is a listed equity,” the IDA report says. Applying the IDA’s current margin methodology for a blue-chip stock, for example, would result in a client margin rate of 17.5%.

In addition, the IDA paper notes that various other conditions would apply to firms that intend to offer CFDs to clients, including registration requirements and disclosure and suitability obligations.

Despite the best efforts of the marketing departments at the country’s large financial institutions, all forms of investing retain a whiff of the casino to some people.

The distinction between the very riskiest speculations and the blandest bets are merely differences of degree. Soon, risk-loving retail investors may get the opportunity to make some bigger gambles. IE