CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Between 54-87% of retail CFD accounts lose money. Based on 69 brokers who display this data. *Availability subject to regulation.
Although they may appear significant on a chart, fluctuations on a particular financial instrument can be quite minor in real terms. Take for example the GBP/USD foreign currency pair, which upon the news of the Bank of England raising interest rates in the UK on the 2nd November 2017, and that limited and gradual policy action would follow, sterling fell around 0.9% or around 120 pips. This was a relatively large price movement for the currency in such as short time span, but the reality is that the average holidaymaker would not really notice the difference between an exchange rate of 1.313 and 1.325 dollars to the pound.
However, to professional Forex traders, with significant sums of money speculating on the market movements of the currency pair, even normal, day to day fluctuations of 1 pip or less can have a huge impact.
Average retail traders do not tend to place such large sums on trades, however many financial brokers do allow clients to trade on margin, using leverage. This enables them to amplify their exposure to the small fluctuations, with a deposit that just covers a fraction of the value of the underlying asset.
Fluctuations can be much more extreme than this, however. The Swiss franc shock in 2015 gave rise to incidents where private traders lost ruinous amounts of money as a result of leverage on CFDs and currency trades. Because the exchange rate jumped away from the previous price range so quickly following sudden news that the Swiss National Bank was decoupling the Swiss franc from the euro, traders did not have sufficient opportunity to close their positions.
Such instances inevitably caught the attention of the financial regulators around the world, who subsequently have proposed and/or applied new regulations around leverage and CFDs (contracts for difference) in general. This is to ensure the protection of inexperienced traders who do not fully understand the risks involved when trading on margin.
One of the actions taken by regulators such as BaFin (the German Federal Financial Supervisory Authority) and CySEC (the Cyprus Securities and Exchange Commission) was to abolish the additional payments obligation associated with CFDs and such products. This transfers the negative balance risk from the trader to the CFD provider or Forex broker.
As a risk mitigation tool, the broker may place a margin call, which requires the trader to correct a negative balance by increasing the margin on the trade or by closing the trade themselves within a specified time period. If neither action is taken by the trader, then the broker will close the trade at the price specified on the platform at the end of the grace period. This provides the trader with negative balance protection, as they either have opportunity to extend their trade by adding additional maintenance margin, or the trade will be closed before allowing a negative balance situation to arise.
In the case of a price gap, or abrupt price jump, there will not usually be the opportunity for a margin call. However, if a broker offers true negative balance protection, then they will assume responsibility for the losses, rather than the trader.
The clear advantage of choosing a broker that offers negative balance protection is that a trader will never be liable for losses greater than the balance of their trading account. The broker assumes responsibility for this risk, and will apply a margin call where possible to protect themselves against it.
The reason this can be disadvantageous is that it may result in a trade being closed out by the broker just prior to the markets moving back in favour of the trader. This means that the trader will suffer the losses of the trade, where they could have regained a favourable position by holding on to the trade for longer. However, the margin call should give them the opportunity to make this decision.
Another disadvantage cited by brokers is that this can lead to increased brokerage costs, as they recoup the losses incurred as a result of providing negative balance protection, through their fees.
Some brokers also argue that disposing of the additional payments obligation for traders can lead to more risky trading behaviour, as the trader is not responsible for bearing the full extent of the losses.
Following the publication of a Questions and Answers document from ESMA (European Securities and Markets Authority) in October 2016, regarding the provision of CFDs and such products to retail traders, CySEC released a circular (Circular 168) to provide further guidance to Cyprus Investment Firms (CIFs).
One point that CySEC drew particular attention to was the use of leverage. The circular instructed CIFs to ensure that the default leverage offered on the platform was not above 1:50; that an appropriateness test should determine whether higher leverage should be offered to clients; and that a thorough leverage policy should be put in place.
In addition, firms were required to put negative balance protection in place, ensuring that clients’ losses would never exceed their available funds.
More recently, CySEC have felt the need to reiterate and clarify the requirement. In their announcement on 18th September 2017, they explicate that their maximum loss requirement applies to a client’s particular account, rather than being restricted to a trade. This means that the broker can use a client’s other positions within the same account to offset a negative balance from a leveraged trade.
BaFin consulted at length on the issue of CFDs, eventually issuing their final General Administrative Act on the subject in May 2017.
During the consultation process, there was moderate resistance to the proposed measure of prohibiting the marketing and sale of CFDs with an additional payments obligation to retail traders. However, BaFin disputed the objections and used their product intervention powers to apply the restriction.
The regulator argued that as potential losses were incalculable for clients, inexperienced traders should be sufficiently protected against such losses. They also deemed risk mitigation features such as margin calls and stop loss orders to be insufficient to protect consumers, citing price gapping as a reason. Even guaranteed stop loss features did not offer traders the protection they required according to BaFin, as although they protect against price spikes, they are not compulsory and are therefore not applied by many inexperienced traders.
The rules came into effect for German regulated firms in August 2017, although many were in practice already offering negative balance protection to clients.
The FCA’s proposals around CFD products did not include this restriction, however they were much more strict with regards to leverage, capping this at 1:25 for traders with little experience, and 1:50 for more experienced traders.
Many online regulated brokers offer some degree of negative balance protection, although some are more stringent about the requirements than others.
As a BaFin regulated broker, XTB offer true negative balance protection by ensuring that client losses are limited to the available funds in their accounts. This means that clients are not permitted to enter a situation where they owe the broker money. This protection is also offered in the other jurisdictions, such as the UK.
Plus500 offer negative balance protection, however concede that a temporary negative balance situation may occur in the interval following a margin call and prior to any action being taken, either by the client or by the broker.
IG also offer a degree of negative balance protection through their margin call feature. However, although this allows IG to take action to prevent a negative balance occurring by closing a trade, they make it clear that they cannot guarantee against a negative balance occurring and traders should use the guaranteed stop loss feature if they want to be certain that their losses will not exceed the funds in their account.