When it comes to finance, contracts for differences involve making cash payments for differences in settlements rather than delivery of securities and assets.
CFD trading comes with advantages but as it appears, those advantages mask the risks associated with it. In that regard, U.S. citizens and residents are banned from opening both foreign and domestic CFD accounts.
Most people would view that as an invasion of freedom but a closer look, and you get to understand why. Let us look at some of the reasons why this investment strategy is banned in such a developed country.
Counterparty Risk
A counterparty is just the organization that offers the assets in financial transactions. When selling or buying a CFD, the contract is the only asset being traded is the contract provided by the CFD provider.
Doing this exposes the investor to the contract’s issuer counterparties such as other clients that they conduct business with. The main risk here is that the counterparty failing to honor its financial obligations.
The thing is that if the issuer of the contract fails to meet the financial obligations therein, the value of the underlying asset becomes irrelevant.
You want to acknowledge that the CFD industry is not governed by strict regulations and the broker’s reliability is based on financial standing, longevity, and reputation.
Although the market boasts of exceptional CFD brokers, you want to go into a broker’s background before opening an account with them. The last thing you want is to end up dealing with a fraud.
Market Risk
CFDs are copied assets that an investor uses to predict the movement of underlying asset prices. As an investor, if you think that an asset will rise, you pick a long position. On the other hand, if you feel like an asset will fall, you take a short position.
Here, you can only hope that your asset of interest will move in the direction you anticipate but the truth is that even the most experienced investors make the wrong predictions at times.
Factors like government policy and fluctuations in market conditions can result in rapid changes. Owing to the nature of CFDs, even the smallest changes can have a huge effect on returns.
For instance, an unfavorable impact on the value of an asset can force the provider to ask for a second margin payment and if that cannot be met, the provider can close positions forcing the trader to sell at a loss.
Client Money Risk
It is important to recognize that in countries where CFD trading is legal, there are laws and regulations in place to safeguard investors from potentially detrimental CFD provider practices.
Lawfully, money wired to the CFD provider must be separated from the trader’s money to prevent the provider from hedging their investments.
That said, the law may not ban the client’s funds from being pooled into single or multiple accounts. Once a contract is signed, the provider draws the primary margin and even has the right to request more margins from the pooled account.
In case the other client in that pooled account fails to meet the call for further margins, the CFD provider is within their right to draw from the account and that may affect the profits.
Gapping and Liquidity Risks
The risk of suffering losses can be affected by market conditions. If not enough trades are made for an underlying asset in the market, your contract can be rendered illiquid.
When that happens, a CFD provider can close contracts at lesser prices or ask for extra margin payments. Owing to the rapid-moving nature of financial markets, the price of your CFD can reduce before your trade can be implemented at the price you had agreed on. This is known as gapping.
It means that whoever is holding the contract will be forced to take less than expected returns or cover losses incurred by the provider.
Final Thoughts
When engaging in CFD trading, stop-loss-orders can work to reduce impending risks. Some CFD providers offer the same, which is a pre-determined price that automatically closes the contract when met.