THOMSON FINANCIAL Strategic Research: Contracts For Difference Summary Ian Littlewood Contracts For Difference A contract for difference (CFD) is a contract between an investor and a counterparty April 2007 (often an investment bank), that allows an investor to receive the difference between the price of a security when the contract is taken out and the price of the same securi- ty when the contract is closed out. Through CFDs, investors can gain an economic inter- Strategic Research reports est in the share price movement of a company, without having to buy the share itself. from Thomson Financial are designed to enable strategic This guide explains what CFDs are and how they are used, along with the reasons for decision-making for investor their growth. The guide will be of general interest to market practitioners and investor relations and other corporate relations professionals in particular who wish to gain an understanding of a type of professionals. trading with growing importance and increasing significance for shareholder identifi- cation. For more information about this report, please contact: [email protected] For more information about Thomson Financial Corporate Services, please contact: www.thomson.com/financial [email protected] North America: +1.800.262.6000 Europe: +44.20 7369.7199 Asia: +852.2533.5564 © Copyrights Thomson Financial 2007. All rights reserved. Reproduction of, dissemination of, modifications to or cre- ation of derivative works from this document, by any means and in any form or manner, is expressly prohibited, except with the prior written permission of Thomson Financial. This document contains trademarks of Thomson and its affiliated companies in the United States and other countries and used herein under license. Non-Thomson marks are trademarks of their respective owners. SM Performance Matters THOMSON FINANCIAL How do they work? An investor agrees the price with the counterparty at which the CFD is fixed and the number of “shares” which are to be bought. If the investor believes that the value of the underlying shares will rise, then they would “go long” and “buy” the contract. If the price of the underlying shares then rises, the investor will close out the contract and receive the difference between the opening price and the closing price of the shares, multiplied by the number of “shares” purchased. Conversely, if an investor believes that the price of a company’s shares will go down, they would “go short” and “sell” the contract with the counterparty and if the share price of the underlying security does fall in value, the investor receives the difference between the starting price and the closing price, multiplied by the num- ber of “shares” purchased. However, just as investors can benefit if the price of the underlying shares moves in the investor’s favour, they could face potentially unlimited losses if the investor were to “go short” and the share price were to rise. In practice though, investors place a “stop loss” or a “stop buy”; a point at which the contract would automatically close out in the event that the price of the underlying security moves against the investor beyond a specified amount. Why do people use them? There are several benefits to buying an interest in shares through a contract for difference rather than by buying the actual shares themselves. Firstly, CFDs are not subject to stamp duty in the U.K., currently levied at 0.5% of the purchase price of shares, which reduces the cost of gaining exposure to a share’s movement. Secondly, investors also receive dividend payments just as they would if they actually owned the shares of a company, while investors are often able to deal on margin, which means that they only have to pay a fraction of the cost of the transaction up front and thus, profits are magnified. A further benefit to the use of CFDs is that they improve the liquidity of the market by avoiding the need for investors to physically take delivery of shares. Finally, there is a more sinister and underhand benefit of taking a position in a share through a CFD, which is that the holder does not have to disclose their holding. In the U.K., investors have to disclose ownership of shares once they have a notifiable interest of 3% of the voting rights of the issuer in question but this rule does not encompass CFDs, unless the company is in a bid situation. In this case, Takeover Panel rules state that CFD holdings must be dis- closed. Therefore, a company wishing to launch a hostile bid for a company could build up a physical holding in the target of just under 3%, while also taking a larger position in the target through a CFD. In order to hedge its risk expo- sure, the counterparty would buy physical shares in the market, while the investor would have either an implicit or explicit agreement with the counterparty that it could convert the CFD position into the physical shares at its request. By using a CFD, an investor transfers the obligation to notify to the counterparty, and thus, a misleading impression of ownership is created. This creates difficulties for corporations’ investor relations programs by cloud- ing the shareholder identification process. The investor could then launch a hostile bid by increasing its physical holdings and then converting the CFD hold- ing into the physical shares. Thus, the investor is able to build up a large stake relatively quickly, without having drawn attention to its interest. Had it built up a physical holding over time, the price of the target’s shares may have been bid up by speculators, raising the cost of the acquisition, while it could also alert competitors to its interest and raise the possibility of a counter approach. Meanwhile, the target may be unable to prepare any “poison pills” or other defence mechanisms in time to counter an approach which involved CFDs being transferred quickly into physical shares. © Copyright Thomson Financial 2007 SM Performance Matters THOMSON FINANCIAL Worked Example An investor, John Smith, believes that Big Log Forestry Company’s shares are undervalued at 1 pound each so decides to buy a contract for difference for 1,000 shares at 1 pound each, with a total contract value of 1,000 pounds but John only puts down 200 pounds of cash as his margin payment. Meanwhile, Jim Brown thinks that Big Log is about to suffer a share price fall, so he agrees a “sell” contract for 1,000 shares at 1 pound each. A week later, Big Log’s shares surge to 1.25 pounds after it delivers excellent full-year profits. John Smith closes out his contract of 1,000 shares at 1.25, which gives him a profit of 250 pounds on an initial investment of only 200 pounds, while Jim Brown cuts his losses and closes out his contract at a loss of 250 pounds. Who uses them? CFDs began in the late 1980s as a specialist hedging instrument for sophisticated institutional investors but have since grown in popularity amongst the financial community owing to the ease in which they allow investors to short stocks and because it is possible to trade on margin. This has led to their widespread use by hedge funds, who also like the anonymity that they provide. Meanwhile, instances of CFD use in takeover situations has increased over the last five years, while CFDs have become increasingly popular for experienced private investors because of their ease of use and the fact that investors in the U.K. avoid stamp duty. How do counterparties profit from this? The counterparty to the CFD profits by charging a commission on trades, which usually ranges from 0.10% to 0.25% of the contract to both opening and closing trades, while they will also levy an overnight financing charge on the value of the contract. Alternatively, a counterparty might offer slightly wider bid to offer spreads and make profit in the same way as a market maker. Disclosure? Investors in the U.K. have to disclose their holdings in a company if they have a notifiable interest of 3% or above in the issuer’s total voting rights. They then have to disclose at every 1% boundary they reach, exceed or fall below, above 3% of the issuer’s total voting rights. If an investor’s notifiable interest reaches 30%, the investor has to make a formal bid for the remaining shares in the company in which it has the holding. CFDs are not subject to these rules. However, in a takeover period CFD holders also have to disclose their holding. The FSA are currently considering whether to attempt to resolve this anomaly. Meanwhile, section 793 of the U.K. Companies Act 2006 gives a public company the power to investigate the own- ership of its shares. Companies do this by sending a written notice (the 793 notice) to any person or company whom they have reasonable cause to believe has or had an interest in their shares. The recipient of the notice is required to inform the company making the enquiry whether they have or had such an interest and if so what the nature of the interest is/was. This also does not apply to CFDs. In practice, the ownership of shares would be revealed as the counterparty that was hedging the contract. © Copyright Thomson Financial 2007 SM Performance Matters THOMSON FINANCIAL What are the disadvantages? One of the most obvious disadvantages of the use of CFDs falls on the issuer of the underlying share that the con- tract is taken out on.