Contract for difference (CFD)
Financial contract for difference (CFD) is a derivative product that gives the holder an economic exposure, which can be long or short, to the difference between the price of an underlying asset at the start of the contract and the price when the contract is closed (the characteristics used, for example, by ESMA in the Addendum Consultation Paper, MiFID II/MiFIR of 18 February 2015, ESMA/2015/319).
17 October 2023
The reform aims to steady long-term electricity markets by boosting the market for power purchase agreements (PPAs) generalising two-way contracts for difference (CfDs) and improving the liquidity of the forward market.
The Council agreed that member states would promote uptake of power purchase agreements, by removing unjustified barriers and disproportionate or discriminatory procedures or charges. Measures may include among other things, state-backed guarantee schemes at market prices, private guarantees, or facilities pooling demand for PPAs.
The Council agreed that two-way contracts for difference (long-term contracts concluded by public entities to support investments, which top up the market price when it is low and ask the generator to pay back an amount when the market price is higher than a certain limit, in order to prevent excessive windfall profits) would be the mandatory model used when public funding is involved in long term contracts, with some exceptions.
Two-way contracts for difference would apply to investments in new power-generating facilities based on wind energy, solar energy, geothermal energy, hydropower without reservoir and nuclear energy. This would provide predictability and certainty.
The rules for two-way CfDs would only apply after a transition period of three years (five years for offshore hybrid asset projects connected to two or more bidding zones) after the entry into force of the regulation, in order to maintain legal certainty for ongoing projects.
The Council added flexibility as to how revenues generated by the state through two-way CfDs would be redistributed. Revenues would be redistributed to final customers and they may also be used to finance the costs of the direct price support schemes or investments to reduce electricity costs for final customers.
According to the Notice of 22 May 2018 of ESMA’s Product Intervention Decisions in relation to contracts for differences and binary options (ESMA35-43-113) CFD is a derivative other than an option, future, swap or forward rate agreement, the purpose of which is to give the holder a long or short exposure to fluctuations in the price, level or value of an underlying, irrespective of whether it is traded on a trading venue, and that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event.
Economically, a CFD is an agreement between a buyer and a seller to exchange the difference between the current price of an underlying asset and its price when the contract is closed.
ESMA’s product intervention measures in relation to CFDs and binary options offered to retail investors, 27 March 2018, ESMA71-98-125, p. 3
What are CFDs?
- CFDs are complex financial instruments, often offered through online platforms. They are a form of derivative trading.
- CFD trading enables you to speculate on the rise or fall of the price, level or value of an underlying, including such asset classes as currencies, indices, commodities, shares and government bonds. You do not need to own the underlying asset.
- CFDs are typically offered with leverage which means you only need to put down a portion of the investment’s total value. However, financing costs and transaction costs (such as bid-ask spreads) are typically based on the investment’s total value.
- Leverage also multiplies the impact of price changes on both profits and losses. This means you can lose money very rapidly. Leverage can contribute to losses being so rapid that people have ended up owing large sums of money to the product provider.
- A recent market event underscoring the importance of a Negative Balance Protection was when the Euro fell suddenly and dramatically against the Swiss Franc in January 2015. As a result of this event, in the absence of Negative Balance Protection, some retail investors ended up owing very large sums of money to providers, often much more money than the investors could afford.
From this point of view, CFDs can be perceived as flexible financial derivatives, suitable to give exposure to a variety of different underlying instruments: shares, currencies, commodities, indices, etc. Broadly, there are the following CFD classes, defined at the type of underlying level: i. equity; ii. bond; iii. futures on equity; iv. option on equity; v. commodity; and vi. currency (FX). CFDs having an equity instrument as underlying represent around 72% of the notional amount traded, followed by contracts on currencies.
CFDs are listed as financial instruments in the Annex I, Section C(9) of MiFID II (which means no change to status quo established under MiFID I). However, the European Commission in its Guidance on the implementation and interpretation of MiFID I (Directive 2004/39/EC on markets in financial instrument) observed:
“Financial contracts for differences are covered under Annex I, Section C(9) of Directive 2004/39/EC.
CFDs on commodities are covered by Section C(5) and CFDs in relation to other underlyings such as climatic variables, freight rates, emission allowances or inflation rates are covered by Section C(10).
A sports, political or similar CFD, which depended on the results of a match, election or other variable not mentioned in Section C(10), and which does not otherwise fall under Section C(9) or C(5), would not be covered.”.
In principle, MiFID II provisions (Annex I, Section C) are in this regard analogous to MiFID I, hence, the above interpretation seems to be still applicable. CFDs are mostly, if not exclusively traded OTC. In general, such instruments offer exposure to the markets while requiring to only put down a small margin (‘deposit’) of the total value of the trade. The above mechanism allows investors to take advantage of prices moving up (by taking ‘long positions’) or prices moving down (by taking ‘short positions’) on underlying assets (if an investor speculates on the price of a given commodity going up, a CFD provider, who acts as the contractual party in this CFD and does not hedge against market risk, speculates on the price of this commodity going down). When the contract is closed the investor will receive or pay the difference between the closing value and the opening value of the CFD and/or the underlying asset(s). If the difference is positive, the CFD provider pays the investor, in turn, if the difference is negative, the investor must pay the CFD provider.
CFDs might seem similar to mainstream investments such as shares, but they are very different as the investors never actually buy, trade or own the asset underlying the CFD.
On 28 February 2013 the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) issued warning for investors in CFDs underlining the risks involved wiith everaged products. In the said document regulators recommend that investors trading in CFDs carefully analyse the following:
- the costs of trading CFDs with the CFD provider,
- whether the CFD provider will disclose the margins it makes on the trades,
- how the prices of the CFDs are determined by the CFD provider,
- what happens if the position is held open overnight,
- whether the CFD provider can change or re-quote the price of an order,
- whether the CFD provider executes orders even if the underlying market is closed,
- whether there is an investor or deposit protection scheme in place in the event of counterparty or client asset issues.
Also the German financial regulator BaFin in its comments of 8 May 2017 underlines that in CFDs:
- the client's risk of loss is not limited to a particular margin payment but instead may encompass the entirety of the client's assets,
- if the clients’ loss exceeds the balance on their account for the purpose of CFD trading, they must pay for the loss from their other assets (additional payments obligation).
According to the BaFin, German legislators treat CFDs as a subgroup of derivatives.
In the said notes of 8 May 2017 BaFin also refers to the US example, where, similarly to Europe, CFDs are not traded on the stock exchange, however, in the US:
- over-the-counter CFD trading is prohibited for retail clients unless the investor has a minimum investment capital of USD 10 million or USD 5 million solely for hedging purposes in CFD trading;
- for other products which are economically similar to a CFD with a currency pair as the underlying asset (e.g. leveraged forex products), a leverage limit of 50 applies;
- on behalf of the Commodity Futures Trading Commission (CFTC), the National Futures Association (NFA) has additionally limited the permissible leverage for forex products with particularly volatile underlying assets to 20.
The main CFDs’ cost may potentially be the loss incurred on the contract. Moreover, CFDs’ providers charge commissions, which can take the form of a general commission or a commission charged on each trade (i.e. on opening and closing a contract).
Additional costs related to CFDs’ trading may also include:
- bid-offer spreads,
- daily and overnight financing costs,
- account management fees, and
- taxes (depending on the jurisdiction in which you and the CFD provider operate).
There is the need for careful analysis of the respective offer as the costs linked to transactions in CFDs can be complex to calculate and, in principle, may outweigh the gross profits from a trade.
Nordic electricity forward market arrangements
The ACER and CEER Draft Policy Paper of 1 June 2022 on the Further Development of the EU Electricity Forward Market refers to the use of CfDs as the electricity forward market arrangement (contracts for differences without coupling) and notes the following respective features:
- TSOs are not involved, PX offers trading with CfDs to market participants,
- those CfDs allow the market participants to hedge the price difference between a zone and a hub,
- the supply and demand of CfDs in respective zones A and B is perfectly matched – there is no cross-zonal matching,
- in the settlement after delivery, the market participants will have the following financial flow through the PX (negative value indicate pay for buy orders):
𝐴𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 𝑝𝑎𝑦/𝑟𝑒𝑐𝑒𝑖𝑣𝑒 = 𝐶𝑓𝐷 𝑉𝑜𝑙𝑢𝑚𝑒 ∗ ((𝑍𝑜𝑛𝑎𝑙 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒 - 𝐻𝑢𝑏 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒) -𝑀𝑎𝑡𝑐h𝑒𝑑 𝐶𝑓𝐷𝑃𝑟𝑖𝑐𝑒) [€/𝑀𝑊h].
ACER observes that, in principle, also another model is possible i.e. CfDs with coupling, which relies on power exchanges to facilitate trade with CfDs, which can be done based on auctions as well as continuous trading. In this case it includes market coupling, which is traditionally able to better allocate cross-zonal capacities compared to explicit auctions. This enables more continuous trading and secondary markets as well as effective hedge against cross-zonal price risk. CfDs with coupling pool the forward market liquidity to a common hub thereby giving the same market access to all bidding zones and more likely reducing bid-ask spreads and risk premia.
For the description of CfDs as an instrument of the EU electricity forward market reform see: Forward electricity markets.
Carbon contracts for difference (‘CCfD’)
Carbon Contracts for Difference (CCfD) remunerate the investor by paying the difference between the CO2 strike price and the actual CO2 price in the emission trading scheme.
European Commission Communication of 8 July 2020 (A hydrogen strategy for a climate-neutral Europe, COM(2020) 301 final, p. 13) observed:
„With the need to scale-up renewable and low-carbon hydrogen before they are cost-competitive, support schemes are likely to be required for some time, subject to compliance with competition rules. A possible policy instrument would be to create tendering systems for carbon contracts for difference (‘CCfD’). Such a long term contract with a public counterpart would remunerate the investor by paying the difference between the CO2 strike price and the actual CO2 price in the ETS in an explicit way, bridging the cost gap compared to conventional hydrogen production.”
European Commission Guidance on the implementation and interpretation of Directive 2004/39/EC on markets in financial instrument
Are contracts for differences (CFDs) financial instruments under MiFID?
Financial contracts for differences are covered under Annex I, Section C(9) of Directive 2004/39/EC. A ‘financial’ contract for differences is a contract for differences in relation to MiFID instruments, currencies, interest rates or other financial indices. A contract for differences in the form of a credit derivative contract would also be covered.
Contracts for Difference as an instrument of the ‘Fit for 55’ package
The respective recital of the Directive of the European Parliament and of the Council amending Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading within the Union and Decision (EU) 2015/1814 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading system reads:
“In order to align with the comprehensive nature of the European Green Deal, the selection process for projects supported through grants should give priority to projects addressing multiple environmental impacts. In order to support the replication and the faster market penetration of the technologies or solutions that are supported, projects funded by the Innovation Fund should share knowledge with other relevant projects as well as with Union-based researchers having a legitimate interest.
Contracts for difference (CDs), carbon contracts for difference (CCDs) and fixed premium contracts are important elements for the triggering of emission reductions in industry through the scaling-up of new technologies, offering the opportunity to guarantee investors in innovative climate-friendly technologies a price that rewards CO2 emission reductions above those induced by the prevailing carbon price level in the EU ETS. The range of measures that the Innovation Fund can support should be extended to provide support to projects through competitive bidding, leading to the award of CDs, CCDs or fixed premium contracts. Competitive bidding would be an important mechanism for supporting the development of decarbonisation technologies and optimising the use of available resources. It would also offer certainty to investors in those technologies. With a view to minimising any contingent liability for the Union budget, risk mitigation should be ensured in the design of CDs and CCDs and appropriate coverage by a budgetary commitment should be provided with full coverage at least for the first two rounds of CDs and CCDs with appropriations resulting from the proceeds of auctioning of allowances allocated pursuant to Article 10a(8) of Directive 2003/87/EC”.
In this context “contract for difference” means a contract between the European Commission and the producer, selected through a competitive bidding mechanism such as an auction, of a low- or zero-carbon product, and under which the producer is provided with support from the Innovation Fund covering the difference between the winning price, also known as the strike price, on the one hand, and a reference price derived from the price of the low- or zero-carbon product produced, the market price of a close substitute, or a combination of those two prices, on the other hand.