Just three letters - CFD - at centre of shares controversy
Buy-now-pay-later device made millions as long as the stock market rose and rose - and you didn't have to tell anyone
At one stage in 2006 up to half of all Irish share trades were done in CFDs
The convoluted tale of Sean Quinn and his shareholding in Anglo Irish Bank has thrust CFDs into the limelight. Just what are these previously arcane financial instruments? Diane Walshe tells you everything you need to know.
- What in God's name are CFDs?
Contracts for difference (CFDs) are a contract between a buyer and a seller where the seller agrees to pay the buyer the difference between today's share price and the share price at some date in the future.
If the share price rises then the buyer receives the difference from the seller at the due date. However, if the share price falls then the buyer must pay the shortfall to the seller.
- Why not just buy shares instead?
Anyone buying shares must pay 1pc stamp duty. While that may not seem like an awful lot when your name is Sean Quinn and you are lashing out €1.5bn, it's still €15m. Even for a one-time billionaire that's serious money.
However, there is no stamp duty payable on CFDs, which would have saved Quinn €15m. This significant stamp duty saving meant that CFDs became a very popular way of trading shares. At one stage in 2006 up to half of all Irish share trades were done in the form of CFDs.
- Surely it wasn't just the desire to save €15m that prompted Quinn to opt for CFDs instead of plain old-fashioned share purchases?
The stamp duty saving isn't the only advantage CFDs enjoy over buying the underlying shares. By using CFDs Quinn was also able to bypass Stock Exchange disclosure requirements that all shareholdings over 3pc be revealed to the market.
By using CFDs Quinn was able to accumulate an effective 25pc shareholding without anyone being any the wiser. By allowing investors to bypass the Stock Exchange's disclosure requirements,CFDs permit investors to build up huge effective stakes in publicly-traded companies without moving the price in a way that straightforward share purchases would.
- I'm still not convinced that CFDs make more sense than share purchases.
Back in the good old days, before the credit squeeze when credit was cheap and plentiful, brokers would sell you CFDs by putting down as little as 5pc to 10pc as an initial outlay.
This means that Quinn's estimated €1.5bn-plus punt on Anglo could have cost him as little as €75m up front. Throw in the stamp duty saving and hey presto CFDs are a game everyone can play.
- Are there any disadvantages to using CFDs?
You bet. As with any leveraged product CFDs are great when markets are rising but when things go wrong they can go very wrong indeed. Just ask Sean Quinn. While initial outlay was relatively modest the same can't be said about his losses, which have been estimated at over €1.5bn. Even for a billionaire that's serious spondulicks.
- Will we be hearing more about CFDs in future?
CFDs' best days are almost certainly behind them, at least for the time being. The credit squeeze means that brokers now insist on much higher margin requirements, often up to 20pc.
Following the use of CFDs to bypass disclosure requirements, most stock markets are preparing to tighten up their regulations to close the CFD loophole.
This makes CFDs much less attractive vis-a-vis shares than they used to be. While we almost certainly haven't heard the last of CFDs, they have largely gone into hibernation until credit markets re-open for business.