Monday, March 11, 2013

EU Securities and Banking Authorities Warn Investors on Contracts for Difference

The European Securities and Markets Authority and the European Banking Authority have issued a joint investor warning on investments in contracts for difference, which are agreements between a buyer and a seller to exchange the difference between the current price of an underlying asset, such as shares, currencies, or commodities  and its price when the contract is closed.

A contract for difference is a share in a derivative product giving the holder an economic exposure to the change in price of a specific share over the life of the contract. Contracts for difference are thus leveraged products that offer exposure to the markets while requiring investors to only put down a small margin of the total value of the tra the time when de. They allow investors to take advantage of prices moving up by taking long positions or prices moving down by taking short positions on underlying assets. When the contract is closed, the investor will receive or pay the difference between the closing value and the opening value of the contract and/or the underlying asset.

Contracts for difference carry a very high level of risk, warned the Authorities. They are not standardized products. Different providers have their own terms, conditions and costs. Therefore, generally, they are not suitable for most retail investors.

The  Authorities advised investors to consider trading in contracts for difference if they wish to speculate, especially on a very short-term basis, or if they wish to hedge against an exposure in yheir existing portfolio, and have extensive experience in trading, in particular during volatile markets, and can afford any losses.

In addition to overall profit and loss risk, there are some specific risks associated with contracts for difference. There is, for example, liquidity risk, which affects the ability to trade at the time one may wish to trade. There is execution risk that is associated with the fact that trades may not take place immediately. There is counterparty risk that the provider issuing the ontract for difference defaults and is unable to meet its financial obligations.