As a financial services lawyer, I would sometimes provide advice to providers of CFDs, or “contracts for difference”.

I hated being involved with CFDs, especially those which were marketed to individuals as a way of generating exceptional investment returns.

Basically, a CFD is a leveraged bet against another party in relation to the value of an underlying asset, such as a particular share, index, commodity such as gold or silver, or currency. If you predict correctly, you can end up with great returns. If you predict incorrectly, you can end up losing more than you put in, in the first place.

CFDs are often thought of as similar to derivatives such as options. However, options directly involve the underlying asset – with an option, at a given point in time you can purchase the underlying asset for an agreed-upon price. With a CFD it is all notional and the underlying asset is nothing more than a benchmark for keeping score.

CFDs = betting in disguise

I’ll be blunt: CFDs are betting in disguise. I’ve never seen, nor heard of, any credible financial adviser recommending CFDs as an investment strategy.

There might be a situation where a CFD might be relevant to someone. But my general advice is steer clear of CFDs.

There is, however, another characteristic of CFDs that is interesting and is worthy of attention. It’s counterparty risk.

Counterparty risk

You see, with a CFD you can make the right “trades” and end up ahead. But the value of your investment is only as strong as the ability of the provider you’re dealing with to pay out.

The other party to the bet is a counterparty. This is called counterparty risk.

The counterparty risk involved with CFDs is generally pretty high.

Especially when you compare it to, say, investing in a managed investment scheme which has a reputable, independent trustee.

One of my favourite providers of investment funds in New Zealand is Simplicity. When you invest in a Simplicity fund, for example, you are essentially investing in a special type of a trust called a unit trust. Your interest in the trust is represented by units, and each of your units are treated identically to all of the other units in the trust. The money that you put into the trust is then invested into the underlying assets in the fund. For example, a Vanguard fund, which itself is invested in thousands of shares across dozens of countries in the world.

So unlike when you’re dealing with a CFD provider and you’re relying on their ability to “pay out” when it comes to your investments, the money you’re investing goes into a trust, and your share of the assets in the trust are held on your behalf by the fund’s trustee. You actually have an interest in relation to the assets held by the trust, which is proportional to your investment relative to everyone else who has invested.

On top of this, the Simplicity fund (like most other reputable investment schemes) uses a trustee that is independent of the investment manager. Simplicity funds use The Public Trust, a Crown Entity to act as trustee in relation to its funds. Because there is an independent trustee involved, it would be exceptionally difficult for the investment manager to funnel funds out of the trust in a way that isn’t for the benefit of its beneficiaries (the investors). On top of this, if something happened to the investment manager, the trustee would still hold the assets on your behalf and would be in a position to act in the best interests of all of the beneficiaries.

This means the counterparty risk you’re exposed to when you invest in this manner is minimised, especially compared to investing in a product like a CFD.

Always consider counterparty risk

Whenever we enter into a transaction, whether that be a CFD transaction (please don’t!), investing in a managed investment scheme, or otherwise, always give some thought to the counterparty risk. Will the party you’re dealing with be able to pay you back, and the returns you’re entitled to? What is the chance of something happening to your money, and if something happens to the counterparty, what degree of protections are in place?

Sonnie Bailey

Sonnie is an Authorised Financial Adviser (AFA) and former lawyer with experience in the financial services and trustee industries. Sonnie operates Fairhaven Wealth (www.fairhavenwealth.co.nz).