The contract for difference as an instrument

A contract for difference is one of the shortest contracts in finance to state and one of the easiest to misread. Two parties agree on a reference price for a market that neither of them intends to deliver. One side gains if that reference price is higher when the agreement ends, the other gains if it is lower. Nothing changes hands at the moment the contract opens. No shares move, no metal moves, no currency settles. When the agreement ends, the difference between the closing price and the opening price is multiplied by the size of the contract, and that amount of money passes from one side to the other.

The name is unusually literal, and almost everything else follows from its two halves. Contract means a private, bilateral agreement between two named parties rather than a security that can be registered in a holder's name, carried away or sold on to a third party. Difference means the only thing that ever settles is a change in a price, so the question of who owns the underlying market never arises at all.

What the contract references 

A CFD has no price of its own. It borrows one. The market whose price it references is called the underlying, and it continues to exist entirely independently of the contract written on it: a currency pair, a stock index, a barrel of crude, a listed share, an exchange traded fund. The underlying is quoted wherever it is normally quoted, and the contract reads that quotation. Two parties writing a contract on the price of gold neither change the price of gold nor remove an ounce of it from the market.

The second number in the agreement is its size, stated as a quantity of units of the underlying. Conventions differ by market and are published per instrument in its contract specifications. A currency pair is conventionally written in lots of the first currency in the pair, a share contract is written on a stated number of shares, and an index contract states a money amount per index point. Size is not a housekeeping detail. It is one half of every calculation that follows, and it is the reason two positions in the same instrument can produce results that differ by orders of magnitude.

Price multiplied by size gives the notional value of the contract, also called the contract value or the face value. Notional value is the number profit and loss is calculated on. It is not the number that has to be funded, and the distance between those two facts is the single most consequential thing about the instrument.

The settlement arithmetic 

The calculation has two steps and no third one. The difference between the closing price and the opening price is taken, and it is multiplied by the number of units the contract covers. The result is an amount of money carrying a sign, and the sign depends on which side of the contract is being calculated. The party on the other side records the exact mirror of it.

Calculated on the contract, not on the deposit 

A CFD does not have to be funded in full. The counterparty requires a percentage of the notional value to be posted and held for as long as the contract is open, and that percentage is the margin requirement. Posting margin is not paying for the contract. It is collateral held against the difference the contract may come to owe, and it is returned to the account when the contract is closed.

Because the difference settles on the full notional value while only a percentage of it has been posted, an adverse move is measured against the whole contract and not against the margin, so a loss can exhaust the margin entirely and is not limited to the amount deposited. A favourable move is measured on exactly the same basis and to exactly the same degree. The margin requirement is the level at which a position becomes liable to be closed, never a boundary on what the arithmetic can produce.

Reading those rows together makes the mechanism visible. The percentage move is a percentage of the notional value, not of the margin, so the money amount it produces bears no relationship at all to the size of the deposit. That is how a CFD position can produce a debit larger than the money placed behind it.

Who the other party is 

Every contract has two parties, and in a retail CFD the second one is the broker. The contract is written between the client and the firm. It is not routed onto an exchange and matched against another retail client, and no central clearing house stands between the two sides in the way one stands between the buyer and the seller of an exchange traded future. That is what over the counter means in practice: bilateral, agreed between two named parties, and existing only between them. A firm may hedge its own resulting exposure with a liquidity provider, but that is a second contract to which the client is not a party.

Two consequences follow, and both are checkable. A CFD can only be closed with the firm that wrote it, because there is no secondary market for it, no transfer of an open position to another broker and no certificate to move. And the financial standing of that firm is part of what a CFD holder carries, because the firm is the party that owes the difference whenever a contract settles in the client's favour. Regulators address the second point by requiring client money to be held apart from the firm's own money.

How it differs from owning the underlying 

Buying the underlying outright is a different transaction with a different ending. The full purchase price is paid, title passes to the buyer, the asset settles into an account in the buyer's name and stays there until it is sold. Whatever comes with ownership comes with it: a place on a share register, a vote at a general meeting, the entitlements an issuer distributes. Once the trade has settled there is no counterparty left, because nothing further is owed by anybody.

A CFD produces none of that. No title passes, nothing settles into anyone's name, and the contract stays open and owed until it is closed. It also carries a running cost an outright purchase does not: because the full notional value was never funded, a position held past the daily cut off carries a financing adjustment for every night it remains open. A CFD is a leveraged derivative contract, not a holding in a company or a stake in a fund, and the two are not interchangeable descriptions of the same exposure.

How a contract ends 

Settlement is the moment the obligations under a contract are discharged. A CFD settles in cash and only in cash: the difference is calculated, the money moves, and the contract is extinguished. Closing a position is not selling something to a third party. It is entering the equal and opposite contract with the same firm, so the two net to nothing and what remains is the difference between the price at which the first was opened and the price at which the second was written.

Most CFDs written on spot markets carry no end date and remain open until they are closed or until the margin held against them fails its requirement. CFDs written on futures inherit the calendar of the futures contract beneath them: they carry a stated expiry on which they are closed at the prevailing price or rolled into the following contract, and that date is published in the instrument's specifications rather than chosen by either party.