CFM11110a - Understanding derivative contracts: regulating derivatives
Contracts for differences
Some particular problems relating to contracts for differences are:
Confusion of terminology
In recent years, the term ‘contract for differences’
has become synonymous in many people’s minds with a
particular derivative product which is sold mainly to individual
investors. These new style CFDs are based on the price movements of
individual shares or bonds, stock market indices, or futures
contracts. The customer agrees with the provider that for each day
that the contract is open, the customer will pay the provider, or
receive from the provider, a sum based on the upward or downward
movement in the index or other reference indicator. Confusion can
arise between this narrow sense of ‘contract for
differences’ and the very wide sense in which the expression
is used in FSMA 2000.
‘Contract for differences’ is defined in the FA
2002 legislation in almost precisely the same terms as in FSMA
2000. Where the expression is used in this guidance, it is in the
statutory sense. New style CFDs will, of course, fall squarely
within the statutory definition.
‘Pretended purpose’
The FSMA 2000 definition of contract for differences refers to a contract ‘the purpose, or pretended purpose, of which is to secure a profit or avoid a loss. Pretended in this sense means aimed for or aspiring to (as in pretender to the throne). It does not imply any fraud or deception.
Gaming or wagering
The term ‘contract for differences’ dates from the
19th century, when it was used to differentiate contracts which
were, in effect, bets on stock market movements from genuine
transactions in shares. Until the Financial Services Act 1986 (the
predecessor to FSMA 2000) came into force, debts arising on such
contracts were unenforceable because they were regarded as wagering
contracts. Subsequently, debts were (and are) enforceable provided
the contract was entered into by way of business.
Case law (such as Morgan Grenfell and Co Ltd v Welwyn
Hatfield District Council [1995] 1 All ER 1) has established that,
although contracts for differences can be entered into
speculatively, and may be capable of being wagers, they are not
necessarily so. It will depend on the intentions of the parties.
Since a company will normally enter into a derivative contract to
hedge or to invest, rather than to wager its shareholders’
money, it would be unusual for a CFD entered into by a company to
be a wager.
However where a derivative contract falls within the Schedule
26 FA 2002 rules, you will not have to consider whether or not it
constitutes a wager – see CFM13214.
