CFDs were initially used by hedge funds and institutional traders to gain cost-effectively exposure to stock market instruments traded on the London Stock Exchange.
Hedge funds and other asset managers use CFDs to replace physical securities and physical short selling for UK listed equities, with similar risk and leverage profiles. A hedge fund’s prime broker is the counterparty to the CFD, and it hedges its own risk (or net risk) under the CFD (or all CFDs it holds) by trading shares on the exchange. Prime broker trades in its own account will be exempt from UK stamp duty.
Prime brokers typically provide leverage to hedge funds in order for them to pursue their investing activities and to maximize returns. Many forms of leverage are possible. Typically, the most popular option is a margin loan, in which the hedge fund deposits a specific amount of equity with the broker-dealer, such as 50% of the purchase price. The broker-dealer loans the remainder.
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