A contract for difference is an agreement between two people with regard to the price of two assets on a future date. In order to settle the agreement, one person pays the difference of the price changes between two assets depending on how much one asset goes up or down in price relative to the other asset. A contract for difference agreement is like a bet. Each person usually reserves an amount of money or assets beforehand as collateral to settle this agreement.
Example 1: Let's say one person named Bob owns 100 shares of Apple. If Apple's share price is $500 right now, the value of Bob's 100 shares is $50,000. Let's say Bob wanted to lock in the value of his Apple stock at $50,000 for a year. Bob finds another person, April, who wants to invest in 100 shares of Apple for a year but does not want to purchase shares directly at a brokerage. Bob & April enter into a contract for difference with each other.
They agree that if Apple goes up, Bob will pay April the difference in value, because Bob's 100 shares will be worth more. If the value of 100 shares of Apple goes down, April would pay Bob. April brings $50,000 as collateral for the agreement. Bob is now happy because he can lock in the his value in Apple at $50,000 no matter what Apple prices do over a year. April is happy because she has the same exposure as investing in Apple shares directly.
If the value of 100 shares of Apple goes up to $100,000 in one year, April is happy. Bob may feel he missed out, but he is happy to have had certainty. Bob pays April $50,000 after selling 50 shares. In this scenario, Bob maintains his Apple value at $50,000 and April doubles her money and now has $100,000. If instead the value of 100 shares of Apple had gone down to $10,000 in one year, April would have to pay Bob $40,000 dollars. In this scenario Bob still maintains his value at $50,000 and April now only has $10,000. In this example, both parties reach agreement because Bob wants to lock his value, and April wants to have the same exposure as investing in Apple directly.
Example 2. Let's say Bob owns 100 shares of Apple and his friend Charlie also owns 100 shares of Apple. Suppose Charlie is very confident about Apple and wants to get more exposure to Apple, but has no extra cash. Just like April in example 1, Charlie can enter the same contract for difference with Bob for one year. Unlike April who put $50,000 in cash as collateral, Charlie puts 100 shares of Apple (worth $50,000) as collateral.
If the value of 100 shares of Apple goes up to $100,000 in one year, Charlie is happy. Bob may feel he missed out, but he is happy to have had certainty. Bob pays Charlie $50,000 after selling 50 shares or can just send Charlie 50 shares. In this scenario, Bob maintains his Apple value at $50,000 and Charlie now has three times his original value instead of just double.* Charlie still has his original 100 shares that doubled in price plus $50,000 (or 50 shares more of Apple).
If instead the value of 100 shares of Apple had gone down to $40,000 in one year, Charlie would have to sell 25 shares and pay Bob $10,000 dollars (or alternatively send Bob 25 shares). In this scenario Bob still maintains his value at $50,000 and Charlie holds 75 shares.
If instead the value of 100 shares of Apple had gone down to $25,000 in one year, Charlie would have to sell 100 shares and pay Bob $25,000 dollars (or alternatively send Bob 100 shares). In this scenario Bob still maintains his value at $50,000, but Charlie no longer holds any shares!**In this second example, both parties reach mutual agreement because Bob wants to lock his value, and Charlie wants to have double the exposure for his Apple shares. The first and second examples are the same, except April uses cash as collateral and Charlie uses shares of Apple. When Charlie uses Apple shares as collateral, the value of the collateral shrinks or expands along with share prices.
The bitShares bitAsset system brilliantly implements the idea of contracts for difference to create market-pegged assets. The BitAssets system is very similar to example two and also similar to example one.
I was going to explain more, but ran out of time today...feel free to make suggestions on what to cut out.. make any corrections ... etc.. I want to make it easier for people to understand how bitAssets are created so we can offer more informed opinions about the future design. I think it's important to understand the basics.
*Update: Charlie actually gets 3x his original investment instead of double. The value of his original shares doubles and he gets an extra $50,000 from Bob.
**Update: Corrected share calculations in Example 2. Sorry and please re-check my calculations!