You bet your loss is a market maker's gain

THE ability of some contracts-for-difference providers to profit from their customers' losses springs from the differences between two business models: direct market access and market maker.

By InvestSMART · 28 Aug 2010

By InvestSMART ·
28 Aug 2010

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THE ability of some contracts-for-difference providers to profit from their customers' losses springs from the differences between two business models: direct market access and market maker.

The largest direct market access providers include CommSec, Macquarie, MF Global and E*Trade. The largest market makers are the country's largest providers, IG Markets and CMC Markets (they also offer direct market access services).

In the first model, every CFD sold is based on a linked trade in the underlying market the product is based on, meaning every trade is 100 per cent hedged. These providers perform as brokers, placing a series of orders. Their risk has been laid off, or hedged, as much as possible.

In the second, every CFD sold is not linked to a trade in an underlying market, and the amount of hedging can vary. These providers act as "principals", deciding at what level they should hedge, or lay off the risk of their trades.

A direct market access provider with 100 per cent hedging will simply act as a broker. A market maker with no hedging will profit from investor losses. Conversely, the risk comes in for the market maker when the investor wins.

The managing director of CFD training provider Seismo, Jim Taig, questions some market practices. "Direct market access CFD providers make money through financing costs and brokerage," he said.

"With CFD market makers there is a mechanism for your losses to go straight into the CFD providers back pocket, and this is why they often have the most profitable CFD business model," he said.

"I believe a market maker CFD provider taking the other side of a client's trade to be unethical, as they are essentially trading against their client. They effectively supply the CFD product, charge brokerage and finance costs, make up the prices (with spread costs) and then take the other side of the trade against the client all at the same time. Direct market access CFD providers do not trade against their clients."

Taig's critique includes the way the market makers price their trades.

"Market makers make the prices that you then have to take from them. Market makers can requote the price whereby they might sell you a CFD over a share for $40.05, compared with the share-trading on the ASX at $40.00 (the actual price)," he said.

Others experts say market makers reduce the margin or amount of money down to attract those willing to take riskier bets and pump up volumes.

In a casino analogy, this is similar to adjusting the win rate on a poker machine.

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Frequently Asked Questions about this Article…

What is the difference between a direct market access (DMA) CFD provider and a CFD market maker?

Direct market access (DMA) CFD providers act as brokers and link every CFD to an actual trade in the underlying market, meaning trades are typically 100% hedged. Market makers act as principals: they don’t necessarily link each CFD to an underlying trade and can choose how much to hedge, so they may take the other side of a client’s trade.

Which companies are examples of direct market access CFD providers and which are market makers?

According to the article, large direct market access CFD providers include CommSec, Macquarie, MF Global and E*Trade. The largest market makers named are IG Markets and CMC Markets, which also offer direct market access services.

How do DMA CFD providers typically make money compared with market makers?

DMA CFD providers generally make money through financing costs and brokerage while hedging their exposure by executing linked trades in the underlying market. Market makers earn money from spreads and can profit directly from customer losses when they take the opposing side of trades.

Why do some experts say market maker CFD providers can be more profitable as a business?

Experts quoted in the article, including Jim Taig of Seismo, say market makers can be more profitable because there’s a mechanism for client losses to flow straight to the provider when they take the other side of trades, in addition to charging spreads, brokerage and financing.

Is it ethical for a CFD market maker to take the other side of a client’s trade?

The article reports that Jim Taig questions that practice and considers it potentially unethical, because market makers can effectively trade against their clients while supplying the CFD, setting prices and charging fees all at once—unlike DMA providers who do not trade against their clients.

How can market makers’ pricing and requotes affect everyday investors using CFDs?

Market makers set the prices investors see and can requote them. The article gives an example where a CFD may be sold at $40.05 while the actual ASX share price is $40.00, which can widen costs for investors through spreads and requotes.

What risks do investors face when a CFD provider reduces margin or attracts higher volumes?

The article notes experts say market makers may reduce margin requirements to attract traders willing to take riskier positions and boost volumes. Lower margins can amplify both gains and losses, increasing the risk that more customers will incur losses that may benefit the market maker.

How can everyday investors use this information to choose a CFD provider?

Investors should understand whether a provider is operating as DMA (acting as a broker and hedging trades) or as a market maker (acting as principal and possibly taking the opposite side). The article names CommSec, Macquarie, MF Global and E*Trade as DMA examples, and IG Markets and CMC Markets as major market makers—knowing the business model helps assess conflicts of interest, pricing, spreads and how the provider makes money.