Sep 10 2010
There are a couple of sorts of CFD models, Market Maker and Direct Market Access. Each type has its own advantages and drawbacks and each CFD provider makes money in a very different way. It is important to understand how CFD providers generate income whenever you trade. In this article we are going to focus on Direct Market Access or DMA CFD providers only.
Direct Market Access CFDs are one of the most transparent variety of CFD available, the main reason for this is basically because DMA CFD providers hedge each trade they receive from their clients in the underlying market. When buying and selling DMA CFDs you will actually see the CFD providers hedge order in the order book of the equity listed on the underlying exchange on which the CFD is quoted.
So that they can hedge in a cost effective manner and enable the DMA CFD provider to provide CFDs on offshore exchanges the DMA CFD provider will utilize the execution services of a global investment bank that has exchange memberships globally. Creating a relationship with one execution provider also allows the DMA CFD provider to realize economies of scale resulting in lower execution and financing costs for the provider and eventually the end client.
The global investment banks offering the DMA execution into the underlying exchange on behalf of the CFD provider also supply the financing on the positions, this execution and financing service combined works much in a similar way to a CFD but on a far bigger scale. The CFD provider’s hedge transactions with the investment bank are called SWAP transactions and the service offered by the bank is known as prime broking.
A DMA CFD provider model is straightforward, aggregate as many customer trades and positions as possible with a view to achieve reduced execution and financing rates on the SWAP contracts offered by their prime broker.
CFD providers make money very similar to any business where the business owner buys through the wholesaler and then sells the merchandise in stores to retail consumers.
The formula is simple, if your CFD provider is charged 0.01% commission on their SWAP trade and pay a financing rate of 0.50% over or below the RBA rate any they charge you 0.10% commission on the trade and 3.00% over or below the RBA rate they'll make money. Along with earning profits on commission and financing
DMA CFD providers also obtain the advantage of netting all client positions against each other. Put simply netting means that if a long position offsets a short position the CFD provider has no position, however, as the client who is long is having to pay interest and the client who is short is being paid interest less a small haircut, the
CFD Provider profits from the difference between the two interest charges.
It is imperative to note that prime brokers won't deal with retail clients themselves and will typically only deal with large hedge funds and
CFD providers, as such CFDs are a great way of attaining access to global markets in much the same way as the international investment banks themselves and hedge funds do.
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