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Market Maker CFD Model

Posted By Robert On Thursday, April 23rd, 2015 With 0 Comments

A market maker is a person or a firm who quotes both a buy and a sell price in a financial instrument or commodity, hoping to make a profit on the turn or the bid/offer spread. In foreign exchange trading, where most deals are conducted OTC, and are therefore completely virtual, the market maker sells to and buys from its clients. Hence, the client’s loss is the company’s profit and vice versa. Most foreign exchange trading firms are market makers and so are many banks, although not in all currency markets

Most stock exchanges operate on a matched bargain or order driven basis. In such a system there are no designated or official market makers but market makers nevertheless exist. When a buyer’s bid meets a seller’s offer (or vice versa) the stock exchange’s matching system will decide that a deal has been executed. Most CFD Brokers are Market Makers, but some just provide a portal or access point to these Market Makers making them plain old CFD Brokers.

When trading CFDs your broker becomes the market maker by creating a Synthetic Market. This ensures that all of your Buy/Sell orders are guaranteed at the requested price, theoretically creating infinite liquidity. Sounds pretty sweet right? While high liquidity is one of the large benefits of CFDs it does come at a price, The Spread. Since CFDs trade on a Synthetic Market, that has minimal regulation and costs they are defined as an Over The Counter product. You cannot move CFDs between brokers, transfer them from funds to trusts or even to other people as they are a contract between you and your broker and that contract says that you can only sell that CFD back to the broker you purchased it from.

This gives brokers the enormous power of spread control, something that they can use to create large profits for themselves (by offering larger spreads than the underlying market). In the nature of turning a profit (in the long run) this is however a financially unsound move for the brokers as smaller (tighter) spreads attract more customers, which in turn earn the broker more dollars. You will usually find that the most prominent brokers will offer a tight bid/ask spread in order to retain their customers.

A Market Maker CFD provider does not give clients any direct market price feeds and nor are 100% of the trades hedged. This means quite a few things for a trader. Firstly you will not see the actual market. This can be a huge disadvantage market depth and volumes are important factors in trading decisions made by many. Also there is no guarantee on market prices although due to pressure provided by DMA providers means majority of Market Makers do guarantee market price. Even though this guarantee is in place is does not mean you will not get re-quoted or your order rejected. Market maker means that all price feed and order are intercepted and regulated by a dealer.

With regards to the fact that not all trades being hedged is a little more complicated. It is entirely up to the provider as to whom or what they decide to hedge. It can almost be guaranteed that some if not all of your losing trades are pocketed by the provider raising the question as to whether or not your provider and you as a trader have your interests aligned. Again keep in mind its entirely up to the provider and it will vary between providers. Whilst there is some negativity and controversy surrounding market makers there are some benefits that will suit traders.

Synthetic Pricing

Synthetic Pricing relates to how your CFD broker creates the bid/ask spread for any particular CFD. This will usually start with the broker examining the underlying asset then placing the policies or rules it has determined and pricing them into the spread.

Advantages:

  • Platforms and data fees are usually free
  • Better margins because not everything is hedged
  • Extra liquidity provided but again because they will not hedge
  • Access to exotic instruments some providers will not
  • On instances they can be cheaper
  • Their margins will tend to be slightly better than DMA
  • Will offer smaller in value Indices etc.

Disadvantages:

  • Platforms have to be downloaded usually
  • Trades are not hedged
  • No volumes
  • No depth
  • Re quotes
  • Order rejections
  • Slower execution
  • Dealer intervention
  • No market auctions
  • Limited equity product ranges
  • Spreads can be widened
  • Pricing does not necessarily match the underlying
  • Susceptible to slippage

The flow chart Below should illustrate the dealers intervention in everything slowing down processes and execution times.

Market Maker Model

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