Price Taker or Market Maker?

Choosing between direct market access and a quote-driven service can be a real dilemma for CFD traders. Nick Sudbury has some helpful advice

There are plenty of factors to consider when selecting a CFD provider, but perhaps the most fundamental issue is whether to go for a direct market access (DMA) or a quote driven product. This important decision can have significant implications for the feasibility of different trading strategies and the costs of actually implementing them.

The majority of companies offer quote-driven CFDs. These are generally considered to be the easiest to understand, since anyone placing an order is simply presented with his provider's bid and offer. When dealing in normal sizes these will generally mirror the underlying cash market prices, with the company making its money by charging commission on the transaction. CMC Markets is the only provider to let people, in the words of its former brand name, 'deal for free'.

'We often get asked how we make our money,' says David Jones, chief market analyst at CMC Markets. 'Our CFDs mirror the underlying market spread, so if Vodafone shares were trading at 150.75-151 our CFDs would be priced to match. It is the sheer volume of transactions that we handle that enables us as market makers to simply to take a little bit out of the spread.'

Most if not all quote-driven providers claim to price their CFDs from the underlying cash market. This is fairly straightforward for clients to check, since all they need to do with an equity CFD is to compare the order ticket with the real-time share price - something that can be done quite easily on the internet.

When it comes to transparency, however, it is impossible to beat direct market access. A DMA CFD order generates a trade directly on to the relevant stock exchange. For example, whenever anyone places an order to trade UK equity CFDs the provider will instantaneously create the equivalent position in the underlying cash market to hedge its exposure. The shadow trade exactly mirrors the client's instruction in terms of price and volume and appears as an individual entry in the London Stock Exchange's electronically-traded SETS order book. This means that it can be seen on the Level 2 screen. Quote-driven providerswill also typically hedge their CFD exposures, but this would generally be on an aggregate basis so an individual client trade would be unlikely to appear as a separate transaction.

E*Trade is unusual in that it operates both a DMA and a quote-driven CFD service. Tony Celentano, a relationship manager on its CFD desk, says that a lot of clients trade more on the quote-driven system because it is simpler. In terms of the process, dealing on the bid and offer is no different from trading shares.

'Sometimes people start with the quote-driven product but then as their experience grows they may decide to switch to DMA,' he says. 'In my opinion it is the nature of the trading opportunity that determines which is the better to use. Having access to both systems means our clients can take full advantage of all the different trading techniques.'

Level 2

DMA - or Level 2 - allows market participants to trade directly with each other on the central limit order book. This gives subscribing institutions and individuals the freedom to enter their orders at whatever price and quantity they want. The system then automatically matches willing buyers and sellers on a price/time priority basis. In the UK this process applies to the most liquid shares traded on the SETS and SETSmm platforms. The associated Level 2 data from the LSE displays all the outstanding buy and sell orders with their associated price and quantity. Time and sales data for the most recent trades is also listed.

Stockbrokers have traditionally tended to avoid giving private clients direct market access to the central order book, opting instead to execute orders using a retail service provider or RSP. These are automated quoting systems where the RSP trades in a principal capacity, albeit with the obligation always to match or improve the best bid and offer displayed by the exchange.

Sophisticated share traders are increasingly demanding the extra control only available with DMA. To date, iDealing and Interactive Brokers offer this facility for shares listed on the LSE and more firms are likely to follow.

DMA allows individuals who have enough experience to be classed as intermediate investors to add their buy and sell orders to the central book at whatever price and quantity they want.

Hugh Brown, head of trading product development at the LSE, says there has been a noticeable increase in interest in direct market access. 'DMA can result in significant cost savings,' he says. 'If the spread on a stock is 100-105, someone buying 10,000 shares through a broker may be able to do so at 104.5, whereas a DMA trader could potentially buy on the bid at 100 and save £450.'

The recent extreme volatility has also highlighted some of the limitations of RSPs. 'There have been some suggestions of RSPs widening their spreads, reducing size or not offering a service at all in certain stocks,' says Brown. 'There is also a delay between requesting a quote and actually receiving it, whereas with DMA, if there is an order in the market, an investor can trade against it straight away.'

Foster Bowman, managing director of, says that as far as DMA traders are concerned, the recent volatility has created opportunities and additional liquidity. 'During the first sell-off there were plenty of liquidations by fund managers, hedge funds and individuals that allowed DMA traders to pick up bargains simply by being on the central limit order book,' he says. 'Traders couldn't get this via an RSP as some stopped their services altogether while others cut the size. This also made it more difficult and expensive to unwind existing positions.'

Trading Strategies

Quote-driven CFDs tend to be used for short-term trades where people simply want to deal on the touch price. This might be an intraday position or it may be held for several days, but the key point is that any strategy which entails buying on the offer and selling on the bid requires nothing more complex than a quote-driven CFD.

Scalping, by contrast, is only possible with DMA. This strategy relies on trading within the bid and offer to make money from the spread. Scalpers will have their own watchlist of stocks and when they see a spread widen from its normal level they will look to capitalise. Shares that attract this type of activity include the likes of Invensys and Thus. Take the latter as an example. With the quote fluctuating around 13.5-14 a scalper may look to join both the bid and offer hoping that both positions will be filled for a profit of 0.5p or £500 on a trade of £100,000. DMA trading platforms allow clients to interact directly with the order book so that they may not have to pay the usual bid/offer. With a quote standing at 150-151, someone looking for a long exposure who didn't want to pay the full offer of 151 could put an order on the bid at 150.5 so that he becomes the best bidder in the market with a good chance of getting an improved fill.

The full market depth of the LSE's electronic order book can be viewed via a Level 2 screen, which is now quite a common feature on CFD platforms. The display shows all the outstanding buy orders on the left of the screen with the sells on the right. The yellow touch strip comprises the best prices based on the current orders, with deals automatically executed when they match in price.

'All E*Trade CFD clients get free access to Level 2 data but DMA traders benefit from interactive Level 2,' says Celentano. 'Just clicking on the yellow touch price generates a pre-filled order ticket meaning that all that they have to do is enter the number of CFDs and then choose the relevant order option.'

DMA gives traders full access to the liquidity of the market itself, whereas anyone using a quote-driven service is dependent on the provider. For example, clients using the quote-driven model at E*Trade will see a green price, which is the instant cash market price with dealing as quick as via DMA. If trading a bigger size they will instead see an indicative, volume-weighted average price.

CFD traders

Over the past few years many active traders have switched away from the underlying cash market in favour of CFDs. These offer leverage of ten to 20 times, allow short positions to profit from price falls, and are free of stamp duty. CFD traders have the choice of using either a quote driven product provider or one that offers DMA.

With a quote-driven service the trader is simply presented with the company's bid and offer. These are derived from the underlying cash market prices and, when dealing in normal market size, will generally be identical, with the company making its money from the commission on the transaction. Quote-driven providers include: City Index, CMC Markets and E*Trade.

A direct market access CFD provider operates very differently. Whenever a client places an order to trade a UK equity CFD, the company will instantaneously create the equivalent position in the underlying cash market to hedge the exposure. This shadow trade exactly mirrors the client's instruction in terms of price and volume and appears as an individual entry in the LSE's order book as seen on the Level 2 screen.

Companies operating on this basis include: GNI Touch, IG Markets and E*Trade - which is unusual in offering its clients the choice of both DMA and quote-driven CFDs.

ODL Securities offers a direct market access service for CFDs and US stocks. James Bateman, head of marketing, says clients tend to use both facilities. 'All the advantages of DMA are the same whether trading the cash market or CFDs, it's just that CFDs offer the extra benefits of gearing, going short and no stamp duty,' he says.

DMA CFD providers normally have a headline commission rate of around 0.2%, although active traders will often be able to negotiate better terms. This means that the two-way charge of 0.4% on UK equity CFDs is noticeably less than the stamp duty saving. The only other costs are an overnight financing charge on long positions and the exchange fees for the DMA - on the LSE this is £15 a month - though not all providers pass this on.

Improving the price

The primary benefits of DMA are the speed of execution and the mpotential for better pricing. In particular, being able to join the order book can create opportunities to buy or sell well within the existing bid/offer spread.

With Thus trading at 128.5-131.5 (see Level 2 screen) someone using a broker would be limited to buying at the offer price of 131.5 or selling at the bid price of 128.5. DMA however offers the scope to improve on these, perhaps even to the extent of buying at the bid and selling at the offer.

To buy on the bid, a DMA trader simply has to enter a buy order at 128.5. This would then appear as the second item in the left hand column below the only other order at this price. Conversely, to sell at the offer involves entering a sell order at 131.5, which then appears in the right hand column below the existing order at this level. In essence, DMA traders have become their own market maker and can join the bid on the left hand side or the offer on the right. Of course this doesn't necessarily mean that these orders will be filled. With a fast-rising stock someone on the buy side may well be ignored as others step in front with higher prices. Equally, sell orders on a rapidly falling share could easily be bypassed as more traders join the order book at lower levels.

Another alternative is to pitch in at the best bid. With Thus trading at 128.5-131.5, someone looking for a long exposure who did not want to pay the full offer of 131.5 could enter a buy order at 129 to become the best bidder in the market. If a seller just wants a market fill then this is the order that will be hit. The trade-off with entering a bid rather than hitting the offer is the opportunity to improve on the price, albeit at the risk of not getting filled or getting a part fill.

Auction Advantage

One clear-cut advantage of DMA is that it enables traders to participate in the LSE's opening, closing and intraday auctions. Stocks quoted on either the SETS or SETSmm platforms start each trading day with a pre-market auction between 7.50am and 8.00am, and end it with a post-market auction from 4.30pm to 4.35pm. It is often during these auctions that a stock records its high or low of the day, which means that only those who take part have a chance of achieving the best prices and hence the biggest possible moves.

Those with a DMA provider cannot actually trade during the auction, but they can place and delete orders. These appear on the Level 2 screen along with the indicative uncrossing price updating in real-time as calculated by the LSE. At the end of the auction all the crossed trades will take place at the final official uncrossing price.

Sometimes a liquidity imbalance arises during the auction that offers the potential to be filled at day high/lows. In many cases these opportunities are news related. On Monday 31 October for example the FTSE added more than 100 points as a result of speculation surrounding six different mergers and acquisitions. The pre-market announcement of the £17.7bn purchase of O2 by Telefonica resulted in lots of activity in the mobile operator's shares during the opening auction. The last trade in O2 on Friday 28 October was at 164.25p, yet the uncrossing price after the opening auction on Monday morning was around the 202p level. Someone with DMA could have got in at this official open and made money, as the shares rose to a high during the day of 206.75p and then hit further highs the day after.

Opportunities can also arise in the closing auction. This represents the last chance to trade the cash market on any particular day and as such there are instances when large institutional buyers or sellers can find themselves with no option but to participate. Large orders can create a liquidity imbalance with any resulting price distortion likely to reverse as soon as the market reopens the next day.

One notable example occurred on 17 June when the expiry of futures and options contracts - the so-called 'double witching' - led to a particularly volatile auction. Almost every blue-chip stock rose considerably above the price at which it had been trading. Anyone with DMA who was prepared to run some overnight risk could have taken advantage of this by entering a short order during the auction to be filled at the official close - the expectation being that the price rises would quickly correct themselves on the following day.

Foster Bowman has recently been using the auctions to good effect in trading Soco International, an oil exploration stock. 'A lot of the times, the auction price has been significantly different to the intraday prices. This has allowed me to sit on the bid during the opening auctions and be filled at 1% to 1.5% below the market price,' he says. 'High liquidity during the closing auction has then enabled me to close my position at or near to the high of the day.'

Managing Costs

CFD providers typically stipulate a headline commission rate of anything from 0.15% to 0.25% with minimum charges varying from £15 to £25, although active traders will generally be able to negotiate more favourable rates. E*Trade is unusual in offering a fixed-ticket commission charge of £9.95 for FTSE100 stocks, which works out very good value when trading large size. Either way, the commission will apply to both the opening and the closing trades thereby making a 0.3% to 0.5% charge for the two-way trip, which when dealing UK equities is no more than the stamp duty saving compared with a trade in the underlying. The other major cost with CFDs is the overnight financing charge, with long positions typically debited at the rate of 2.5% over LIBOR, and shorts attracting a small credit.

The majority of companies do not charge for the use of their trading platforms. These typically include many valuable features such as access to real-time prices, as well as news feeds, research and charting packages. DMA providers will also routinely include Level 2 market depth data, though in some cases there will be a separate monthly fee of around £30 to cover the data charge made by the LSE.

Brought to you in association with MoneyAm Shares Magazine