CFD Providers Hedging Exposure

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CFD Providers Hedging Exposure

Q.: Does my broker hedge all client cfd positions as opposed to spread betting?

A: First of all, you don't have it all that far off from what is the case.

Simplified, the key difference is that spreads are based on futures products and CFDs are based on stocks. I use only UK regulation (or EU in the case of MiFID) to base my points on, as that is my area of knowledge upon which I base my answers.

There is no obligation on an FSA firm to hedge with its own brokers on a client position. This may lead to a greater capital base requirement especially in light of the new ICAAPs required as of 1 January 08. In other words, if your business plan/risk management policy articulated a policy not to hedge or rarely hedge, you might be called to take this into account when you have to calculate your capital requirement minimum.

Providers have different business plans. For instance, I had always heard that CMC rarely hedged any client positions. This is classic bookmaker model, no? Other companies have a strict policy of always hedging and earn money off commissions.

Do you see the important point here? - The client side trade and the hedge are totally different contracts. A CFD provider doesn't have to hedge at all--it is the issuer of the security, not a broker. Sure, the provider had better have a large balance sheet since it would have to pay a huge gain out of pocket in this scenario.

The reason that spread betting gets tax free treatment (to private persons in the UK) is because HMRC/Inland Revenue historically views spreads as something where the pricing is set internally, by odds, and not market forces. This is a punt--I mean do you really know if it's 3:1 that the Daily Mirror will run a headline on Princess Diana tomorrow?

Compare: CFDs are pegged to actual equities and incorporate the life of an equity: for instance there are provisions in the provider's terms and conditions for passing on dividends to long position holders (and taking for shorts), even though you have zero legal connection to the company you are getting a CFD on.

To that I would note that most professionals don’t trade spread bets, only CFDs. Too much distortion and own pricing (versus market) in spreads. This is why firms started offering these Rolling Cash/Rolling Day sorts of products--CFDs wrapped up in a spread trade so as to get the market transparency of CFDs with tax free treatment of spreads. Rolling cash won't work for you with a nominee company as the client needs to be a biological person.

Q.: As I understand that some CFD providers hedge their client positions on the stock market by shadowing client trades...

A: In the UK there is an exemption to stamp duty for a London Stock Exchange member who is buying to hedge a derivative transaction.

Elsewhere, it's generally included in the commission you pay.

In fact there are two exemptions, Market Maker Exemption and Broker Dealer Exemption.

Market Maker Exemption is for those brokers who are acting as a market maker in the securities. Broker Dealer Exemption is available when a broker firm is a member of the ISE or London Stock Exchange and where shares are acquired as principal.

 ...Continues here - CFDs versus Options