Hedging Exposure

CFD Providers Hedging Exposure

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

My impression was that CFDs were exchange traded and therefore that you were betting against “the market”, whereas spread betting was essentially betting against the bookmaker who uses the markets as a reference. The point being that if you enter into a CFD, the broker is obligated to hedge that bet in the market, but this obligation doesn’t exist in 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.’

In practice, the aim of the CFD provider is normally to maintain a neutral position, profiting from the spread. Because of this when a CFD provider gets your trade he has one of two options -:

  1. Matches it with another investor of theirs that placed a sell order for the same underlying asset.
  2. Offset with another CFD company or by buying the actual underlying instrument.

However, 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. CFD providers using the direct market access business model do however promise to ‘hedge’ all client trades in the underlying market. This means that when you place a CFD trade, you should be able to see the corresponding trade being placed in the underlying market. This makes the CFD pricing and trading process more transparent for investors trading contracts for differences, although DMA trading then by its very nature limits the number and types of CFDs that can be traded (since for a transaction to take place it has to match an opposing trading on the exchange). Even though the order is placed in the underlying market, it doesn’t mean that you own or are entitled to the underlying asset, and you are still subject to counterparty risks.

Market maker CFD providers may also hedge the CFDs they offer, but these arrangements are generally less transparent than for direct market access providers. Providers have different business plans. For instance, I had always heard that CMC rarely hedged any client positions. In fact, it is documented that in the past CMC Markets used to profile its customers and placed them into several different groups, including the ‘A-book’, the ‘B-book’ and the ‘C-book’. According to a document previously used within CMC, the ‘C-book’ was a ‘classification for clients with a past history of excessive losses on their account and the propensity to churn their Australian equity-only positions’. People with knowledge of CMC’s Australian operations said CMC did not hedge the C-book… ‘Hedging’ is a fancy way of saying a company attempts to lay off its risk from individual trades. What CMC was doing was identifying a C-book risk that it wanted to take, because it was more likely that ‘C-classed’ investors would lose their money. This is classic bookmaker model, no? Other companies have a strict policy of always hedging and earn money off commissions. It is well worth noting that CMC Markets decided to ‘transition’ its hedging practices in June 30 2009 and now CMC has a target of hedging 90 per cent of its book, meaning it cannot profit from investor losses in the hedged portion and there is no longer any client profiling to determine the 10 per cent that is unhedged. [Source: Sydney Morning Herald]

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 and in particular market makers may not hedge all the CFD trades you place, and so may directly benefit if you lose on your trade. 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.

Do brokers hedge client positions?

The chief executive of IG Australia, Tamas Szabo, said it was unlikely his business would be 100 per cent hedged, because some clients’ trades would be set off against each other, creating what is known as a ‘natural hedge’. He said his business profiled clients to the extent high net worth clients were identified, but he denied IG deliberately set hedging policies to profit from customer losses. ‘Quite frankly, it’s unethical. No company should aim to see clients lose money to their [the company’s] advantage,’ he said.

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

But dont CFD providers have to pay stamp duty when buying the shares?

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.

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