How Market Makers Work

How Market Makers Work
Written by Andy

As opposed to DMA brokers who pass the client’s CFD order to the exchange with a trade in the underlying asset, market makers may assume the risk of a trade by taking on proprietary positions as a result of customer order flow. The CFD market maker provides price quotes for clients to transact with, in the process creating a bid-offer spread outside of the underlying market environment (which are however based on the price of the underlying security CFDs). Usually, we would expect spreads offered by market makers to be slightly wider than if we were to trade the underlying market direct, such as trading on a futures exchange or buying the shares directly. This is because market makers will neutralise their exposure by trading in the market and leaving the difference as their gain. The good news is that the market for CFDs is quite competitive with many providers competing for clients so spreads these days are very tight.

Market makers offer traders a market in an ever-expanding range of financial markets to speculate on all from one single account on a common platform. These typically including forex pairs, indices, shares, commodities, interest rates and more (as opposed to a Direct Market Access service which only supports shares). Traders are able to go long or short on these markets and contracts are made between the trader and the CFD broker. The size of the bid offer spreads depends on the liquidity and volatility of the underlying instrument so market makers may offer narrower spreads for certain instruments or wider dealing spreads for other markets. Note that some CFD market makers may not charge commission (some do, some don’t) but may simply look to make a profit from the dealing bid-offer spread and the financing arrangements offered to clients.

Do Market Makers Hedge Client Positions?

Market Makers don’t necessarily match buyers and sellers on a one-to-one basis. It’s basically a contract directly with the CFD provider company. So they are your counterparty and market makers are not obliged to hedge that transaction in the market; in fact it is perfectly possible for a CFD market maker to assume the risk of a client’s CFD trade. Once a trade is executed, the market maker will net the position it has taken on with those of other traders it has accepted on the same market.
Ideally for them they’ll have a bunch of investors speculating that prices will move up and another bunch of investors speculating the other way and the risk cancels each group out and they take the spread. When they have large groups speculating one way and only small groups speculating the other way they may manage that risk via hedging in the underlying cash markets depending on how their dealing desk believes the market is going to move. Thus, a CFD market maker will typically net trades and then hedge any residual exposure directly in the underlying market.

So often your trade is really playing the market and not versus the market maker. As a small trader we’re lumped in with all the other small traders and the risk is presumably managed collectively. For the big players market makers will obviously take an individual approach to how they handle their positions for them – if they’re consistently good winners their positions will probably be hedged straight away.

Example: How CFD market makers net orders

Suppose the following trades have placed by different CFD traders with the broker:

Trader A goes long the Dow Jones for £25 per point

Trader B goes long the Dow Jones for £30 per point
Trader C goes short the Dow Jones for £35 per point
Trader D goes long the Dow Jones for £100 per point

The provider is acting as the counterparty to each of these trades and this leaves the broker with a net long position of £120 per point. At this point the broker might decide to hedge this excess exposure by going into the market direct and buying a number of futures contracts equivalent to this £120 per point exposure. By doing this, the broker effectively neutralises its excess exposure and is hedged against any price movements of the Dow Jones.

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