Most private traders who trade CFDs today do so by either trading a range of market instruments via OTC providers or through Direct Market Access (DMA) networks. Having said that, there’s a number of descriptions CFD brokers may give themselves, including Direct Market Access CFDs (DMA), Straight Through Processing (STP), DMA Pricing CFDs, Hybrid DMA and Market Maker CFDs. To simplify, all CFD providers can be divided into two easily recognisable groups that describe the framework used by each to create CFDs. Some providers offer a DMA model (Direct Market Access) while other providers are market-making, setting their own prices which are somewhat broadly in line with the market. In actual fact there is another model (exchange-traded CFDs) but that is outside the scope of this article.
If you decide to open an account with a CFD provider, you should know what the CFD provider’s business model is (that is, how they structure and price their CFDs). Not all CFDs are the same. Learn about the different types of CFDs and their features and risks.
The difference between these models relates to the ways in which the prices are derived and orders are placed between yourself and the CFD provider. With DMA the trader can directly interact with the order book on the exchange, rather than just with the in-house trader at the brokerage. DMA providers use cash market prices direct from the exchange, your CFD order is placed in the real underlying market, resulting in real time execution, true market prices, participation in the order book and opening and closing phases of the market.
CFD Provider Business Models
It is important for you to understand the CFD provider’s business model. In Australia, for instance there are three types of business models: ‘market maker’, ‘direct market access’ and ‘exchange-traded’. Market maker and direct market access models are both provided over-the-counter (OTC) and are the most commonly available trading products.
Markets Makers base their prices on the physical market but still act as a middle man and most claim to mirror the price rather than actually matching prices, sometimes resulting in orders being filled at inferior prices. Also, there’s the issue of large orders; a market maker is limited to orders it can absorb and large investors or institutions might well need to transact much larger trades. On the positive site market maker platforms offer you access to the whole range of financial markets from forex, commodities to shares and indices. This is in contrast with DMA where typically only share CFDs are supported. In practice there is a place for both types, depending on your trading style, and you may want to consider opening an account with both types of providers. In both cases the CFD brokers decides the range of underlying assets on which CFDs may be offered as well as defining the terms and conditions of the client agreement, including margin requirements.
In the direct market access model, the CFD broker places your order directly into the market (i.e. say the London Stock Exchange) for the underlying asset. The price you pay will be determined by the underlying market. DMA gives a trader greater control over the orders he or she places. Because it bypasses the broker, it has been blamed in some cases for violent market movements caused by traders all hitting the market at the same time, but is generally seen on balance as a good thing. This is because the alternative allows price manipulation by the broker, and the broker’s involvement in market making normally means that the costs are higher.
Not all DMA systems are created the same. They can vary in their accuracy, their fees, and how long they take to process orders. As they involve your interface with the trading platform being routed directly to the market through the broker’s computers, there are various ways of fulfilling this function and no industry-standard. Having said that, the DMA version of order entry is more likely to be uniform and orders fulfilled as expected.
The market maker model of order entry is obviously more open to a broker’s discretion and misuse. It was the original way in which contracts for difference were traded before exchanges existed, and it works quite well. Your CFD order is not placed directly on the market, trading is slower, especially in fast moving markets. The fact is that competition has tended to keep brokers straight on the pricing, and excluded or eliminated many of the providers who wanted to take advantage of the system. However, it is worth noting that market makers do not hedge 100% of their CFD positions and can make money when you lose money.
It is also easy to forget that the market maker system is exactly the way that all markets and exchanges used to operate in the past. The trading floor of an exchange would have market makers, usually concentrating on one stock or group of stocks, who would shout out the prices and take the orders. Market making at a broker is not as noisy or hectic, but the principle of trying to match orders and hold together the book for the security is still the same.
So a benefit of trading CFDs with a market maker is that you can do things you cannot do with shares, such as guarantee your exit price. Another advantage that you get with the market maker system is that you can find CFDs in practically all markets, so you have a large range of products available for your trading. There is no standardization so you will have individual interest rates and brokerage costs, and you are reliant on competition to ensure that these offer good value.
One of the disincentives for these brokers converting to the DMA system is the sheer cost for the customised software, which can run into millions of dollars. As fees are expected to be less with DMA, there is little incentive for the provider to change unless to match the competition. However, in the long term, given that market makers provide access to a much wider range of markets than a DMA service, you’ll find that it’s useful to have access to both DMA (Direct Market Access) and market maker.
It is worth noting that the market-made CFDs are currently the most popular as investors are able to trade CFDs over indices and forex currency pairs. Direct Market Acess (DMA) CFDs tend to be more common with day traders that already trade shares for the reason that DMA CFDs allow stock market traders to participate in the opening and closing phases of the market as well as interact directly with the order book of the underlying share over which the DMA CFD is based. In any case it is important to note that both CFD types have useful utilities and you simply have to choose the type that satisfies your trading needs.