CFDs provided by a market maker do not strictly follow the underlying market and the provider determines their own price for the CFDs they offer, which may be the same as the market price for the underlying asset, or may involve an extra margin on that price (referred to commonly as a ‘spread’). In other words the broker will refer to the underlying financial instrument and quote buying and selling prices from the underlying instrument on which the contract for difference is based rather than quoting the exact exchange price of the instrument like Direct market access CFD providers. The spread is often a little wider than with the direct market access provider, but to counter this frequently no commission is charged as this is included in the spread.
People who trade CFDs via this model are said to be price takers (rather than price makers as with DMA). When trading Market Made CFDs trades do not flow directly onto the exchange which means that there is a risk that trades are filled at the discretion of a dealer and as a consequence may result in orders being filled slower and at inferior prices. As a market maker acts as the middleman between the CFD trader and the market, there is the opportunity for prices to be changed in favour of the market maker and against the trader, which for example might trigger a stop loss or result in slippage when an order is placed. This is a function of the system — the market maker has to protect his position and you would not expect him to change prices to favour the trader. There are varying reports on the different market makers as to what extent they may seek to take advantage of their clients in this way.
Market Makers do not hedge 100% of their clients’ contract positions – typically they hedge only the resulting amount after their clients’ long and short positions net each other off, however in some cases they do not hedge at all in which case they would stand to profit directly from their clients losses. The market maker may certainly choose to hedge some of the positions on to the market, typically by pairing off the contracts that have been placed with them and hedging the residual exposure. The provider may also decide to take their own view of the markets and hold the positions unhedged with the intent to profit from clients’ losses. This can be a risky strategy for the broker, particularly as he is not likely to have spent as much time as the trader analysing each potential trade, so despite some rumours to the contrary it may not be a widespread practice.
Certainly with an uncertain spread and variable pricing, you may not want to consider scalping with a market maker, as it would be easy to lose your edge in the re-quoting and dealing, but for longer term trading in contracts for difference there is less reason to shun the market maker and use direct market access, and some reasons that you may prefer a market maker.
So why use a Market Maker?
Trading requires someone to take the other side of trades and this is what market makers are practically doing so having them taking positions against clients shouldn’t really be considered a bad thing. In fact this model is ideal for small to medium private traders who intend to hold positions for very short periods of time. Market made index CFDs also represent an inexpensive and simple way trading the actual futures contract which normally requires a much higher upfront margin. Another key advantage of using a market maker for trading CFDs is that they are likely to have a much bigger selection of underlying financial securities on which to trade. They can make the market for financial instruments such as index and commodity CFDs as they are not required to directly hedge the position. This is because market makers can write CFDs against ‘synthetic’ assets (for example, an index) or against real assets, even if there is little or no liquidity in the market for the underlying asset, or a market does not exist. Market Makers may also be able to offer extra liquidity in bigger stocks, the reason for this is because they might have positions on their internal order book which they would like to clear out.
Also, a market maker may be able to provide fixed spreads which sometimes compare favourably to the interbank rates and high leverage of up to 400:1. Another area where you need to use a market maker is if your trading system requires you to place guaranteed stop losses to prevent runaway gaps in volatile stocks from crippling your account. The use of GSLs is a matter of some debate, because you are charged for them when you take out the trade, whether or not they are needed, and this cost can impact your profits; but if you trade in volatile or thinly traded markets where you frequently find that stop losses are not filled near the set level, you may want this facility.