CFD market makers: How is the price coupled to the underlying security?

Question

If I understand it correctly, there are two different CFD provider modes of operation: DMA (direct market access), where the provider will immediately hedge all positions with matching trades on an exchange, and market making, where he takes on the opposite position of his clients' trades, bearing some risk.

I can see how a DMA CFD provider would have it in his best interest to provide prices very close to the underlying security prices.

But for market makers, there doesn't seem to be an equivalent mechanism. At the contrary, if a market maker were to take on a large position, it would be in their best interest to move the price in the opposite direction, forcing the client to eventually close at a loss.

As this doesn't seem to happen in practice: What are the regulatory or market mechanisms that tie CFD prices close to the exchange prices of the underlying securities?

I've heard claims that any price difference could be arbitraged away, but I fail to see how that is possible since CFDs can only be closed at the prices the provider is quoting.

Victor · Accepted Answer

CFD providers typically offer CFDs to investors using either the direct market access (DMA) model or the market maker (MM) model.

Direct Market Access

The DMA model gives you access to trade the Underlying instrument on the relevant Exchange from which the CFD is then derived.

All CFD Transactions under the DMA model have corresponding trades in the Underlying instrument.

Under the DMA model, providers typically charge their clients Commission based on the notional contract value of the CFD.

Market Maker

The MM model uses the price of the Underlying instrument to derive the price of the CFD that is offered. Trading under the MM model does not necessarily mean that your CFD will be reflected by a corresponding trade in the Underlying instrument.

Under the MM model each CFD Transaction creates a direct financial exposure for the provider, which may or may not be hedged in the Underlying instrument. Where the financial exposure is not hedged, the market risk may increase for the market maker.

The MM model enables the provider to offer CFDs against synthetic assets, even if there is little Liquidity in the Underlying instrument, which can result in a wider range of products on offer than with the DMA model. Volatility and Illiquidity in the Underlying instrument can affect the pricing of MM CFDs.

The MM model can charge its clients Commission based on the notional contract value or it can incorporate costs and fees in the dealing Spread, which represents the difference in price at which the issuer is prepared to Buy and Sell the CFD.

What Do I use and why?

I have traded with both DMA and MM models and prefer the MM. The big advantage with MM is that they will provide a market even when the underlying is very illiquid and only might have a few trades each day.

Regarding the spread of the MM to the spread of the underlying, I have found the MM to be practically in line with the underlying spread about 95% of the time. The other 5% it may have been slightly wider than the spread of the underlying by usually 1c or 2c.

Most MMs aim to give you the best spread they can because they want to keep your business. If they gave too wide a spread (compared to the underlying) it wouldn't be long before they had no customers.

CFD market makers: How is the price coupled to the underlying security?

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