There are a couple of kinds of CFD models, Market Maker and Direct Market Access. Each type has its own advantages and drawbacks and each CFD provider makes money in a very different way. It is essential to become familiar with how CFD providers generate profits when you trade. In this article we will concentrate on Direct Market Access or DMA CFD providers only.
Direct Market Access CFDs are the most transparent type of CFD available, the main reason for this is basically because DMA CFD providers hedge each trade they receive from their clients in the underlying market. When trading DMA CFDs you'll actually see the CFD providers hedge order in the order book of the share listed on the underlying exchange on which the CFD is quoted.
So as to hedge in a cost efficient way and enable the DMA CFD provider to provide CFDs on overseas exchanges the DMA CFD provider will utilize the execution services of a international investment bank who has exchange memberships globally. Creating a relationship with one execution provider also enables the DMA CFD provider to achieve economies of scale resulting in lower execution and financing costs for the provider and eventually the end client.
The international investment banks offering the DMA execution into the underlying exchange on behalf of the CFD provider also supply the financing on the positions, this execution and financing service combined works much like a CFD but on a far bigger scale. The CFD provider’s hedge transactions with the investment bank are known as SWAP transactions and the service offered by the bank is called prime broking.
A DMA CFD provider model is simple, aggregate as many customer orders and positions as possible so as to attain reduced execution and financing rates on the SWAP contracts offered by their prime broker.
CFD providers generate profits much like any business where the business owner purchases through the wholesaler and then offers the product in stores to retail shoppers.
The formula is simple, if your CFD provider is charged 0.01% commission on their SWAP trade and pay a financing rate of 0.50% above or below the RBA rate any they charge you 0.10% commission for the trade and 3.00% above or beneath the RBA rate they're going to make money. In addition to earning profits on commission and financing DMA CFD providers also receive the advantage of netting all customer positions against each other. Put simply netting means that if a long position offsets a short position the CFD provider has no position, however, as the client who is long is having to pay interest and the client who is short is receiving interest less a small haircut, the CFD provider profits from the difference between both interest charges.
It is important to note that prime brokers will not deal with retail clients themselves and will generally only deal with sizable hedge funds and CFD providers, as such CFDs are a great way of attaining access to global markets in much the same way as the international investment banks themselves and hedge funds do.
Author Resource:
Matthew Jones is one of the most knowledgeable DMA CFD traders in Australia. Matthew has been trading for over 15 years and began trading CFDs when they were first first launched in Australia in 2003. Matthew is a well known CFD trader having dealt with all of the main CFD providers and published a number of courses and learning manuals on trading Market Made and DMA CFDs for a livelihood, including titles such as How to Choose your CFD provider and What is a DMA CFD?.
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