There are two types 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 important to understand how CFD brokers make money when you trade. In this article we will focus on Direct Market Access or DMA CFD providers only.
Direct Market Access CFDs are the most transparent type of CFD available, the reason for this is simply because DMA CFD brokers hedge every order that they receive from their clients in the underlying market. When trading DMA CFDs you will actually see the CFD providers hedge order in the order book of the share listed on the underlying exchange on which the CFD is based.
In order to hedge in a cost efficient manner and enable the DMA CFD broker to offer CFDs on overseas exchanges the DMA CFD provider will utilize the execution services of a global investment bank that has exchange members globally. Having a relationship with one execution provider also allows the DMA CFD provider to achieve economies of scale resulting in lower execution and financing costs for the provider and ultimately the end client.
The global investment banks providing the DMA execution into the underlying exchange on behalf of the CFD provider also provide the financing on the positions, this execution and financing service combined works much like a CFD but on a much larger scale. The CFD brokers hedge transactions with the investment bank are known as SWAP transactions and the service offered by the bank is known as prime breaking.
A DMA CFD provider model is simple, aggregate as many client orders and positions as possible in order to achieve reduced execution and financing rates on the SWAP contracts offered by their prime broker.
CFD providers make money much like any business where the business owner buys from the wholesaler and then sells the product in stores to retail customers.
The formula is simple, if your CFD broker is charged 0.01% commission on their SWAP trade and pay a financing rate of 0.50% above or below the RBA rate any charge you 0.10% commission on the trade and 3.00% above or below the RBA rate they will make money. In addition to making money on commission and financing DMA CFD brokers also receive the benefit of netting all client positions against each other. Put simply netting means that if a long position offsets a short position the CFD broker has no position, however, as the client who is long paying interest and the client who is short is being paid interest less a small haircut, the CFD provider profits from the difference between the two interest rates.
It is important to note that prime brokers will not deal with retail clients themselves and will typically only deal with large hedge funds and CFD brokers as such CFDs are a great way of achieving access to global markets in much the same way as the global investment banks themselves and hedge funds do.