Capital Properties FX
Capital Properties FX

CFD vs. Spread Betting Brokers – Everything You Need to Know about Financial Intermediaries


Brokerage houses are nothing but financial intermediaries. Against a fee and/or commission, brokers connect traders to the various financial markets that exist today.

Moreover, brokers do not represent one market only anymore. Back in the day, one house offered equities, another one currencies, and yet another one specialized on commodity trading.

Nowadays, the brokerage industry became so competitive that all markets appear in a trader’s account. The responsibility belongs to one financial product only: the CFD.

The acronym stands for Contract for Difference, and the name speaks for itself. By opening or closing a position (i.e., trade), the difference between the prices represents a gain or a loss. But more about CFDs, a bit later in the article.

For now, we must mention that brokers are only a small part of financial intermediaries. Other entities are investment banks, mutual funds, hedge funds, commercial banks, and the list can go on.

The idea is that financial intermediaries are market participants. Because the retail trading size of the entire financial market is so small, understanding financial intermediaries helps to calibrate trading expectations.

Spread Betting

Different Types of CFD Brokers

Almost every element in a trading account (i.e., financial product) is a CFD. CFD trading comes with a lot of pros (as well as cons) as outlined in this article by BrokerNotes.

First, from one single trading account, a trader has access to various markets: commodities (gold, oil, silver), indices, cryptocurrencies, traditional currencies, bonds, and many more.

Second, the idea behind trading all these products remains the same. Every trader must square the opened position at some point in time.

For instance, going long means buying from the ask price. Effectively, a trader that goes long is bullish, wanting the price to increase.

If that happens, at some point, the trader wants to close the position. More precisely, to book the profit. In doing that, the long trade is squared with a trade in the opposite direction. Namely, a short trade, from the bid price.

The difference between the bid and the ask price represents the spread. It typically belongs to the broker.

However, the difference between the entry and exit price belongs to the trader as a profit or loss. What’s important to remember here is the part that takes the other side of a trade. As you’re about to find out, not all brokerage houses play using fair rules.

Finally, the possibility of accessing different markets from the same trading account allows traders to diversify. By gaining exposure to different markets, traders better manage the risk in their portfolio.

All these are possible because of CFDs.

Financial Intermediaries

Market Makers

As the name suggests, these brokers make a market. Effectively, their trading platforms mirror the international financial markets.

In other words, traders using such brokers do NOT buy or sell in the open markets. Instead, they trade with the broker.

Not that is anything wrong with that, as huge market-making businesses exist. However, an ethical question arises.

Because a trade has only two outcomes (win or lose) and only two parties take the trade (buyer and seller), it means that one party wins and the other one loses. As you can imagine, the broker rarely loses.

When trading with a market maker, the broker effectively takes the other side of a trade. If you go long, the broker automatically goes short for the same amount/volume. On the other hand, if you win, the broker loses. And, if you lose, the broker makes a profit. What’s the catch?

Statistics help. As always, numbers give us an explanation as to why brokerage houses prefer to organize as market makers.

Most of the traders lose. That’s the crude reality.

In fact, almost all retail traders lose their first deposit. Armed with such info, market makers are happy to take the other side of retail traders’ positions. Who wouldn’t?

But again, it’s not an illegal activity, only that has some moral issues. After all, if a broker wants your business, it should be for pure representation, rather than playing a separate game of who is right by trading some numbers on a trading platform that imitates financial markets.

Also called dealing desks, they “deal” traders with quotes like real markets. And, most of the times, they trade against their clients.

Conditions differ from market maker to market maker. CFD trading is leveraged, and some restrictions exist in different jurisdictions.

Non-Dealing Desks CFD Brokers

Such brokerage houses are Alternative Trading Systems or ATSs. When trading CFDs with a non-dealing broker, you can rest assured that the broker routes your trades to the market. Or, at least, some of them.

Depending on how the non-dealing desk brokers function, different categories exist. Some only use the advantage of naming themselves non-dealing desk brokers and, in fact, they run a hybrid business. More on that a bit later.

ATS’s are nothing but multilateral trading facilities. Simply put, they function as ECNs (Electronic Communications Networks). And now you know why almost all non-dealing desk brokers call themselves ECN brokers.

They literally function as exchanges, but only represent the trading activity in their systems. Also known dark pools, because they do not display the orders that the clients send, ECN brokers are the true intermediaries for the retail traders.

The curious thing is that not many brokers well-known among retail traders are ECN. They claim to be, but they aren’t.

A true ECN broker routes all the trades to the liquidity provider. Moreover, a true ECN broker has more liquidity providers and always picks the best price for its traders.

However, this is a costly process and not very popular among brokers that target retail traders. Because ECN brokers earn only from fees, commissions, and spreads, the income sources aren’t so diversified as in the case of a market maker. Hence, the temptation is to run a hybrid business, rather than a true ECN one.

Some other CFD brokers use a similar system, called STP (Straight-Through Processing), that has only a few differences (mostly insignificant) when compared with ECN brokers.

Hybrid CFD Brokers

This is the category were most CFD brokers fit in. Such brokerage houses run parts of their business as a non-dealing desk and other parts as market markers.

Using this approach, they tend to profit from all types of traders. They guide experienced retail traders towards the ECN part of the business, and the rookie ones to the market-making part of it.

From the first category, CFD brokers earn commissions based on the traders’ consistency. One that trades for a living is an active trader, and the brokerage’s challenge is to make sure the trader is happy and continues to trade.

From the second category, the hybrid CFD brokers earn everything as in the first category. But, on top of that, such brokers also earn from taking the other side of their clients’ trade.

Therefore, it isn’t unusual for the broker to offer multiple types of trading accounts. Some trading accounts are ECN, some others are dedicated to the market-making business.

However, the real challenge is how to divide the traders into each category? How do brokers know which trader will fail and which one has more chances to be consistently profitable over the long run?

The truth is that they don’t. But, statistics, again, help. And some tricks.

Info About Traders Helps

From the moment that a trader decides to open an account with a CFD broker, most of the times, there are some questions to answer. Part of the enrolling process, such questions seem harmless.

The broker wants to know your experience, how often you trade, what’s your occupation, how much money you tend to fund the account with, and so on.

If the trader’s answers show that he/she has little or no experience, trade very often has a day job and plans to fund the account with a thousand bucks or so, the broker directs the trader to the market-making business.

On the other hand, if the answers point to years of experience, a large sum to fund the account, and trading for a living, the broker doesn’t want to take the other side of those trades. Hence, it will redirect the trader to the ECN part of the business.

Armed with such info, the hybrid CFD broker has an educated guess about the capabilities of a trader. And, if wrongly assigned to a category, it can easily switch the trading activity to the other part of the business.

Between market-making and true ECN, the first category is more profitable. This is the reason why brokers choose to engage in complex hybrid activities.

It is also worth mentioning here that brokerage houses that run huge market-making businesses have their own trading departments. At some point, the hybrid brokers can’t match all the trades of all their clients, and so they must deal with the remaining portfolio.

As such, they become active market participants, and the respective trading department uses all necessary tools to diversify the risk as much as possible. It is not by chance that CFB brokers are one of the largest categories of market participants in the world.

Spread Betting Brokers

When compared with CFD brokers, spread betting brokers aren’t so numerous. There’s a reason for that. Namely, legislation.

Spread betting is legal and popular in the United Kingdom. However, that’s pretty much the largest jurisdiction where one can spread bet.

Forbidden in the United States, Australia, or Japan, spread betting is, like the name suggests, a bet. It is NOT a position in the market.

In fact, in many ways looks like part of the derivatives market, where the product (spread betting) moves based on the characteristics of the underlying. In this case, the underlying is a cryptocurrency, an index, a currency pair, or the stocks of a company.

Hence, spread betting allows traders to bet on the future direction of the underlying. However, they don’t buy or sell the actual financial product on the market. It is just a bet with the spread betting broker.

For instance, if the quote of the EURUSD pair is 1.1275, the spread betting broker offers a “spread” centered around this quote. Due to the increased competition among brokerage houses, the spread narrowed drastically in the last years.

The result is that spreads on spread betting brokers ended up being similar with the bid-ask prices offered by the CFD brokers. As such, traders are confused and don’t quite know what is the difference between a spread betting broker and a CFD broker. And this is one of the reasons for writing this article.

Another difference is that the products offered in spread betting usually have an expiration date, whereas when trading CFDs there none. But, the most critical reason why spread betting is popular is because of taxes. In the U.K., spread betting is a tax-free activity, and therefore, many traders are attracted to it.

Also, there are no commissions in spread betting. When compared with CFD brokers that do charge a commission for most of the products they offer, spread betting is commission-free.

Conclusion

Most of this article here treats CFD trading. The explanation is that, around the world, CFDs are more popular.

And, CFD brokers have more experience because they can access multiple markets. While spread betting seems cheaper, in reality, trading is more difficult.

The expiration date, for instance, doesn’t help. It puts a time limit on a trade, a barrier that doesn’t exist when trading CFDs.

In both cases, brokers tend to benefit from increased trading activity. The more active the traders are, the more commissions and fees brokers get.

But that’s not something wrong, and traders should be happy. After all, because of brokers like these, we can access markets otherwise forbidden due to the exorbitant costs of trading individually.

When choosing a broker to trade with, it helps knowing more about the business, regulation, and how the broker earns its fees. In the end, what matters for a trader is to be right about the market direction. If that’s the case, and a profit is made, it doesn’t really matter who is on the other side of the trade.