Not all CFD providers are created equal. In Australia, there are three types of business models: market maker model, direct market access (DMA) model, and exchange-traded model.
CFD providers who are market makers provide their own prices for the underlying assets (shares, indices, commodities, Forex, etc.) on which CFDs are traded. The price they offer may or may not differ significantly from the market price.
Market makers may or may not hedge the CFDs they offer, but these arrangements are usually less transparent than DMA providers. If they don’t hedge all CFD trades, they may have a business model that allows them to benefit if you lose.
Direct Market Access
DMA CFD providers place your order into the market for the underlying asset; hence your price will be determined by the underlying market. DMA CFD providers do not carry any market risk from the trade, so they will only offer CFDs on an asset if there is sufficient trading volume in the market.
DMA providers hedge all client trades in the underlying market, meaning that if you place a CFD trade, the provider will make a corresponding trade in the market. In the case of shares, if you pay a margin to go long on share CFDs, the provider will buy the corresponding shares. This makes the CFD pricing and trading process more transparent, though it means the number and types of CFDs that are offered are more limited than those of market makers.
Both Market maker and DMA models are both provided over-the-counter, meaning there is no central exchange, so CFDs are traded directly between the provider and the client. Over-the-counter also means that there is no central regulation, and each CFD provider has its own terms and conditions.
Many CFD providers offer both market maker and DMA CFDs.
Exchange Traded Model
CFD providers who use an exchange-traded model offer CFDs that are listed on the ASX – this model is unique to Australia. ASX-listed CFDs can only be traded through brokers authorised to trade them.
The terms and conditions of these CFDs are standardised by the ASX, which may reduce some risk. ASX 24 is responsible for registering, clearing and processing all trades in ASX exchange-traded CFDs, and the seller and the buyer contract with ASX 24 rather than each other. This means that ASX exchange-traded CFDs have a lower level of counterparty risk than over-the-counter CFDs.
The market for these CFDs is separate to that of the underlying assets, which means that CFD prices are determined by trading activity, rather than by the price of the underlying assets. Usually the CFD prices closely follow the market price of the asset, though there can be divergence if liquidity dries up.
Which is best?
Market makers and DMA providers are quite similar in that they are both over-the-counter CFD providers. However, the main difference between them is transparency. DMA providers are much clearer about the breakdown of the cost of trading, and you know that your trades will be hedged in the market. I prefer DMA providers, or providers who offer both DMA and market made CFDs, as market makers may profit from their clients’ losses, and I’m uncomfortable trading with a provider whose business model makes profits from my losses.
The exchange-traded model is a different matter to consider, and may suit those who want to trade with higher regulation and security. However, as this style of CFD trading is only available in Australia, if you decide to trade from another country at some point you won’t be able to continue using the same model.