The term Bucket Shop has in fact been defined in the US Supreme Courts as in the United States of America it is illegal to operate a bucket shop in any form. The term itself was defined as any:
‘establishment, nominally for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets, or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain, oil, etc., there being no transfer or delivery of the stock or commodities nominally dealt in.'(Gatewood v. North Carolina, 27 S.Ct 167, 168 1906)
So in a traditional bucket shop example a rogue individual would generally Buy or Short sell a small amount of a particular commodity or asset class to individual. But in fact no such deal had actually taken place and instead the client would have taken on a bet against the rogue broker or individual who would then attempt to swindle the individual out of his money.
However the term becomes blurred when talking about Contract’s for Difference, where an individual is not trading a physical entity but rather entering a Contract based on the price of a particular Forex instrument or commodity. As no physical exchange of the underlying asset is undertaken it would appear that such a trade would be by definition a ‘bucket shop trade’. And in US law at least that is in fact right as CFD’s are not permitted by the US Securities and Exchange Commission.
But in Europe CFD’s are legal over-the-counter instruments. So it would appear that under the supreme courts definition that European CFD providers were in fact running bucket shops. However what people mean when a CFD company is running a bucket shop is something quite distinct from what is meant by the US legal decision.
Many CFD’s mitigate their risks by directly placing trades in the open physical markets. For example if a client of CMC Markets for example took out a large position in a particular stock, say Buying 200,000 Marks & Spencer’s shares. They could for example replicate such a position by taking a position in the real physical market and still make a profit due to the fact that they offered a wider spread to the CFD client than they faced and pocket the difference.
When a person talks about a Contract for Difference provider who is running a bucket shop, they are talking about a provider who never places trades in open markets in order to mitigate there risk. For example some of the major CFD providers may not need to open a position every-time a client opens a small position only needing to do so when a large position or a considerable amount of action is being undertaken in the said position. Also clients taking different positions in the same instrument can mitigate any risk they face removing the need to mitigate risk by opening a position in the open markets.
However, a Bucket Shop will simply take bets and not make any effort at reducing their risks by taking open market action. This means a bucket shop is essentially engaged in a bet against their clients and will often make attempts to claw money back from clients profitable trades by any means necessary. This can include saying that profitable trades were fraudulent or that they ban scalping etc.