Understanding the Difference between a Direct Market Access Brokers and Market Makers

Contracts for difference are the most popular over-the-counter financial derivative and a vast number of brokerages have been set up to provide CFD’s. Contract for difference providers operate under two very different models which have implications on the cost of trading.  

Market Makers
The most popular method for providing CFD’s is by taking the role of a Market Maker (sometimes shortened to MM), this is the way that majority of both regulated and unregulated brokerages operate. What does it mean to be a Market Maker? A Market Maker makes the price for CFD based on the underlying asset value and takes all orders onto its own book. These positions are then hedged based on the brokers using their own risk models. How the brokerage hedges these positions differs hugely between brokerages, the most simple way being to buy or sell the underlying asset. But more complicated ways of managing risk include things such a portfolio hedges and the offsetting of different clients who are trading the same instrument, short and long. This doesn’t effect the CFD itself as no matter what the Brokerage does with its own internal risk, a CFD is a contract between a trader and the brokerage. It can however effect the quoted spreads on offer as a Market Maker may have to take into account the positions of other traders. Brokerages who are Marker Makers generally tend to offer wider spreads as this is one simple way to minimize internal risk. 

Direct Market Access 
The Direct Market access model was created in response to concerns about the Market Maker model of CFD provision. A Direct Market Access brokerage provides a guarantee to its clients that it will undertake a physical trade which matches each CFD trade. For example, if a trader open a 500 Share Buy order on BP, the CFD provider goes into the physical market a buys 500 Shares of BP itself. The trader doesn’t take on share ownership with the Contract still being between the trader and the CFD provider. This guarantees the price the trader receives is the same as the price quoted in the physical market and ensuring that they won’t be requoted. Being a Direct Market Access provider is easy from a risk management point of view with the provider making a profit as long as their spreads are wider than the spreads offered in the physical market. These DMA providers often also charge a commission to cover their transaction costs. The Direct Market Access model does have a number of drawbacks as it only works for instruments where one can easily sell or buy the underlying instrument in the quantities needed. For this reason the DMA access model is used primarily for Share CFD’s. The DMA model is much closer the traditional broker model and for this reason is preferred by many professional and institutional traders.

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