For several years, practically zero interest rates prevail in many countries, which means that investors can not count on large profits from investments in bonds or even bank deposits. It may even turn out that the investment will bring a loss, because now the prices are going up and our investment may not exceed the level of inflation. One solution is to invest in investment funds, which will choose investment for us, but, of course, a commission will be charged for this service, often quite large. In addition, the same rates of return achieved by investment funds give much to be desired.
Due to this situation, many people started investing themselves on financial markets. Currently, the simplest way to start an adventure with investing is trading on the CFD market. Contract for Difference are derivatives that follow the price of the underlying instrument, such as currency pairs, stock indices, equities, bonds, commodities or recently increasingly popular cryptocurrencies (bitcoin, ethereum etc.). For example, a contract may based on EUR/USD currency pair, the German index DAX 30 or physical assets such as gold, oil, etc. We do not physically purchase a given asset, we only speculate about the price changes. If we think that the price of the DAX 30 will increase, then we buy a CFD contract for the DAX 30, and if we think that the index will fall, we sell a contract based on the DAX 30 index, meaning we take a position so-called short sales.
CFDs are only available on the over-the-counter market (OTC). This market does not have one location where transactions are made, as it is in the case of the stock market. The CFDs market is created by brokers who mediate in transactions. Brokers provide all the infrastructure needed to trade CFDs. Depending on the model, they are the other party to the transaction, or they send transactions to liquidity providers.
Business models of CFD brokers
CFD brokers use two business models. The broker on the CFD contract market may conclude transactions with its clients, be the other party to the transaction or transfer transactions to liquidity providers, which is why we distinguish for types of brokers:
- Market Maker
The market maker broker creates market. All transactions are carried out by the broker, that is, the other party to the transaction. For example, we bought shares of an American company IBM, the broker is the seller of this packet of shares, or more precisely the seller of the CFD contract for these shares. The same happens when we take a position in a contract for a pair of EUR/USD, etc.
However, not always the Maker Maker broker will earn when we lose. Dealing Desk can open the same transactions as we do to protect against possible loss when we make money. This means that if we took a long position on EUR/USD, the broker will also take the same position. We will receive a worse spread from the broker, and the broker will earn a difference in the spread, not on our possible loss. In this situation, he does not want us to lose because he has the same position. If the broker can not protect himself, it may make it difficult for us to enter into a transaction, i.e. there may be so-called “re-quotes”. Of course, not all transactions are hedged, and taking into account the statistics that say that up to 80% of people in the FX market lose, there is a good chance that a lot of transactions are carried out on the client-broker line.
- a large number of instruments, even very exotic ones,
- usually a fix spread,
- usually a guaranteed pending order (stop-loss, take-profit etc.),
- small deposit requirements.
- possibility of re-quotes,
- an obvious conflict of interest, which in extreme cases can lead to a situation where the broker intentionally interferes in trading to clients.
In this model, the broker should transfer transactions to liquidity providers. Does it always do that? We never have a guarantee. We do not have access to Level II on the MT4 platform, nor to “Time and Sale”, so we need to trust the broker that he is not the other side of the transaction.
- theoretically, there is no conflict of interest,
- no re-quotes.
- usually a floating spread, which means that with unfavorable market conditions it may expand,
- no guaranteed pending orders,
- the possibility of a negative balance,
- sometimes slower execution of orders that must be transferred to liquidity providers.
Beware of dishonest brokers
The CFDs market, and especially forex trading, has become very popular recently. This has resulted in the appearance of many dishonest brokers on the market. Many brokers have headquarters in Cyprus, Russia or even more exotic places, such as the Cayman Islands, Mauritius etc. This means that they are subject to the laws of those countries. It can be a troublesome situation when we would have to assert our rights in a country several thousand kilometers away. In addition, the broker may be the other party to the transaction, i.e. earns when the customer loses and vice versa. In extreme situations brokers get phone numbers by buying databases and persuading potential customers to invest in the CFD market. Pseudo-advisor employed in these companies often offer a certain profit through investments in the IPO. Often, it turns out that brokers do not even have these equities on offer. At the moment when the client opens an account, he is persuaded to trade in various instruments, for example wheat, which has a very wide spread. Typically, after a few transactions, the client loses all the money. Unfair practices of brokers are described in more detail in the Comparic portal.
Some tips on how to avoid dishonest companies
- If a broker has obtained a phone number from unknown sources, this is the first warning. In fair brokerage companies, it is usually the norm that the sales department calls customers who have left their phone number themselves, creating a demo account, during training session etc. If the broker so cares about our money that he got the number himself, this fact should arouse our great concern.
- Often people employed in these companies do not have basic knowledge about investing in financial markets. It’s worse if we do not have either. However, if we have at least basic knowledge we can quickly find out that we are not talking to a professional. Often, these people do not know that FX means foreign exchange market, or they call and say “Good morning, I’m calling from capital markets”. It’s like a salesman from an IT company said “Good morning, I’m calling from the Internet”.
- If anyone guarantees a profit by investing in financial markets, the conversation should be terminated immediately! Nobody is able to guarantee profits, especially when investing in financial markets. It is as if we would tell someone that in a month it will surely rain. Maybe we will have luck and will be right, but it certainly will not result from our skills.
CFDs have opened many markets for retail investors. Additionally, thanks to leverage, we can start trading with really small capital. it is very important to choose a stable broker who will act as an intermediary in CFD transactions. There are two types of brokers, Market Maker and STP/ECN. The first one is always the other party to the transaction, and the other one should theoretically transfer the transactions to liquidity providers. Therefore, a very important element is a stable trading partner, in this case a broker.