While the price of a contract for difference mimics the undying asset it follows, transactions using CFDs can be VERY different to purchasing the asset itself.
CFD Broker as the Market Maker
A market maker is a person or a firm who quotes both a buy and a sell price in a financial instrument or commodity, hoping to make a profit on the turn or the bid/offer spread.
In foreign exchange trading, where most deals are conducted OTC, and are therefore completely virtual, the market maker sells to and buys from its clients. Hence, the client’s loss is the company’s profit and vice versa. Most foreign exchange trading firms are market makers and so are many banks, although not in all currency markets.
Most stock exchanges operate on a matched bargain or order driven basis. In such a system there are no designated or official market makers but market makers nevertheless exist. When a buyer’s bid meets a seller’s offer (or vice versa) the stock exchange’s matching system will decide that a deal has been executed.
Most CFD Brokers are Market Makers, but some just provide a portal or access point to these Market Makers making them plain old CFD Brokers.
When trading CFDs your broker becomes the market maker by creating a Synthetic Market. This ensures that all of your Buy/Sell orders are guaranteed at the requested price, theoretically creating infinite liquidity. Sounds pretty sweet right? While high liquidity is one of the large benefits of CFDs it does come at a price, The Spread. Since CFDs trade on a Synthetic Market, that has minimal regulation and costs they are defined as an Over The Counter product. You cannot move CFDs between brokers, transfer them from funds to trusts or even to other people as they are a contract between you and your broker and that contract says that you can only sell that CFD back to the broker you purchased it from.
This gives brokers the enormous power of spread control, something that they can use to create large profits for themselves (by offering larger spreads than the underlying market). In the nature of turning a profit (in the long run) this is however a financially unsound move for the brokers as smaller (tighter) spreads attract more customers, which in turn earn the broker more dollars. You will usually find that the most prominent brokers will offer a tight bid/ask spread in order to retain their customers.
Synthetic Pricing
Synthetic Pricing relates to how your CFD broker creates the bid/ask spread for any particular CFD. This will usually start with the broker examining the underlying asset then placing the policies or rules it has determined and pricing them into the spread (see below for Costs of the Spread).
Direct Market Access
Direct Market Access (DMA) pricing is quickly becoming the most popular form of CFD pricing (if it isn’t already). With traders seeking fairer pricing the the form of tighter bid/ask spreads and the increasing competition between CFD brokers, DMA pricing has prevailed among most CFD Brokers.
When using DMA pricing, a broker promises to deliver a bid/ask spread identical to that of the underlying market. This gives many advantages including the ability to participate within a real electronic order-driven market and gain access to the grey market. The largest limiting factor of DMA trading is the liquidity provided (which also mimics that of the underlying market).
The other advantage of DMA trading is that it ensures a delta of 1. A phenomena rarely experience with other derivatives (and synthetically priced CFDs).
DMA Trading is usually more costly to the trader in terms of commission and monthly access fees, but the savings that can be made from the controlled spreads usually makes up for the additional fees.
Exchange Traded CFDs
While not operational yet, the ASX is looking to launch the first Exchange Traded CFD Market in the world in late September. See the future(below) for full details.