Types of CFD Providers
CFD providers differ in a number of key ways, and no two platforms are exactly the same, with the natural variances of competition breeding in some organic differences in the way they do business. But there are two main broader classifications of CFD providers, and indeed a middle ground between the two, in which most brokers tend to fall. When you're first starting out as a trader, it's important to understand these fundamental differences between different classes of broker, such that you can ensure you're making a wise choice and dealing with a broker that provides the right level of execution and the best value proposition for your trading.
CFD Agents (also known as Intermediaries)
CFD agents offer investors the chance to effectively directly engage with the markets, offering CFDs that are pinned to underlying equity positions. When a trader opens a CFD position, the CFD agent then reflects that same position in the underlying asset class to match its potential liability as a broker. This effectively hedges against the risk profile of the CFD position, creating a perfect scenario for the broker whereby upside exposure is covered by a rising parallel position, and downside trader liability is margin called but limited on the broker side by the extent of the hedged position.
Example: Joe Trader wants to go long with a CFD on shares in Company X. The broker, falling broadly into the aforementioned category buys a corresponding stake in Company X, matching the position offered by the CFD, in return for a commission and applicable financing costs on the margined portion.
Scenario 1 - Company X performs well: Joe Trader sees a rise in the value of his CFD, and the broker will be liable for that upside gain should Joe Trader close his position. Fortunately, the underlying hedge in the form of the broker's Company X shares has cancelled out the upside payable to Joe Trader, leaving the broker to profit on the commission and financing costs.
Scenario 2 - Company X shares collapse: Joe Trader sees his contracts for difference plummet in value. The broker's underlying hedge is now worthless, but his liability is limited to the value of shares purchased, whereas Joe Trader bears unlimited liability in respect of his CFD position, and is liable to the broker for any such amounts.
The second broad classification of CFD broker is the market maker. Unlike CFD agents, market makers take no corresponding positions in the underlying asset market, instead taking the risk on each transaction. The spreads offered by market makers provide the profit portion for the broker, unlike CFD agents who account for their share through a higher commission portion. The market maker decides the spreads, which by and large do tend to mirror the markets but are at the sole discretion of the market maker. While market makers may take their own steps to hedge against the wider risk of their portfolio, they don't take out corresponding positions like CFD agents, allowing more efficient trading and cutting the direct costs of each transaction.
The differences between the two different classifications can be subtle, but broadly they can be broken down into price and transparency. CFD agents effectively provide traders with a direct and live portal to access the markets, with their spreads reflecting accurately the current asset prices at a given time. Because the agent will mimic the trader's position in real assets, there is a much greater degree of transparency in their spreads and the contracts they offer, thus traders can more readily depend on the figures they are quoted. Of course, this additional level of broker involvement comes at a higher price, and therefore may not be a preferable option for many traders.
In contrast, market makers are free to set their own spreads and are not operationally bound to lock-in market prices. In practicality, their spreads tend to be wider, but transaction costs much lower than with direct access CFD agent platforms. Essentially, it's a toss-up between which type of provider you choose, and trying both over time is likely to yield positive results in terms of identifying which broking style is most suited to your trading.