The market for CFD brokers has increased considerably in recent years, off the back to the dramatic rise of CFDs as a consumer investment instrument of choice. As the portal between traders and the markets, CFD brokers are set up to efficiently make money from both the markets and their trading clients in a variety of ways, and the ingenuity and innovation with the field of brokers is to be admired.
Contrary to the beliefs of some sectors of the trading community, CFD brokers are set up to actually encourage their trading clients to succeed, and in doing so will be able to generate more revenue over the longer term. So what are the main revenue generating channels for CFD brokers, and how exactly does each of them work?
Spreads
The first, and indeed the most transparent, way in which CFD brokers make money is through the spreads quoted on each market, thus traders benefit from the lowest spreads. This is a way of making money from the trader, but in a way that is effectively built in to the DNA of the CFD transaction.
The spread is the gap between the ‘buy’ and ‘sell’ prices quoted on a given market, and represents a direct fee payable to the broker. It works by creating a distance between actual market price and the quoted price, essentially allowing the broker a mark-up on the trade.
For example, CFDs on shares in Company X might be quoted at 99-101, with the actual price frozen at 100. If you were to buy the CFD here, you would buy a position worth 100 at 101, thus your profit from the transaction would only kick in from 102 onwards. The remaining 1 point, which is otherwise unaccounted for, goes directly to the broker.
Commission
Along the same lines, brokers may also charge a commission, as a percentage on the size of a transaction. This is again a direct way in which the broker will make money from its clients, but works on the basis that winning trades are more profitable all-round. Fortunately, the highly competitive nature of the CFDs market of late has meant that many brokers are waiving their commissions and even slashing their spreads in a race to the bottom to attract new consumer investors to the markets. As a result, the dependency on alternative revenue streams from CFD brokers has become all the more crucial.
Overnight Financing
The costs of financing are also marked up by brokers, allowing them to cover the costs of arranging financing for their clients. For transactions traded on margins, financing plays a significant role in allowing the trader to take larger positions than would otherwise be possible, which makes CFDs the attractive and popular instrument they are today. The costs of providing finance build in both a profit portion for the broker, in addition to an amount representing the risk of default in arranging the finance, although in practicality brokers keep a tight grip of security over their traders, in the form of margin requirements.
Hedging
Another crucially important but often overlooked method of making money employed by the brokers is through hedging, and investing in the markets themselves. Hedging is designed primarily as a means of mitigating losses, but it can also prove a profitable strategy for the brokers if executed correctly. Hedging is the process of matching liabilities with contradictory or complimentary positions in different markets, such that if the trader wins, the broker can offset their liability to that trade. While hedging is a difficult process to get right, it can help brokers no end financially, allowing them to minimise losses and profit from their market expertise.
Traders’ Losses
This one really shouldn’t surprise anybody as it’s a fact that most of the traders lose money trading CFDs and brokers know it well. Contracts For Difference is an Over-The-Counter (OTC) instrument where customers effectively trade against their broker, and as most traders lose it’s another revenue stream for brokerages. Of course, CFD providers will evaluate their exposure and hedge when they deem necessary but it’s important to understand that traders’ losses play an important role in how CDF firms operate.
CFD brokers earn money in a myriad of different ways, and they are constantly finding innovative and new methods of driving revenue. As the market for CFDs continues to grow amongst consumer investors, brokers can expect to see a consistent increase in their trading revenues, while these primary alternatives will continue to make the CFD industry a profitable one for brokers.