The growing popularity of the contracts for difference (CFD) market is bringing with it new participants from both a retail and institutional background, including both trading firms and individuals as well as intermediate brokers.
While it welcomes new players and embraces new technology such as API connectivity, there are aspects of the CFD market which remain stubbornly traditional, such as its predominantly over-the-counter (OTC) nature, which runs contrary to the general regulatory trend to encourage more central clearing.
Some parties have tried to change this. For example, in 2007 the Australian Stock Exchange attempted to introduce exchange-based clearing but in 2014 it had to admit defeat and wound up its offering citing a lack of interest from the market.
The flow of new entrants to the market allied to its decentralised and OTC nature mean that there is a strong reliance on liquidity providers, of which there are a growing number. So what characteristics should these intermediate brokers and traders look for from a prospective liquidity provider? Why are some firms able to offer broader and more diverse liquidity than others? How transparent is the liquidity provider market and how important is the underlying technology? Is CFD liquidity provision purely a question of size and scale or are there more nuanced properties that have to be considered?
“Because of the OTC nature of CFD liquidity provision, one critical attribute of a liquidity provider is that they are a good counterparty from a credit risk perspective,” says Mark Chesterman, Chief Operating Officer at IG’s institutional division. “A CFD liquidity provider must also offer a broad spectrum of markets, deep liquidity, and reliable continuity of pricing. We’re also increasingly finding that clients want 24/5 access to major markets – something they are used to in FX but is very unusual in CFDs. A liquidity provider also needs to ensure a broad range of connectivity options.”
The breadth of liquidity offered by brokers in the CFD market can vary considerably as can the range of connectivity options available. While a progressive attitude to new technology trends such as API connectivity are helpful for the latter, experience is an important factor in the former, says Chesterman.
“IG has a long history in CFD trading so we have established strong, lasting relationships with Tier 1 brokers in primary markets. This means we have access to all the major global exchanges and can pass on that liquidity. In addition we are market leaders in CFDs so have significant amounts of internal liquidity with which we can bolster the exchange liquidity.”
IG has also invested in its infrastructure and API connectivity to enable it to process large liquidity volumes. “We have built our API so it is highly scalable, so sending such large amounts of data / receiving high numbers of executions across our partners is very simple for us,” says Chesterman.
The diversity of the liquidity takers is also an important factor in the attractiveness of the liquidity provider’s offering, not least because of the OTC nature of the market and strong reliance on secondary liquidity. And once again, says Chesterman, size matters.
“A large client base gives CFD liquidity providers significantly more liquidity than smaller brokers may have. There is much less primary liquidity in the underlying markets on CFDs compared to FX, so being able to add internal liquidity to the exchange liquidity is critical to providing a high level of service to broker partners.”
In addition to running and developing their own CFD liquidity provision service, the likes of IG and others are also offering white label solutions and partnership services to a growing base of institutional and intermediate brokers. However, says Chesterman, many of them are looking for something beyond the traditional white labelled service. “In addition to the older white label model, brokers are increasingly looking to a more modern setup whereby different services are sourced from different providers – having all your eggs in one basket by partnering with just one broker via a white label of their platform is a much higher risk than sourcing technology and liquidity from different partners.”
Relationships are also of critical importance for a market where participants are making their first forays into the CFD market and looking for reliable partners, says Chesterman. “Many partners are moving in to CFDs from a solely FX background, so it is very important that they partner with someone who they can trust to help them in their journey. Although CFDs share some similarities with FX, there are also a lot of differences, and a good relationship with your liquidity provider can help a brokerage navigate these with minimal fuss.”
So what should trading firms look for from their CFD liquidity providers? Chesterman says that there are some key questions they should ask of any potential partner. For example, what is your balance sheet? Are you sourcing primary liquidity? Can you give 24/5 coverage? Do you actually understand the product? Can I connect to you easily?
“There are enough issues a broker needs to focus on without the need to worry about their CFD liquidity provider. Picking a counterparty who removes these concerns can help a broker build their business more quickly and with better long-term success.”
There are many liquidity providers right now in the CFD market but the ability to offer liquidity that is your own natural internal flow is an important differentiator, says Richard Elston, Global head of Institutional for CMC Markets. “There are so few top-tier, genuine liquidity providers out there in the CFD market. There is so much recycling in other people’s name and that makes it difficult for everyone to make an informed choice.”
There is also a substantial range of CFDs that needs to be covered by any liquidity provider with a large and global client base. “Our position as a global player facilitates us having a broader range of clients. When you look at the providers offering recycled liquidity, they only tend to have the core products, whereas I would argue that we have one of the broadest range of CFDs on offer.”
Time and experience has made things easier for CMC Markets says Elston. So has building a large infrastructure. “our global client base combined with our exchange relationships allow us to augment liquidity and enable clients to take a larger position at a more cost effective price. We have had hedging relationships with brokers and other intermediaries in place for years but it is also important to be connected to the industry’s fintech providers and to consequently enhance our distribution capability.”
Elston was brought to CMC Markets in 2015 specifically to spearhead its adoption of next generation technology in the institutional space, including the development of API connectivity. “The flexibility of CFD liquidity providers and their ability to connect to the various fintech houses in the space has become much more important and API connectivity is a critical part of that,” he says.
“While there is still a place for proprietary GUI execution, an API is essential in today’s market. We have seen a metamorphosis in third party technology in the last 10 years and APIs have become a ubiquitous source of execution,” he says.
“The MT4s and MT5s demand that you have API connectivity but it is not just about having a FIX connection to a London data centre, you also have to provide connectivity to the fintech intermediaries – MetaBridges and other ECNs. This provides convenience to clients and also to us as a provider in terms of enhancing our distribution.”
The decision to move into the world of APIs was made about 24 months ago, a move that Elston concedes was made after many others had already done so. “We were quite late to the party but the market technology demands that you have a high quality API or else you cannot play in this space anymore.“
Elston says that the provision of API connectivity has opened up new avenues in terms of clients. “It has brought us the types of clients we did not previously have and given us a more diverse client base with broker aggregators as well as small and emerging hedge funds. The CFD market would have previously been an anathema to hedge funds but with all the changes we have seen in the prime brokers’ world, their appetite has changed.”
CMC Markets is also a liquidity provider that offers a white label service for market counterparty brokers and has done so since the 1990s. It also offers ‘grey’ label IB service where it takes on the administration and KYC responsibilities. However there are also a number of clients out there simply looking for liquidity via API connectivity, says Elston. “I think matters have moved much more in that direction.”
The CFD market has become increasingly popular with traders, both retail as well as institutional. In terms of liquidity providers there are a number of well-known and established players like IG and CMC Markets but there are also some newer entrants to the space, including Swissquote, the Swiss bank that specialises in online trading and started offering CFD trading four years ago.
“We added CFDs as a means to diversify our eForex product range,” says Ryan Nettles, head of eForex Trading & Market Strategy. “FX is still the dominant product, responsible for around 90% of our eForex activity, but the 5% share of CFD trading is continually growing.”
Like many others, Nettles believes that any CFD liquidity provider needs to have some core attributes to be successful. The first of these is a broad product range. Currently the most popular classes for CFDs are equity indices; commodities; shares; and bonds, says Nettles. Of the emerging asset classes, there is also a growing interest in trading crypto-currencies as a CFD.
Another core attribute is the ability to offer both access to credit and good margin rates. One factor influencing this attribute is regulation, says Nettles. More specifically, there is a greater requirement for liquidity providers to be able to match their use of leverage with the capital.
“Liquidity providers have always offered different leverage but they have not always been matched with capital and balance sheet strength,” says Nettles.
For traders, retail especially, it has not always been possible to do the necessary financial due diligence given that so many of the liquidity providers are not listed companies thus not required to disclose their financial statements. But in certain jurisdictions, there is likely to be more regulatory pressure on liquidity providers to strengthen their balance sheets. The EU is currently looking at the issue of leverage while the German regulator BaFin has recently brought in a new rule that any liquidity provider marketing to German residents must provide negative balance protection.
Should the regulations result in more disclosure from liquidity providers, it should be welcomed by participants, says Nettles. “The more transparent the liquidity provider is, the better for the client, especially if the financial reports are disclosed.”
Capital is also a big factor in the ability to source a broad and diverse pool of liquidity, says Nettles. “Most liquidity providers are sourcing CFD liquidity from underlying exchanges and that can make it a very costly capital-intensive asset class. There are the exchange data feed and execution costs and the posting of margin with the clearing firms, which are often at a higher rate than the margin liquidity providers are requiring from their own clients.”
There is also the direct vs recycled liquidity divide, or the systematic internalisers vs the auto-hedgers. Generally speaking, firms able to internalise their liquidity can offer clients better execution, less latency and reduce costs because they are not paying execution fees with the exchange or posting margin. Although systematic internalisers do have to ensure they have a liquidity pool that has both size and diversity in order to create the ability offset trading positions and find matches.
“From a retail trader perspective, it is again not always easy to tell whether a liquidity provider is internalising or auto-hedging and for many traders, it may not be an important issue as long as execution quality and pricing is acceptable. Where it may become an issue is in latency and for traders looking to execute quickly but being held back by the liquidity provider’s need to auto-hedge.,” says Nettles.
Liquidity providers should also offer a choice of platforms for clients to trade on, says Nettles. Swissquote offers its proprietary platform, Advanced Trader, as well as popular third party platforms, including MetaTrader 4 and 5. MetaTrader has effectively dominated the retail brokerage space for many years with just a limited number of new entrants enjoying any meaningful share of the market – the likes of cTrader and ProTrader, for example.
However, while MetaTrader is hugely popular with retail traders, it is not always as popular with the liquidity providers that work with it, explains Nettles. “Metatrader 4, for example, is limiting from a business scalability perspective. It is not as adaptable for liquidity providers and we find that we are often constrained in terms of breadth of product coverage, margin management, and customising liquidity for our clients. The latest version, MetaTrader 5 has improved on some aspects, but it still can’t compare to the scalability of our proprietary platform, Advanced Trader.”
“With proprietary technology you can adapt functionality ahead of competition and meet new regulatory requirement faster whereas with MetaTrader you are dependent on them for upgrades or system changes.”
White labelling as already mentioned can be an important part of CFD liquidity provision and Swissquote offers a white label service using its own proprietary trading platform (Advanced Trader) as well as MetaTrader. The partnership service is designed for institutions that are looking for both, technology and CFD liquidity.
“The MetaTrader technology is the most popular retail forex platform, the differentiator is with the counterparties and the liquidity,” says Nettles. “It can be hugely beneficial for the financial intermediary to have a strong, transparent partner that offers a competitive compensation plan.”
A final thought on relationships
Relationships are now very important in the CFD market, especially as the market is dissected by those traders taking liquidity on either a disclosed or non-disclosed basis, says Nettles. “I believe it is important to know who your client is and to know their trading behaviour – how frequently they trade, what time of day they trade, what instruments they trade, transaction sizes and so on. If you know what you’re clients are looking for, it is much easier to service them. Conversely if you are providing liquidity via an external trading venue on a non-disclosed basis and you don’t know who your client is, things become much harder. This may not be as important for retail traders accessing the market through a broker but for institutional clients I think it is very important to have a disclosed relationship with your liquidity provider,” he states.