CFD Brokers and Regulation

There are several reasons why being selective in choosing a broker is important no matter what kind of trading you are looking to do. In traditional trading, brokers act as the middleman between you and your trades, as well as being where you store the money in your account when it is not being used in trades.

Since brokers primarily provide order execution services, it’s obviously important that they do a good job at this. While order execution does tend to be fairly similar across retail brokerages, some provide better execution than others, with better routing, faster execution, seeking the best markets rather than having some arrangement, the size of their own order book, and so on.

CFD Brokers and RegulationWhile many retail investors and traders don’t tend to worry about this too much, some do, especially frequent traders, where advantages or disadvantages here can add up to a lot of money at the end of the year.

For the most part, this issue is taken out of the picture with CFD brokerages, as all of the trading occurs directly with them instead of on an external market. However, this does not mean that there cannot be any issues, but there should not be, and if there is, this alone should cause us to look for another broker.

Order execution is a pretty big deal among frequent traders, the kind that would trade CFDs, and cutting off microseconds per trade can make a real difference. Not having to worry about any of this is surely a real benefit of CFD trading.

Costs Per Trade Really Matter

The whole idea behind looking to avoid bad fills is to look to reduce trading costs, so how much a brokerage charges to trade with them will matter a lot as well. This is actually the biggest thing traders look at, and if you are trading a thousand times a year, even an extra dollar for a round turn trade is going to add up to $2000.

The differences out there with retail brokerages can be a lot more than this, ten or twenty times more, and the trader who only trades infrequently may not care that much about this, but this can add up to tens of thousands of dollars worth of differences among brokers.

While in most cases CFD brokers aren’t charging anything directly to trade, where there are no trading fees or commissions with most products, those who want to trade shares will find that there are such costs, similar to other types of brokers.

In this case, you definitely want to be taking these additional trading costs into account, as they are on top of what you will pay for the spread and what you may pay in interest to the broker for borrowing money.

You can trade anything else but shares with CFD brokers without paying any commissions at all though, and while that’s a great advantage, this does not mean one can trade completely for free. One must still pay the spread, and spreads do differ quite a bit among CFD brokers.

CFD brokers tend to get almost all of their business from marketing, and many of their clients are new and very inexperienced. Many do not shop around much and some not at all. This is evidenced mostly by the wide range we see with spreads, with some brokers offering ones that involve several times the cost per trade as some others.

Spreads aren’t the only deciding factor in choosing a CFD broker, but this is certainly one of the main ones, if not the main one, and maybe even the biggest one by far if you trade frequently enough.

If people shopped around more with this, we would not see anything like the wide disparity that we see in the market where spreads are concerned, as no one would go with a broker with the big spreads when they could just choose a comparable broker in all other ways and pay a lot less.

Some of the most expensive CFD brokers also tend to be among the most popular, where they spend more on marketing and perhaps they need to recoup that, or perhaps their more aggressive marketing allows them to gain a lot of clients who don’t pay much attention to these things.

The Brokerage Itself Matters Much More with CFDs

This is not to suggest that we just go with the best price out there with no regard to the brokerage itself. Since we’re trading directly with the broker with CFD trading, rather than their just being an intermediary, the broker is the counterparty here, and must be trustworthy to always carry out their part of the bargain.

If, for some reason, the broker is unable to fulfill their obligations in our trades, which is to cover our gains and their losses, then we have a problem. While the chances of that happening is extremely small, it’s still something we need to pay attention to.

In the old days, in the unregulated world of bucket shops, this is exactly what used to happen, where unscrupulous bucket shops would just close their doors and move if they got in trouble on their end of the trading. Traders simply lost all their money.

There are two issues here actually, which are keeping the funds of traders segregated from the firm’s own money, as well as the firm having the capacity to cover their side of the trades they enter in.

Nowadays, the brokers are regulated, and regulated well for that matter, which is the reason why any of this happening is now very unlikely. You’re actually more at risk having your money held by a very large investment bank than with a reliable CFD broker, since CFD brokers manage risk much better than investment banks do, because their business allows them to.

Investment banks can make multi billion dollar bets that are pretty risky indeed, like we saw with the credit default swap crisis a few years ago, and this was during a time where the housing bubble put the market at a high risk of default with massive losses in these swaps to follow.

Poorly managed CFD brokers can expose themselves to some real risks as well, but they are in the business of managing them and do so quite well. All they need to do is transfer the risk by taking real positions in the market to hedge their positions with their client and can do so with minimal effort.

Thanks to regulation, client’s money is segregated in separate bank accounts, and while it’s possible that a broker may not comply with this regulation, this is all monitored very tightly by the regulators.

One Should Still Pay Attention to a Broker’s Reliability

So while some people think that placing trades directly with brokers is more risky, it certainly does not need to be. Due to regulation, the CFD market really doesn’t involve a meaningful addition of counterparty risk, although this does not mean that we should not be selective in who we do business with.

There are a lot of CFD brokers out there, some better situated to manage their businesses than others. Being regulated is the minimum threshold, and no matter how well the regulations are designed, some brokers will simply be set up better than others to manage the risks involved and conduct themselves in a way that inspires more confidence.

Some CFD brokers offer CFD brokerage in addition to other financial services, and some may think that this is preferable, but this is not necessarily the case. Offering CFD trading is actually on the lower end of the scale as far as risk goes, and a firm may be exposed to greater risks from their other activities, risks that cannot be hedged as well as ones involving CFD positions with their clients.

Traders looking to either get into CFD trading for the first time or looking at the possibility of switching CFD brokers should perform at least a minimum of due diligence with prospective new brokers. Size, experience, and reputation all matter here.

Other Considerations When Choosing a CFD Broker

There are a number of other things that need to be considered when choosing a CFD broker. Whether or not a certain broker is licensed to offer their services to people in your country is of course a big one.

Countries differ in their regulation of CFD trading. Some countries permit it, and with others, such as the United States, the regulations are more restrictive. Many people think that CFD trading is not available in the U.S., but they don’t realize that forex trading is in fact a form of CFD trading, but other forms of CFD trading aren’t permitted in the U.S. at the present time.

It is also wise to not just assume that a CFD broker is regulated in the country that they operate in, and to actually check to make sure. Depending where you live, CFD brokers may not be regulated in the country you live in but may be regulated in other countries.

It is preferable that the broker be regulated in your country, since there may be some special protections to you that are involved, but if your country does not regulate CFD brokers, you won’t have an option. At least if they are regulated in countries that are known for their sound regulation, such as the U.K., you at least know that they are in good hands.

CFD brokers differ in a number of other areas, what they may charge for margin, their deposit and withdrawal methods, the software they offer, their level of client support, the education they provide, and so on.

It is important to account for all factors when choosing a CFD broker, although some will be more important than others generally, as well as some being more important to you in particular.

CFD trading is not the Wild West that some people think it is though, and far from it. It provides traders with pretty much as safe a trading environment as there is out there, as long as one chooses a good broker, in addition to all the other benefits that CFD trading provides, which are many and which are significant.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: [email protected]

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