Retail brokers - "hedging" & "trading against the client"

Hi

My simplistic sketchy understanding is that some retail brokers (marketmakers) will either hedge individual traders positions (if I go long they will go long - in the underlying market - thus supposedly only making their profit through the spread), hedge on a collective/group basis, or take on the opposite side of the traders position (if i go long they go short - in the underlying market. If I am wrong the broker will not only profit from my loss, but they will also profit from their win).

It is the latter option - taking on the opposite side of a clients position that seems to represent a conflict of interests on the brokers behalf.

Am I along the right lines? Please can somebody give a more accurate description of the different ways in which retail brokers operate, and in what circumstances?

What is the best option/way of operating - for a broker - from individual private traders point of view?


Many thanks

jtrader.

You are confusing "broker" and "marketmaker"

A retail broker acts as your agent. It is his job to get you the best price in the market. He will find you the best bid (highest selling price), or best offer (lowest buying price).

He does not take ANY positions. He is simply a broker / agent /intermediary.

In return, he will charge you a commission for his services.

A marketmaker acts as principal. He takes the other side of the transaction. If you are a seller, he will buy from you. If you are a buyer, he will sell to you. He makes his money from the spread (the difference between the bid and offer price. He may chose to hedge his new position, or trade out of it.

Ordinarily, a retail investor wont deal directly with a marketmaker. A broker will.

There is a slight anomaly when you spreadbet, in that as a retail client, you are in fact dealing with them as principal (i.e they are the marketmaker in the transaction).

Again, the spreadbet company will make their profit off their spread, but may chose to hedge with an off-setting tade elsewhere.

AC(fB) - I've had this discussion a few times on different boards and have yet to get a definitive answer. My particular concern was who is acting as marketmaker with CFD trading - specifically my E*Trade quote-driven CFD account (not direct access).

Others have told me, including E*Trade themselves quite categorically, that they only act as middleman/broker. However I'm not convinced because it clearly says on the CFD trade confirmations that E*Trade have acted as principal, which I take to mean, as you say, 'takes the other side of the transaction'. I also asked 'who are the marketmakers for your CFDs then', I was amazed at the reply 'well that's confidential'.

I can see that SB companies would also act as MM for their CFD trading, but for retail brokers like E*Trade how does it really work?

KenN

Ken,

I can only speak for equities as I have never traded CFD's.

Some broking houses can have what is known as "dual capacity". This means that an integrated broking house will have a "broking" facility where they act as agent, and they will have another area on the trading floor where they act as marketmaker (principal)

All major houses (Goldman Sachs, Merrill Lynch, Morgan Stanlet, CitiGroup etc) have dual capacity.

E*Trade also makes markets in various UK stocks.

You, as a retail client, will be using E*Trade as your agent or broker to get you the best price in the marketplace.

If you want to buy 100 British Airways shares, E*Trade will go into the market place and find the best price. If the lowest price quoted by any of the marketmakers is 500p, E*Trade will buy them from the marketmaker , on your behalf, and charge you commission for doing so. The marketmaker in question might be Goldman Sachs or Merrill Lynch.

However, if E*trade is also a registered marketmaker in British Airways, the E*Trade broking arm can deal with the E*Trade marketmaking arm, rather than Merrill Lynch. But if this happens IT MUST MATCH OR BETTER the best quote in the marketplace at the time.

Not sure if that is clear.....

Only thing I can add to that, nothing to do with CFD's as I know nothing about them, but with regard to stocks. The Nasdaq contains about 600 dealers working for brokerage firms who have met the requirements to become MM's trading around 15,000 stocks. Unlike the New York Stock Exchange (NYSE), the NASDAQ market does not operate as an auction market. Instead, market makers are expected to compete against each other to post the best quotes (best bid/ask prices.
The brokerage firm can handle customer orders either as a broker or as a dealer/principal. When the brokerage acts as a broker, it simply arranges the trade between buyer and seller, and charges a commission for its services. When the brokerage acts as a dealer/principal, it's either buying or selling from its own account (to or from the customer), or acting as a market maker. The customer is charged either a mark-up or a mark-down, depending on whether they are buying or selling. The brokerage can never charge both a mark-up (or mark-down) and a commission. Whether acting as a broker or as a dealer/principal, the brokerage is required to disclose its role in the transaction. However dealers/principals are not necessarily required to disclose the amount of the mark-up or mark-down, although most do this automatically on the confirmation as a matter of policy. Despite its role in the transaction, the firm must be able to display that it made every effort to obtain the best posted price. Whenever there is a question about the execution price of a trade, it is usually best to ask the firm to produce a Time and Sales report, which will allow the customer to compare all execution prices with their own.
A direct access platformwill allow you to interact with the MM's further you may choose to route your trade to an ECN which exists to match buyers and sellers together

Knorrie,
Just to clarify , Etrade are just acting as a broker on the quote driven product.The other party is a big single marketmaker for all their quote trades.
Since you say its confidential, I'd better not divulge who it is esp. as I appear on their trading ads!!!
I was not aware its confidential but will ask them tommorow.Basically, Etrade get a cut of the 10quid commission.

Hope that clears it up for you.

The NYSE on the other hand uses what are known as specialists The majority of volume (approx 88%) occurs with no intervention from the dealer. Specialists make markets in stocks. The responsibility of a specialist is to make a fair and orderly market in the issues assigned to them. They must yield to public orders which means they may not trade for their own account when there are public bids and offers. The spec has an affirmative obligation to eliminate imbalances of supply and demand when they occur.

nobrainer - Many thanks for that - but then what does the phrase 'E*Trade acted as principal' mean on their CFD trade confirmations? It doesn't say that on my equity contract notes.

BTW I was going to attach one on here but you can't get the old trade confirmations any more it seems - I've only just noticed they've changed the account reporting stuff in the CFD platform. You used to have to download PDFs for each single day, which had the above phrase, and was a complete PITA to reconcile. I got fed up with this and decided I'd only do it at the end of the tax year. Now they have a much better spreadsheet like report which you can get for any date period and copy it into Excel - brilliant well done E*Trade! But now it doesn't have all the legal stuff or say 'acted as principal'.

Callum I didn't know that about them being able to make a market themselves in certain stocks, very interesting.

Guys thank you all very much.

KenN