Direct Market vs. Market Maker

[cigarno]

It is my understanding that there are two kind of CFD ( Contract for Difference) providers:
(1)- Direct Market
(2)- Market Maker
In the Direct Market type the cfd provider goes ahead an hedge either the short/long position in the actual market (i.e us stocks, uk stocks, commodities....,etc.). In the Market maker type the cfd provider DOES NOT hedge the short/long position of his clients in the actual market.
Since all CFDs offer huge margin trading (most require only 5% capital outlay) the question is:

(A)- where from does the Direct Market CFD provider get the money to pay for the physical share/commodities of long positions taken by their clients?

(B)- where from does the Market Maker CFD provider get the money to pay the interest and profits, if any, for the short positions taken by his clients if they do not have an opposing long positions and they do not hedge their position in the physical market??

 

[mel_pub]

(A) Repo. Buy $1000 worth of shares, borrow money and give the shares as a collateral and get $900. Use these $900 to buy $900 worth of shares, then use them as a collateral to borrow $890.... The leverage depends on the haircut

(B) You short GOOG

1) Another customer has GOOG shares, the broker deliver them and pay nothing to "borrow" them, yet he receive the short sale proceed which increase his cash balance (earn libor interest)

2) No customer is long GOOG shares, he sells the shares short, then he borrows them in the special market which means he lend money against a special collateral which is GOOG. He lends money at less than libor because 1) the lend is secured by a collateral 2) he required special collateral. libor -30bp for blue chips.

The broker sells the GOOG shares short and get $1000
He then lends these $1000 to another broker. He gets libor-30bp on these $1000 plus GOOG shares as a collateral, and he deliver them.

He can give back up to libor -30bp to the customer.

3) the broker is a bucket shop, he doesn't hedge so no other long position by other customers and no offseting short hedge, then the broker earns libor on all customers balances, that "pays" the interest, the "profit" is paid from the brokers pocket which is filled by the losses of other customers

Most of the time the broker will be in situation 1 or 3 (he earns full libor on short proceeds). Because with a large base of customers you got longs in every large stock, and less shorts than longs (think of the average short interest). If the broker is in need to borrow a stock to deliver a short sale, and if he's a large broker most chances are that this stock is very special ie hard (or costly) to borrow and that means it is lended to cronies, volatile, prone to squeeze...

When in situation 2 he will simply disable the short selling of that stock on his (mediocre) retail platform software.