How does IG Index (or any spread betting firm) make a profit?

mblack

Newbie
6 0
Just interested in the mechanics if anyone has any insight.

1. CFD on Equity Index Instruments

Is IG Index taking a view of its entire book of customers and then hedging itself in the underlying index futures market?

If this is the case isn't IG Index exposed to risk in fast markets because the underlying could move much more quickly?

The bid-ask spreads on IG are much wider than the underlying market. So the spread itself is already a source of profit.

2. Margins

The margins on underlying futures contracts in the market are much higher than that demanded by IG so is IG shouldering more risk?

3. Slippage on CFD on Equity Index Instruments

Since the price on IG only seems to loosely correlate to the underlying market, how are stops in IG's book elected. If you're IG, looking to manage risk and have a full view of the stops in the book, IG could elect the stops to manage its own risk no? There seems to be some chatter about this.

Equally if an underlying moves significantly through a limit and a customer is in profit but IG's book is not, IG could manage its quoted prices so as not to trigger the limit?
 

highbury fx

Well-known member
338 114
Just interested in the mechanics if anyone has any insight.

1. CFD on Equity Index Instruments

Is IG Index taking a view of its entire book of customers and then hedging itself in the underlying index futures market?

If this is the case isn't IG Index exposed to risk in fast markets because the underlying could move much more quickly?

The bid-ask spreads on IG are much wider than the underlying market. So the spread itself is already a source of profit.

2. Margins

The margins on underlying futures contracts in the market are much higher than that demanded by IG so is IG shouldering more risk?

3. Slippage on CFD on Equity Index Instruments

Since the price on IG only seems to loosely correlate to the underlying market, how are stops in IG's book elected. If you're IG, looking to manage risk and have a full view of the stops in the book, IG could elect the stops to manage its own risk no? There seems to be some chatter about this.

Equally if an underlying moves significantly through a limit and a customer is in profit but IG's book is not, IG could manage its quoted prices so as not to trigger the limit?

Hi mblak

its a good question and the answer is they make the bulk of their money in 4 ways:

1. They assume risk on a B book
2. They agency broke big clients or A book clients and capture commissions
3. They capture the spread from different clients trading on opposite sides of the price simultaneously
4. They charge increased overnight funding to roll positions.

The B book for most spreadbetting firms will be where they make most of their money. IG (in this case) will decide on a what is a reasonable amount of risk to run from their client flow. The spread the client pays when he initiates the deal is enough of a disadvantage to make the s/b company a slight favourite. This advantage of risk to the market maker is why they run B books. The s/b company will not run risk against all of its clients, only the ones that haven't been allocated 'A' book. EVERY other client is 'B' book and these are the clients that the s/b co takes on. Too many B book clients trading in one direction will mean that the risk limits of the s/b firms will be breached and a hedge or series of hedges in the underlying market will be executed and the risk returned to its accepted levels. This is the only time B book clients are hedged and it is done as little as possible. When the spreadbet company hedges in the market they are paying someone elses spread and that can mount up to an expensive cost that is avoided unless absolutely necessary.

2. 'A' Book clients. This is easy no risk business for spreadbet companies. An A book client is a client who always deals in big enough size that the B book risk limits are bust and a hedge will need to be done to reduce the B book risk, or he is a client who is good and is backed off so the risk is with the underlying market rather than the broker. Depending on your relationship with the s/b co an A book client will be charged anywhere from a specially negotiated fee to a premium on the standard spread. Spreadbet firms do not retain any risk from A book clients.

3. Cleint X sells £10 a point EUR/USD at 1.2350 at the same time client Y buys £10 a EUR/USD at 1.2352. The spreadbet firm has no risk (the 2 clients have hedged eachother) but has locked in £20 profit from the spread. Happens more often than you'd imagine.

4. Overnight funding is a revenue stream. I don't think any Spreadbet firm has ever denied this. Simply the underlying market will apply market funding to the total net position of the s/b co, whilst the s/b co will widen the funding and apply it to EVERY client position rather than the net position.

Your point about margins: Yes you are correct. The market will charge us far more than we can charge clients but this doesn't cause much more risk to s/b firms. You may only need 0.5% deposit plus another 10 pips for potential slippage to get your trade done and if your stop is triggered and hasn't gone more than 10 points through your stop then you posted enough margin to begin with and all is ok.. the main risk is if you have used all your available balance to get the deal on and your stop goes through your stop level more than 10 points.. this is when the s/b firm could have a bad debt on their hands and that is the risk, not the market asking for higher margins from s/b firms.

Slippage and stops: Yes the s/b company could place a stop just before or after the clients stop level (note, this is only A book clients as all other clients are part of the overall risk) but its a very risky move. for example, say the client put a stop to buy £1,000 point of EUR/USD on stop at 1.3320, the s/b firm to hedge this risk will place a stop to buy €16.8M (£1,000 point equivalent) of EUR/USD at 1.33195 (they'll be happy making half a pip on £1000)... lets say the market goes to 1.3317 very quickly and the client decides to move his stop to 1.3350 but the s/b firm hasn't noticed or reacted quickly enough to move their stop from 1.33195 to 1.33495 and the market spikes to from 1.3317 to 1.3325 and then spikes down to 1.3305.. the s/b firm is now long at 1.33195 (or maybe 1.3325 depending on what bank filled the order) in a market that is 1.3305 offered. This would be a running loss of £14,500 which is not something that can be allowed to happen too often. Therefore, with A book clients if an order is put in to the market against them the client is normally told and asked to let the dealing desk know if they move their stop. You may find this difficult to believe but it is correct. Relationships between most A book clients and most spread bet firms is excellent - they work together to make it easier for them both.
 

mblack

Newbie
6 0
Thank you, highbury fx! That's a detailed and solid answer. I didn't know about A books and B books, but Google is helpful :)

If I may play back how I interpret this, anyone please jump in and tell me if this is not the case / fact.

First off, unlike a book maker, spread betting firms actually take proprietary risks. This is because book makers just try to 'balance' their book and are generally 'market makers'.

Spread betting firms on the other hand take a look at the entire B book (not individual B book clients) and some human trader takes a view as to how much of the the net risk IG wants to take (the rest of the risk is laid off in the underlying market). This risk is in the opposite direction of the B book trader's trade. Isn't this a conflict of interest? If I'm the spread betting firm, the more the B book loses, the more I profit. As the spread betting firm I'm already at an advantage in terms of spread. I'm absolutely not motivated to find best execution for that client, nor do I have to deal fairly because they're inside my book and I set the prices in my book.

With A book clients they're the traditional sort of punter. The spread betting firm stands in the middle and gets paid for making a market.

Why would this scenario work for the big and by virtue of being big, possibly smart, A book client? Why would she ever let someone who knows about her intentions set up as follows:

1.33200 <-- A book client' stop buy (i.e. buy it if touched) for £1,000 per point
1.33195 <-- Spread betting firm's stop to buy
1.33170 <-- Market trades up to here very quickly

Basically the spread betting firm gets ahead of the client and knows there's a buyer at a higher price, that the firm could potentially sell to her at.
 
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