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

[JTrader]

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.

 

[Airthrey Capital]

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.

 

[knorrie]

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

 

[Airthrey Capital]

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.....

 

[roguetrader]

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

 

[nobrainer]

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.

 

[roguetrader]

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.

 

[knorrie]

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

 

[theknifemac]

Ken

Principal means they are taking the other side of the trade - you are dealing with them off their own books. Normally contract agreements are principal or agency. On a direct access CFD it would be agency as you would be dealing directly with a market participant. On a quote driven CFD, you are having to deal at the quote from ETrade's marketmaker rather than live quotes from the market. ETrade may well choose to look at their net positions and then hedge them in the market. Their net positions could include clients who trade CFDs and straight equities with them as principal.

On portfolio trades you will sometimes see a hybrid I think called riskless principal where the firm can deal as agency or principal depending on their in house positions.

Hope this helps

Stew

 

[JTrader]

"Hedging" & "trading against the client" - "retail forex brokers"/marketmakers

Hi and thanks for the replies.

By "retail broker " I did mean marketmaker - I thought they were the same thing - as a "retail forex broker" such as FXCM, GFT, RJOFX, ACM, is a marketmaker - making their own market. Therefore I also presumed that spreadbetting and quote driven CFD companies were also, in effect, "retail brokers" as opposed to a normal "broker" such as Hoodless Brennan.

I did make the original post with forex marketmakers inparticular in mind - I did not make this clear, sorry about that .

Here are my original questions -

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.

Thanks again

jtrader.

 

[roguetrader]

Hi


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.

.

Ok, first thing for me to say is that I know nothing reaally about forex trading.........But if the setup is similar to stocks one of the main functions of a market maker (MM) is to ensure a flowing market. Where there is balance between supply and demand this is fairly straightforward since he just puts buyers and sellers together. However where there is an imbalance, say far more buyers than sellers the MM will have to trade his own account to make the balance, ie he will have to make the supply and so consequently he will sell to you and thereby be on the opposite side of your trade.
Now if you imagine yourself in his position, normally you stalk the market looking to take a position, and lets say today you favour the long side in a given position, however as market maker because there is a shortfall in supply you have to sell to balance that supply. Therefore inyour own judgement you are on the wrong side of the market, due to your obligation as MM. Therefore I can well imagine that you would feel the need to hedge that position.
Just a thought.

 

[JTrader]

Hi

Just to clarify - does hedge mean/= If the client goes long, the "retail broker"/marketmaker also goes long - in the underlying market - therefore if the client loses money on the trade - the marketmaker gains the clients lossses, but also loses an equal amount, because they also went long - cancelling out their gain from the clients loss. Thus the marketmaker only made a profit through the spread which the client paid to enter and exit the trade?

Many thanks

jtrader.

 

[JTrader]

...........On the other hand - if the "retail broker"/marketmaker takes on the other side of the clients position - this is either a WIN WIN or LOSE LOSE situation for the broker...............Because if the client loses money, the broker gains the clients losses but also gains as a result of having taken the opposite side of the clients position and seen the market move in their own favour...................If the client has a winning trade, the broker has to pay out the winnings to the client, and by taking on the other side of the position the "retail broker"/marketmaker will also have lost money in the underlying market.(?)


Therefore what I'm really trying to get at is, under what circumstances would "retail broker"/marketmaker hedge, or take on a trade in the opposite direction of the clients trade?

Thanks again

jtrader.

 

[roguetrader]

A hedge in effect is a protective measure for example say I am long the S&p500 by means of the tracking stock SPY, i have been long for quite some time and have a tidy profit in hand. at this point in time however I am a little worried as to wheither the move will continue oil prices rising again, more trouble in Iraq etc, but at the same time I see no strong evidence for a reversal. In this situation I might look to buy put options on the DJIA as it is much weaker and will likely fall faster if the overallmarket falls suddenly, this trade in the options would be a hedge

 

[roguetrader]

With your particular example, if the MM sold to you it was because there was insufficiant supply in the market to meet your demand, there fore he would have difficulty getting long along with you, more likely he hedges using some other means. Alternatively the MM may not feel long is the right side of the trade to be on therefore he does not need to hedge at all.

 

[knorrie]

theknifemac - yeah that's what I thought, but as I said E*Trade categorically denied this and it doesn't match what nobrainer says

jtrader - sorry for hijacking your thread somewhat

KenN

 

[JTrader]

knorrie -
jtrader - sorry for hijacking your thread somewhat

No worries knorrie - we are all here to learn .....if I can see that the questions I asked go some way to leading to another trader indirectly increasing their knowledge - I can sleep easy at night - knowing that I have helped my fellow man :cheesy:

jtrader.

 

[nobrainer]

knifemac,
''ETrade may well choose to look at their net positions and then hedge them in the market. Their net positions could include clients who trade CFDs and straight equities with them as principal.''

Nice theory but sadly that's not how it happens with the etrade cfd quote product.For ''etrade'' in the above quote substitute ''the marketmaker etrade use'' and then you are correct.As I said previously, Etrade are just getting a cut of the £10 commission, they are not taking the other side of the trade.


knorrie,
I suggest you phone etrade and ask them about your queries....I'm sure if you push them , they will tell you what you need to know.Ask for someone more senior if you have no joy.

 

[knorrie]

nobrainer - but how else can the phrase 'E*Trade has acted as principal' be interpreted if not as they took the other side of the trade?

KenN

 

[theknifemac]

nobrainer - but how else can the phrase 'E*Trade has acted as principal' be interpreted if not as they took the other side of the trade?

KenN

Possibly they are the counterparty with you but have an equal contract with the marketmaker so they are left flat, and the marketmaker ends up with the other side of your position. But for whatever reason they don't disclose the end marketmaker. This is not that uncommon. When I worked for a US IB, we were taking order flow electronically across Europe and then sending it to various brokers, the fills then went straight back to the client and all their contracts etc were with us, and we then netted up positions with the relevant brokers at the end of the day. This saved on ticket charges and meant we could negotiate lower fees due to increased volume than our clients could have done individually. Of course we had a sophisticated system to handle all of this... Also we handled account splits etc for the client and this info was never passed on to the destination brokers.

Stew