It is crucial to know the difference between Market Makers and Brokers in the field of CFD trading. This concept is one of the most misunderstood ones among the retail audience. Because the Market Maker model creates a conflict of interests between counterparties of a trade it is important to know the mechanism of trading CFDs and other such derivatives.
Whereas dealers (market makers) trade on their own account and hold positions in various securities, a broker acts as middleman between two investors (usually referred to as counterparties). The broker brings the buyer and the seller together (e.g. this could be two different dealers or a private or institutional investor and a dealer). The broker does not hold a ‘book’ but charges a commission for transacting the deal between the two counterparties.
Sometimes the broker will consolidate the commission in the bid ask spread. Most large banks provide both brokerage service and have dealers who run a book.
There are full-service broker and discount brokers. Both types of brokers execute orders (including short sales) often over the Internet, they also hold securities for safekeeping and provide margin loans. In addition, full service brokers provide research services and investment advice.
So finally, which model is best for traders – market maker or middleman? There is no definitive answer to this question since there are so many factors to consider for each single trade. First, in CFD trading it is important to know there aren’t any securities actually bought or sold.
It is an OTC market and as such imposes different rules. While an order might get instantly executed with a market maker, this is not necessarily the case with a broker. Sometimes a broker might use slippage and widening bid and ask spreads in order to protect himself against bad execution from its dealer. On the other hand if trading directly with a dealer, there is a conflict of interests between the two counter parties. That is why it is better to consider all factors as a whole rather than making assumptions just on trading models.
Some CFD Trading providers offer both trading models into one account which is definitely an interesting approach. For example, a UK based company DF Markets offers an online platform combining a book listing higher level dealers such as Interactive Brokers, Citibank and FXCM. In this case acting as a pure broker the company also offers trading at quotes which are market maker based. This type of software actually allows traders to close trades with many different counterparties instead of just one.