Do Spread Betting firms Hedge their Customers' Bets?

Q. I am with Finspreads as you know and when betting the FTSE 100 what exactly am I trading? It seems like Finspreads' own FTSE100 and not the actual index itself. I get the impression I am betting against others betting on the FTSE!


A: Regarding your impression of betting against other punters, well yes you are in effect; if you win you take money from the losers and vici versa. Just remember, for every trade that you do, there is a rational person taking the other view. If it is so obvious that you are right, then there must be a big supply of mugs out there, allowing you into your position. If you win you take a portion of the pool of money deposited with your broker by all traders. If you lose you add to the pool of money deposited by all traders. I try not to think of it like that, I think of it as my strategy against the movement of the price, whether I'm trading in the right direction or not. The broker always takes the spread over into their own pool of money. Your broker must cover the net asset value of all accounts under management.

Additionally, the supplier of the CFD/spread bet need not actually place the trade in the market. When you spread bet you are basically betting against a bookie. You are not contributing in any way to the markets, you are making or losing your money against your bookie. So if you place a trade and you get it right, the bookie is paying you. You get it wrong, you are paying the bookie. Of course different suppliers have different policies - some have a strict policy of hedging like for like, some may study clients' performance - if the client is making a lot of money, they'll make the trade; if they're a clueless newbie, who's haemorrhaging cash on every trade, they might not bother and use the customer's losses as their profit. In reality, in most instances they are aggregating both sides, and taking the spread. Providing a marketplace, not setting the market. The idea that there are independent prices out there, that everyone can buy or sell at, is one of the fallacies held by non-professional traders, in general, who trade in small enough size that they never see the liquidity on the 'other side'.

However, in essence you are betting against the spread betting company itself. Over the years there have been plenty of rumours and arguments between traders about whether spread betting providers hedge all bets. In my view this is highly unlikely as evidenced by one spread betting shareholder report that stated profits were less than anticipated because clients had been more lucky than was anticipated and that this anomaly was unlikely to continue.

Q. Am I really trading against the market or against the spread betting company?

A: In technical terms, spread betting firms make up the prices to the clients so, in the first instance, it is true that your counterparty is the spread betting firm who will then manage the resulting exposure.

However, this question probably originates from the fact that some investors have been caught out in a fast moving market. They may have a stop loss or they may have tried to get on the phone and been put on hold for 10 or 30 seconds, but we all know that if the market is going straight down, those 10 seconds seem like 10 minutes. Those bottleneck situations create dissatisfaction and resentment but don't think that this happens only in spread betting!

But basically traders are always trading against the market. There are instances, for example, when the market's closed, for instance you can phone the spread betting company at 7 in the morning and say: 'Where is the daily Footsie?' Here, you could argue that, at that point, you're not trading against the market, you are trading against the spread betting company.

Sadly not all traders make money but really the issue here is psychological more than anything else. If you consider the spread betting company as your trading partner who is facilitating your trades and helping you access the market giving you the best prices and service, then perhaps you will realise that you are really up against the market. Thing is the market is a wild animal and nobody really knows what it's going to do in the short-term; taking the approach that we are all in it together is probably best.

Q. Do spread betting firms hedge their customers' bets?

A: Yes...although don't think that as soon as you place an up bet for 888 at £20 per point, the spread betting provider is going to rush out and buy a two and half grand CFD to hedge the position. What's the point of this if 30 seconds later someone having the opposite view as you will go short on 888. So is there any point for a company to hedge?

For one thing there's the size - for hedging small bets the costs of hedging will offset the benefit of the hedge so the provider is more likely to let the bet running without hedging. It makes more sense that the spread betting firm will want to hedge the NET positions of its clients on a rolling basis, rather than hedge each bet individually. This is a complex area where the risk manager will not only look at the net long or short positions but also at the correlation between the different instruments. So yes, they do hedge, but not as much as everyone believes.

So spread betting providers offset their clients' exposure in two ways -:
  1. If a customer places a bet, and another customer has placed a bet in the opposite direction (i.e. if one customer buys £10/point of share X and another customer has already sold £10/point of share X) then the two bets cancel each other out. In this example the spread betting provider is exposed to no risk, and makes a profit from each customer off the spread (the difference between the buy and sell price) multiplied by the stake (in this case £10/point.
  2. Alternatively, if lots of clients are betting in the same direction, and a new bet cannot be hedged internally, then the spread betting firm will hedge the bet in the underlying market. For example, if more clients are wanting to buy share X than sell share X, the spread betting firm will go into the underlying market and buy shares in company X. If share X rises in value, then the spread betting provider's clients who have bet on it to rise will have made a profit. As the spread betting provider also owns shares in company X then it has also made money, this profit covers the payments made to the clients that have won money. As the spread betting firm is also charging a spread to the clients that have won money, this is how the provider makes money in this instance.
Sometimes I like to compare market making to bookmaking. A bookie knows his clients - in particular the ones who win on a regular basis and the ones who lose on a regular basis. When he see a winner placing a bet he is more likely to lay-off the bet to cover the risk of having to make a payout but when he sees a loser placing a bet he knows it's probably money in the bank. In this business it's a lot easier for a market maker to crunch the numbers as they have complex risk management software which analyses trading habits patterns win/lose ratios, leverage stops, limits...etc of each individual client. That software can easily work out the most profitable way to hedge each client's trades...

Experience of journalist Simon English who visited IG's offices "To the left of me is a bank of IG Index traders, but they aren't taking positions on their own account, or on IG's really. They are hedging the company's risk. So if a client has a position that could see him win £1 million if shares in HSBC fall 20%, IG positions itself to cover this eventuality. It bears some risk without hedging, but beyond certain limits it is always taking the other side of client bets."

Q. So the bookie won't hedge all bets in the markets right?

A: Spread Betting: In essence, it just a matching process. Match all longs against shorts and capture the middle. The house will run a % of overall volume uncovered in normal markets for additional profit. All spread betting bookmakers take on at least some exposure. If they didn't, and went away to hedge every single trade, they would make very little in the way of profits. This is for the simple reason that hedging costs money, both in terms of market spread and broker commission.

The house cannot possibly look at individual clients and make specific choices, all trades drop into a bucket, most will end up naturally hedged and the remainder is either run or hedged into the underlying market. A bookie hedging/not hedging is a risk-management decision, rather than a view for or against underlying clients. All sensible bookmaking companies assume that, in the long run, some clients will win and a slightly larger number will lose; what matters is to ensure that any large aggregate position that builds up because of client business is monitored and contained by making hedging trades to keep its size within a preset limit.

This isn't the easiest thing to get across, so let me give an example:

On the Daily Dow, a company might start the day pretty flat, exposure-wise. The company sees a £10 buyer here, a £50 seller there. etc and will do nothing. If, however, the consensus of client opinion is that today will be an up-day, then clients as a whole will be going long. So, as the day develops, the bookie will go shorter and shorter. Eventually he will go shorter than what policy dictates to be prudent. At this point he will go into the market, buying dow jones futures contracts or, more likely, S&P futures as a hedge. He will buy just enough to bring himself back under his limit. So if the limit is +/-£1000 per point, and client business takes him short £1100 per point, he will buy just £100 per point-equivalent in the futures market, and see where client biz takes the exposure from there.

There is no discretion about whether or not to hedge, and no notice is taken of which clients have built up the position. Your particular bet may end up getting hedged, or it may not - it's really nothing personal.

Some less intelligent salesmen try to turn hedging policy into some kind of marketing tool - i.e. "we hedge everything, so we want you to win, unlike companies x, y and z". This is a pretty weak argument. Firstly, they are lying about their company policy, at least to some extent. Secondly, if they genuinely are hedging everything you do then they'll have to read the price aggressively against you every time you trade, or they'll make no money (because they're paying away most of the spread they receive from you). Thirdly, bookmakers don't actively cheer on client misfortune. If a client is a nice guy and is clearly a reasonable person, seeing him make money doesn't particularly annoy the bookies. If a client is known to be a complete w*nker then the traders behind the desks are likely to laugh when he loses and wish him extreme malice when he wins. That's human nature. But the personal views of dealers has no effect on the (automated) prices at which a client deals, and most dealers are bright enough to understand that profits or losses at the level of individual clients don't mean anything. Take enough business and the magic of spread/efficient markets will make you plenty of money in the long run.

It is true that some companies hedge more than others. But this isn't because they want to be 'on your side', it's because they have unsophisticated risk management systems and therefore can't be relaxed about aggregating and monitoring net client positions.

It's difficult to know individual hedging policies for sure, but I'd put CMC and IG towards the 'not hedging' end of the spectrum, and City and Cantor towards the 'hedge it all' end. But don't take my opinion as gospel.

Q. But isn't it all a big scam if they don't hedge all client positions?

A: Everyone talks about 'hedging' but hedging costs the firms money in terms of execution costs plus spreads plus slippage and therefore they generally try to keep this to a minimum. If a spread betting provider does hedge, which obviously does happen especially with the smaller houses, then the firm must implement some kind of rule structure for the efficiency of its hedging policy. If a firm has identified a larger successful client then it might actually hedge that client on a bet by bet basis and simply make its money on the wrap (the extra which the firm adds to the market spread). This just leaves the firm's own book on each market which obviously represents the net client positions of otherwise unhedged client positions - this the company has to handle differently because the provider cannot afford to, both financially and in terms of man power, hedge or unhedge as each individual trade goes through. The firm therefore will decide to hedge based on two factors -:

i ) a time based examination of its net client book, or
ii ) if its book becomes too heavy in one direction.

At the end of the day whether they hedge your positions or not, it makes no difference to the expectation of your trade or your trading strategy, so this is irrelevant. The provider's expectation is that some 70%/80% of their newbie traders lose money, so on a statistical basis it pays not to hedge them, it's not a personal vendetta against any one trader but just a collective judgement, even if a newbie does win occasionally the odds are they end up giving it all back within a short period of time. Consistent traders that make money are placed on manual execution and hedged in the market. Also, big notional positions would not clear through instant execution, it would be manually executed and hedged regardless of the client. However, what we're talking about is thousands of say £2 rolling FTSE bets from mug punters, on a statistical basis the vast majority will lose, especially when you add in a little slippage and market skew, so it pays just to make the market and not to hedge them at all, even if that leaves a net exposure (although big net exposures in any one direction are hedged as well if they are over the provider's risk tolerance).

Q. Yeah, but IG Index's own customer agreement actually admits that they may have a conflict of interest?

From IG Index's own customer agreement...'(b) We may execute hedging transactions prior to (i.e. in anticipation of) or following receipt from you of a request, or information concerning a contemplated request, to open or close a Bet in order to manage our risk in relation to Bet(s) you are entering into or contemplating, all of which may impact on the price you pay or receive in relation to such Bet(s) and any profits generated by such hedging may be retained by us or an Associated Company without reference to you.'

A: The hedging statement above is a general disclaimer to enable them to manage their risks properly. Do you think a spread betting company will operate without using hedging to manage risk? They all hedge but don't want losers coming later asking for a piece of it.

If they go long, they will be against punters who shorted and if they go short, they will be against punters who went long so of course any hedging position will be in line with some punters and against other punters.


The main point is their hedging position is based on their risk management limit and the net difference between long / short. How can they hedge either without conflicting with the other side!?

Q. Tell me more about how spread betting providers counterparty risk management?

A: Steve Clutton, Finance Officer at IG Group gave quite a good insight of how IG manages its client portfolio risk in the Annual Results Presentation 2008 -:

'Risk management in quality of earnings is a familiar slide with a familiar story. The volatility of revenue remains in a tight range despite heightened market volatility during the year. Our model is to capture transaction fees and we continue to hedge the vast majority of client positions. It is quite rare for us to have loss making days and when we do it is typically on a holiday in a major market, this or both sides of the Atlantic. That is when there is much lower client activity. And we had three of those days during the last financial year, but they were all pretty small losses.'

'Just touching on counterparty risk management. We have split the slide into market counterparties and client counterparties. We hold cash at our hedging brokers for margin requirements and we also have cash at various deposit banks. At the end of May we had just over £250 million at brokers and 93% of that with counterparties rated A1 or above. At the same date we had just over £470 million at banks- all of those counterparties were rated A1 or above. As part of the credit review process, we review credit limits very regularly and mitigate risks by diversification using nearly 40 different counterparties.'

'On the right hand side we talk about client counterparty risk and that is managed through a strict process. Each account is assigned a limit which determines the total amount a client can risk as a deposit. Concentration limits are applied. For example, a client cannot take an underlying position of more than 1% in any company. And this is also considered from a firm-wide level, i.e. a collective exposure from all clients to a single stock. Margin rates reflect liquidity and volatility. They are increased when and where appropriate. For example, we increased banking stocks in crude oil margin rates earlier this year, given the volatility in those sectors. And higher margin rates are applied to larger or concentrated positions, such that individuals could be margined well in excess of headline rates. In addition, clients manage their own risk. Tim has already mentioned the use of stops. In the final quarter of last financial year, 61% of UK financial spread betting accounts, were opened as limited risk accounts, where a client has to deposit cleared funds on an account and put a guaranteed stop on each trade, such that any loss cannot exceed the margin on that account.'

ETX Capital runs two trading books: one for traders who deal in larger sizes and one for the smaller clients. ETX Capital hedges all spreadbets in the larger trade pool in the market so the exposure risk for the spread betting firm is eliminated. 'If a client wins, ETX also wins - if they lose, ETX also loses, but just a little bit less'. In the secondary book ETX assumes a certain degree of risk, which is monitored by risk managers to ensure that it stays within defined risk parameters. Most of ETX Capital's business goes through the secondary book and the exposure is executed directly in the market.

Q. 'There is no trade entered on any market anywhere when you place a bet with them...'

A: That depends largely on the size of your bet and who your counter-party is. CMC Markets - are known for hedging very little on the market. By contrast other spread betting and cfd providers hedge all trades and all but the smallest spread bets since it is uneconomical to do so.

In practice, however, most spread betting providers will hedge out over exposure in illiquid or volatile markets but be quite happy to run exposure on major indices and currency pairs, as well as the constituent equities of the major indices, but it usually all done at the total level and not individual accounts. The key is that while the house will run positions unhedged and look to make a return from overall client losses, it is difficult to do this on an individual basis as there are too many clients. It works by delivering a competitive market price and looking to net off as much client volume with itself and then laying off the excess that it doesn't want to run the risk on.

The only time a client account recieves individual attention is when the trade is in size above the normal market liquidity and so it specifically needs to be hedged. i.e. a client wants to buy 5 times NMS on a crappy small cap, the house will execute the trade in the underlying while confirming the bet to the client. It won't want that sort of business on its books.

Q. So is spread betting just a con?

Never knew that spread betting firms hated that you make money, bit silly as I thought they make money from the spread therefore they wanted me to make a profit so I could trade more. So from what I have read spread betting companies do not like it if I make money because I'm making it out of them and not "the market". I always thought you place an order with a spread betting provider, they go to the market and say we would like to buy shares at e.g. 150p rather than actual price of 220p, this then meant there was an order to be filled at 150p which made sellers think that their stock was overpriced and hence the price came down.

A: I'm not exactly sure what your problem with the spread betting companies is? If you want to buy or sell stock, take the market price, apply interest between the date of the bet to the expiry of the contract (Mar, Jun, Sep, Dec), subtract any dividend due, and then add about .8% to the spread (depends on the company) and you have their price.

It's very predictable and not a con. Give me a market price and dividend due, I'll work out the spread bet companies quotes for you. If you're incredibly successful, they might close you down - though probably not if you're trading shares over longer time frames.

I doubt your suggestion that they're 'a con' is from your own experience. More likely from 1 of 3 sources;

  1. The vast majority who wouldn't make money if they had a copy of next week's financial times, but will blame the spread betting firm for their shortcomings after reading internet Bulletin boards telling them so...
  2. People who only read internet bulletin boards and regurgitate what they're read, like sheep.
  3. Successful spreadbetters who operate on a short time frame and have cleaned out their bookie.

99% of what you read will fall into either 1, or 2. Probably including your own question- though apologies if this aren't the case. Usually the people I see complaining are the ones trying to scalp or taking advantage of arbitrage pricing anomolies.

When I put on a trade and make a loss I do not blame anyone but myself. When you overtrade, blow your account, trade emotionally or fail to trade a plan with an edge then you have only yourself to blame. If you are trading a plan with an edge and make a loss then this is simply the cost of doing business. Blaming the spread is also irrelevant - if a winning trade nets you dozens of pips then a 2 pip spread is not a problem.

What I am saying is if you are holding a bet for a reasonable amount of time (a few hours or whatever) then the spread betting providers really couldn't care less what size it is. Remember, they look at EVERYTHING on a net basis, they don't think "ooh look John Smith just bought 2£ a point on BT, quick quick HEDGE!!"

Every few hours they will look at their overall exposure to each asset and decide what they want their exposure to be (sometimes they will take positions). For this reason, as long as you are not scalping, they don't mind you making a profit. They are very much in control of their exposure. In fact, they like you to make profit because you will be sticking around. You hear so many people saying that they will kick you off if you are profitable. but in reality this only happens if you are arbitraging, scalping or otherwise ****ing them over!!!

Spread betting can be a con when they pretend you can trade whatever style you wish to trade because you will run into problems sooner or later. However, for slightly longer time frame trading it is no worse than trading with non-spread betting providers. You have to remember that most of the problems you hear about are most likely not due to malicious intent on the bookmaker's part. It is usually platform issues related to news trading, fills, etc.

If you are the kind of trader who does predefined Support/Resistance levels, for example, you can just pick up the phone and put the trade/order on and I am sure you will be ok. The control of your own trade execution that comes with online trading is where the problem is at. You are just scaring hell out of them by having that control and they try to curb that as much as they can and that can be a pain in the backside.

 ...Continues here - Segregation and Ringfencing of Client Funds

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