What is Market-Making?

If you spread bet, then you will be dealing with a market maker. When you trade on the stock exchange, your broker will quote you the price that the exchange is offering, but when you trade with a spread betting provider, and in some cases with contracts for difference, you will find that your broker is naming the price.

Market Makers work by contributing liquidity to the market and standing ready to take the other side of trades, earning the bid-ask spread for this service. Spread betting providers are essentially market makers who work just like stock broking firms. Stock exchanges traditionally have market makers on the floor setting the prices. Their function is to buy and sell stocks, standing ready to provide a quote at any time. As their ultimate goal is to balance the amount of stocks bought and sold overall, they set the price to try and achieve that, but it is their responsibility to provide liquidity so that anyone can trade at any time.

The spread betting provider has a similar task. Spread betting involves a bid and an ask price, the difference between these being the spread, and in the case of spread betting on stocks for instance these prices will typically bracket the price offered on the exchange. The provider's task is a delicate balancing act; the prices the market maker quotes should be such that he gets an equal number of buyers and sellers, so that he is not left speculating on the price move. The provider's profit does not come from speculation on the direction of the market, but from the spread i.e. from the different market participants crossing the provider's bid-ask spread quote to go long or short.

In ideal conditions each time someone goes long another trader would go short the equivalent amount eliminating the net exposure. But in the real world prices are constantly changing, and market makers must stay on top of the market's supply and demand in order to have a successful business. Therefore, when many more spread traders are going long than short on a particular market, the company will need to hedge its excess exposure in the markets or futures contracts. As there are many spread betting providers vying for the traders business, the individual provider must not only balance his exposure, spread and market prices, but must also compete against other providers who could offer better terms and attract business away.

How do Spread Betting Brokers Make Money?

The market makers make a tiny bit every time there is a buy or sell on a market which they are quoting. The greater the volume they are transacting, the greater will be their profits. They are providing liquidity to the market by allowing spread traders to go long or short at a price level. Spread betting providers are ready to quote at any time, in all market conditions and are indifferent to the direction in which the market is moving since they seek to earn their profit from the bid-offer spread.

Another part of the calculation that the market maker has to deal with is the matter of how large a spread he will use. If the spread is large, then that potentially translates into more profit for the market maker on each transaction. However, there will be less trading taking place overall because the spread better will see that the price has to move significantly before his position would move into profit. As it is in the broker's interest to maximise trade volumes going through their books, spread betting providers aim to offer competitive spreads.

On the other hand, if the market maker sets too narrow a spread, there will be a lot of transactions but less income for the spread betting company. There is also more risk with a narrow spread that the market price will move against them. If the price did not change, the market maker's task would be much easier as the market maker wouldn't be faced with the risk of the market moving against them. Offering a narrow spread would attract more business and profits would be boosted as a result.

How do Spread Betting Providers Operate?

Spread betting providers are market makers in the sense that they are the counterparty for every trade. They price their markets in a way that their cut is around the bid/offer of the underlying market. So when the cash price of a share goes up the spread betting provider's price will move in line with it. They wrap a spread typically 10bp on shares around the bid/offer of the cash price. For example with stocks providers may add a certain % (typically 0.1% for FTSE 100 and main European and US stocks) to the underlying offer and subtract it from the underlying bid. For Forex (also indices and commodities) they might have a fixed spread of a certain number of pips (e.g. GBP/USD and EUR/USD it is 2 pips) based in the mid-price of the underlying. This percentage is fixed and is not shifted in either direction. If they see a lot of buyers in the same instrument they wouldn't then increase the offer price or increase their spread, as all spreads remain fixed. Doing so would create an arbitrage opportunity which share traders could use to their advantage. If a market is particularly volatile, you may be requoted a price but again the price you are quoted is dependent on the market price available.

Since spread betting providers make their money from the spread, there is no need for them to suddenly move their price above where the actual underlying market is traded. So as you see providers do not move prices whenever they feel like it. The prices they show to their clients directly reflect those in the real world. The only possible time that a spread betting company might manually move a price is if it was making a price in what is called a grey market. That is a market which is actually closed, like the FTSE for example at 2 o'clock in the morning where providers quote basis on what is happening in other markets and business they see. In that circumstance if the spread betting providers sees a lot of buying it would move the price up. Otherwise, all spread betting companies are bound by the FSA and a legal directive called MiFID to offer clients prices that reflect the underlying market.

But then how do they hedge excess exposure in stocks. Say loads of people are going short on Barclays what do they do?

They physically hedge their clients positions in the underlying market. If you win your bet, they pay you with their gains in the underlying, and if you lose they have also lost their hedge. They make their money off the spread. Of course, the don't perfectly hedge as that would be cumbersome, expensive and time consuming and different providers have different risk tolerances. However, they do have to keep tight risk limits, so they have to hedge quite close. Let's take your case of Barclays. Say the market price of Barclays is 312 - 312.5, the provider's price might be 311.6 - 312.8, so clients would be selling with the spread betting provider at 311.6 and they can then hedge the position by selling at the market price of 312 to cover the position 0.4 better off. So in a nutshell if people keep selling Barclays to them then they go and sell Barclays in the market.

Final Comments

Particularly with the larger firms, you'll find a consistency in pricing which means that there are minor differences, but no one is going to take you to the cleaners. However, minor differences can add up and you should shop around for a spread betting provider which offers narrow spreads. Note also that different providers quote different spreads on the different financial markets on offer, so you might need to use one provider for spreadbetting on indices, and another who gives better quotations when you trade currencies.

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