How CFD Issuer Hedging Can Transmit Trades to Underlying Prices

Summary

The document explains how trading contracts for difference can affect the price of an underlying asset indirectly. A CFD is a claim against its issuer, so a customer trade does not necessarily produce an immediate matching trade in the underlying market. Instead, the issuer may pool customer exposures and absorb some of the resulting risk internally.

If the issuer’s net exposure to a stock, sector, or other risk factor becomes large, it may hedge in the underlying market, creating a channel through which CFD activity can influence prices. The answer says that this feedback is not deterministic and is unlikely to be noticeable for relatively small trades. Internalizing many small, sometimes offsetting retail positions can help the issuer retain spread revenue, while increasing the variability of its own profit and loss. The explanation is qualitative: it gives no data, threshold for hedging, or estimate of price impact, and the effect depends on the issuer’s exposure and hedging choices.

Key ideas

• A CFD trade is a claim against its issuer and does not necessarily trigger an immediate underlying trade.
• Issuers can pool customer positions and internalize some exposure instead of hedging each trade one-to-one.
• Large net exposure may lead an issuer to hedge in the underlying market.
• Hedging can transmit CFD order flow to underlying prices, but the effect is not deterministic.
• Small trades are unlikely to have a noticeable impact according to the answer.

Tags

# Does margin trading affect market price?


# Does margin trading affect market price?












Does supply and demand in CFD trading affect the actual price of financial market?

## Answer by LocalVolatility (score 1)

https://quant.stackexchange.com/a/37482

Buying or selling a CFD only indirectly affects the underlying assets’s price through the CFD issuer’s hedging activity. The feedback effect is not deterministic and unlikely to be noticeable for relatively small trades.

The CFD represents a claim against the issuer who usually pools the resulting exposures up to a certain extend instead of directly hedging one-to-one in the underlying asset. This allows them to internalize the bid-ask spread which is often not much wider in the CFD than in the secondary market. However, this also increases the variance of their p&l. Once the net exposure in a stock, sector or other risk factor becomes too large, then the issuer will reduce it by hedging.

This approach works well if the issuer has a lot of uninformed retail traders on his platform which generate frequent trades with small and often offsetting exposures.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.