Thinking Of Trading CFDs? Beware Of Bucket Shops!

'Bucket shop' is an American pejorative expression describing: "an establishment, supposedly for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets, or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain, oil, etc., there being no transfer or delivery of the stock or commodities nominally dealt in".

In contrast with a bucket shop, a broker always "hedges" the investor's bet. Namely it enters into an equal and opposite transaction with a market counterparty.

In case of a winning bet, the broker gets paid from the market counterparty roughly what the broker has to pay the punter. Conversely, with a losing bet the broker pays the market counterparty roughly the amount that it received from the punter.

The broker will earn a commission made up of the difference (spread) between the payment it makes and the payment it receives.

The broker is therefore a virtually riskless counterparty. From the investor's point of view, the only possible risk is that the broker does not get paid by the market counterparty. This is a highly unlikely possibility because the broker's market counterparties are usually financial institutions and other major market players.

CfD platforms invariably tell the world (and their regulators!) that they adopt the brokerage model referred to above.

Unfortunately this is far from the truth.

Several CfD platforms are, in reality, bucket shops. When a punter puts on a bet the platform merely registers it, as the US Supreme Court put it. No corresponding hedge is entered into. So if the bet turns out to be a winning one, the platform must absorb the loss, as there is no market counterparty that will pay it. In case of a losing bet the platform will pockets a windfall, as it has no market counterparty to pay out.

In broad terms this means that, unlike a proper broker that makes money from the spread whichever way the bet goes, the bucket shop has an interest in punters getting it wrong.

This risk is mitigated by the fact the bucket shop's book is naturally made up of opposite bets. That is tantamount a hedge, but the book is never completely balanced.

In order to make the business viable, the bucket shop must make sure that, in aggregate, the losing bets account for more...