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Spread betting explained – over the counter

If any market is to be created, someone has to ‘make a market’, and if we go back to our example with Stuart Wheeler, in effect he was the market maker creating the spread and the market for his colleagues, so that they could back their judgement against his. Now in trading, there are really only two types of market, and the one we probably all know best is the centralised exchange, such as the London Stock Exchange or the New York Mercantile Exchange. Let’s take NYMEX as an example and consider futures trading ( you’ll see why later in the site ) and see how this compares with our spread betting market. The first point to note is the all futures contracts are traded through the central exchange in one form or another ( either electronically or by open outcry) and therefore all contracts must be standardized, otherwise chaos would ensue. So an oil contract will always be for 1000 barrels, for a particular quality and grade of oil, and for delivery on a specific date, which will be known by all the traders around the world. This allows traders to buy and sell through the exchange knowing in advance what one contract ( or however many they are buying or selling) represents. Now in contrast to the stocks and shares exchanges, where companies issue their paper certificates ( or shares) in a fixed issue size, by contrast in the futures market ( as with all derivatives ) there is no issuer, and hence there is no fixed issue size. So for each buyer there is an equal and opposite seller, and a contract is created each time a buyer and seller meet at the exchange, which give rise to the term Open Interest, which simply describes the number of “open contracts” currently being traded. Finally all exchanges operate with a clearing house which ensures that trades are executed in accordance with the rules, and which guarantees that contracts are honoured and obligations met ( in effect the clearing house stands between each buyer and seller and visa versa like a solicitor might do in a property exchange deal, holding funds on deposit ready for exchange). In the futures world this is called margin. Now there are several important points to note from the above and don’t worry if it all sounds a little confusing – I hope it will all be clear after you have read the remaining pages. The key points are as follows :

  • All contracts are standard across the market
  • Buyers and sellers are matched
  • You never know who you are trading against
  • The market is transparent and fair
  • Exchanges are regulated ( NFA, CFTC, LIFFE) to guarantee the market integrity
  • Exchanges are authorised by various regulatory bodies such as the FSA in the UK

Now, how does the above compare with the financial spread betting markets, and in particular the spread betting companies themselves?

All financial spread betting falls into the category of what is called OTC, or over the counter trades, which differentiates them from the central exchange market that we looked at above. In simple terms an OTC market is one which has been created and marketed by the broker or dealer, of which the Forex market is classic. So let’s take a simple example which I hope will make the point. Imagine you have set up your own financial spread betting company and decide there is an untapped market in the correlation of currency pairs. You decide that the GBP/USD and EUR/USD correlate quite closely and decide to offer this to the market as a spread bet on what the figures will be on a daily basis. This contract is unique to you, is not standard, and is not traded on any exchange (indeed another company may feel this is a good idea and create their own market, but based perhaps on weekly data, rather than daily) You are making the market, and any clients will be betting against you and your judgement. This in essence is how the financial spread betting markets are created and the key points are as follows :

  • There are no standard contracts – each is an OTC product designed by the spread betting company themselves
  • As the trader you are trading directly against the spread betting company
  • The markets are not transparent – you will only ever see one side
  • Spread betting companies are simply FSA authorised – the trading markets are unregulated
  • The spread betting company has to hedge the trading risk all the time, which does provide an opportunity to trade against you!

Now the reason I’ve explained the above, is not to put you off financial spread betting, but simply so that you understand how the market works and who is the counter party to your trade. There are no standards, and very few rules – this is an unregulated market where you are trading directly against your spread betting company. In some cases your trade will simply be matched against another opposite trade from another client, but alternatively they may not, in which case the company will almost certainly hedge in the futures market. Stop loss positions will always be on view which raises some interesting questions, which I will leave you to ponder ( but I do discuss this issue later)!