In 1982 the London International Financial Futures Exchange
opened for trading. In a fairly short time futures and options
became hugely popular as financial instruments, and by early
1997 Liffe was the largest derivatives exchange in
It was a market shared by large member firms and smaller
individual liquidity providers, or locals.
However, unnoticed and beyond the glamour of regulated
exchanges and open outcry trading, another revolution was
Bookmakers began to offer 'bets’ on financial
instruments and commodities. In fact, the first real financial
bet had been developed by Stuart Wheeler as long ago as
Unlike the large derivatives exchanges, these bookmakers began
to make the financial markets truly accessible to small retail
investors. In the early 1990s UBS Warburg adopted an instrument
very similar to an equity swap called a contract for difference
Another way of describing the instrument is like a cash-settled
future whose sale price is always the market price today, and
which allows the buyer to choose the moment of expiry. If the
market price has gone up at the point of expiry, the seller
pays the buyer the difference. If the underlying has fallen,
the buyer pays the seller.
It was this derivative that would be adopted by the retail and
wholesale markets, generating huge profits over the last 20
years for providers. With a few exceptions, the exchanges that
list the underlying instruments have completely missed out on
the revenue from these leveraged products.
Nice and easy
Compared with futures and options, the CFD was always much
simpler to understand. It seemed more intuitive, as the price
traded could be the price on the underlying market.
The overnight financing charges were also easy to grasp,
whereas futures would have expiries, expected dividends,
ex-dividend dates and financing all built into the
GNI was one of the first Liffe member firms to recognise the
significance of CFDs by launching GNI Touch, but the take-up by
retail investors was limited as the product was still too
complicated and expensive. It appealed more to wealthy
individuals and small proprietary trading firms.
It took Stuart Wheeler’s firm
Investors’ Gold, now called IG Group, to really
push this instrument for the retail business.
While brokerages and banks did the same for the wholesale
market, the exchanges concentrated on the underlying
instruments including futures and options, missing the boat on
these relatively immature derivatives.
Revolution by stealth
Over the last 10 years a velvet revolution seems to have taken
place. CFDs have become hugely popular derivative
It has been estimated that between 25% and 40% of all equity
trades on the London Stock Exchange are now executed by
institutions as hedges for CFDs offered to their
That is a huge amount of institutional flow, in spite of the
product’s drawbacks of low transparency associated
with OTC products, and no central counterparty (CCP)
The retail market has also grown incredibly. In the UK a CFD
can be executed by individuals as a financial spread bet (FSB).
Both are classed as CFDs by the Financial Services Authority,
it’s just that an FSB is a CFD offered to UK
residents that attracts no capital gains tax.
Both FSBs and CFDs enjoy an exemption from stamp duty, the 0.5%
tax UK residents pay on buying shares.
To the detriment of the exchanges and institutional brokerages,
the image of retail CFDs as a low class betting instrument
seems to have kept these hugely skilled and well capitalised
institutions at a distance.
As a result, the spread betting companies have been left to
continue developing their retail businesses unhindered, with
little or no competition from brokerages or
The established financial institutions should have grasped this
opportunity by the horns and left the likes of IG Group, CMC
Markets and others for dust, but with a few half-hearted
exceptions, they didn’t.
As a result, earlier this year IG Group became worth more than
the London Stock Exchange.
Having started life as a financial bookmaker, IG has helped
create one of the world’s most profitable
derivatives markets. It is not a multilateral trading facility,
and certainly not a regulated exchange or clearing house
– though in many ways it now behaves like all
IG is regulated as an investment firm under Bipru, the
Prudential Sourcebook for Banks, Building Societies and
The traditional exchanges such as LSE keep talking about 'going
after the retail market’ and 'launching
derivatives’, but it already exists, and it looks
like IG Group.
At the time of writing this article the market capitalisation
of IG Group was over £1.9bn. Admittedly, part of its
rapid growth can be attributed to the development of market
access through web browsers and the growing bandwidth and
reliability of the internet.
However, IG Group has realised that getting a large enough flow
of orders has meant it can effectively internalise almost all
its trade flow, while acting as counterparty and
By acting as the counterparty and only allowing customers to
lift IG’s offers or hit IG’s bids,
then it does of course technically accept market risk against
However, each day IG Group has about 45,000 unique users and
over 300,000 trades. This presumably creates an order flow that
often offsets most of the risk in a short space of
On the rest of the un-netted risk, IG manages to make money as
customers lose. Beyond this, it hedges itself in the
conventional derivative or cash markets.
But it is the continual churn between bid and offer that really
generates the company’s returns.
So an exchange-type offering would not be as profitable,
although it would be relatively simple to sell this profitable
order flow to a plethora of financial institutions or trading
groups that would readily buy it, in the form of trading fees
or revenue share.
Fighting over scraps
The exchanges have always been focused on high volume business.
However, IG Group and its competitors are able to generate
higher margins than the exchanges from much smaller volumes and
turnover because the margins in the retail market are still
relatively large, even before factoring in 'risk
revenue’ from unhedged trades.
While MTFs such as Chi-X and Bats Europe are fighting tooth and
nail for share of a wholesale market, and struggling towards
breaking even, IG Group operates with a pre-tax profit margin
of more than 50%. In the full year to March 2010 its revenue
was £298.6m. IG could acquire both MTFs if it wanted
Would it? A deal like that would deliver the required exchange
technology, if that’s where IG believes the future
of retail CFDs lies. It would also be a significant move into
the institutional market to balance against IG’s
retail presence. But it would add little to the
company’s profitability, while also threatening
its existing business model.
About half the revenues for companies like this comes from
running a risk book, and from the churn of bid-offer spreads.
An exchange model would remove both revenue streams, although
the CFD provider could sell the risk revenue.
It is therefore unlikely to be IG Group or one of its
competitors that busts the existing business model. Some other
competitor is going to have to do it for them.
Ways to compete
It seems that the other main reason exchanges are not directly
involved in the retail market is that they feel it is the job
of their members to offer retail access.
But with the present trend towards disintermediation and
members competing with the exchanges, the present structure
could easily change.
If the exchanges really do wish to stay at arm’s
length from retail customers, then they still can –
while participating in the CFD market.
With over 150 firms including Barclays accessing the financial
bookmakers and offering their own white-labelled execution
platforms to retail clients – effectively allowing
them to trade on a CFD provider’s platform through
a Barclays branded interface – it’s time
the exchanges got round to offering their members a similar
The model Barclays uses with its partner City Index is most
likely the traditional white label deal whereby customers can
trade at City Index’s prices and the two entities
share the revenue from spread, commission and client
Exchanges could offer a similar electronic platform but allow
their members to take the role of counterparties, thereby
assuming all market risk. This could then be novated to a CCP
which would assume member default risk and charge margin
against the market risk.
But the exchanges would need to work out how to make money,
since most trades on IG, CMC and City Index are commission-free
and customers are used to this model. This would be the
challenge but not insurmountable.
A further problem is that banks might be unwilling to switch
from a traditional CFD provider to an exchange because it could
mean giving up their customer order flow to other members on
The banks would need to be offered a solution that works in
terms of revenue. This could involve banks, or their investment
banking arms, becoming the counterparties to some of their
order flow so as to generate revenue by taking risk. Or flow
could be outsourced to electronic trading firms like Getco for
a fee or share of risk revenue.
This would require some innovative and complex changes to the
traditional exchange order book model, but nothing that
hasn’t been done before both from a technical and
regulatory point of view.
Of course, on-exchange CFDs have been tried before, for example
by the Australian Securities Exchange, but the reality is that
they were just listed without improving access for retail
At the same time, the product was robbed of non-standardised
financing. The exchanges have tended to charge a standard
financing fee over Libor or the equivalent, no matter who the
This had the effect of stopping member firms from offering
their customers tailored financing costs. Big funds had to pay
their prime brokers the same finance charge as weak
This is one of the main reasons why the LSE’s
attempts to get CFDs going last year were shelved. The
members’ very profitable CFD desks used to make
large amounts of money from financing. If rates were
standardised, they could no longer do this – but had
to charge the same as every other desk. That meant they could
not leverage client relationships or take account of other
business the client did with the bank.
The banks therefore do not want a standardised CFD contract
that standardises the financing rate.
Unfortunately for IG Group and its equivalents, a cloud is
looming. CFDs’ weaknesses of poor transparency and
counterparty risk are about to be 'fixed’ by the
This fix is twofold. First, it seems inevitable that more
transparency will be required. This means running an MTF, with
all the fair pricing and reporting that goes with
Second, CFDs might be classed as OTC derivatives subject to
mandatory central clearing. That would mean IG Group, for
example, would no longer be the counterparty.
In principle, IG Group could solve these problems. It could set
up an authorised and regulated MTF that is accessed by a
separate Bipru entity. Any market risk could be held in this
Bipru firm, or even a separate firm offshore, to limit
regulatory capital requirements.
IG would of course also need to find margin for the CCP on
trades where a direct customer-to-customer offset could not be
found. And, along with its customers, IG would have to pay a
clearing fee. But perhaps it is already too late for
Probably in the next two or three weeks, Betfair, the online
sports betting and gambling website, will launch the London
Multi-Asset eXchange (LMax). The beta version is already
Betfair already processes 5m trades a day on its sports
platform – more than all the European exchanges handle
in equities, according to the Wall Street
In October Betfair floated 15.2% of its existing capital on the
London Stock Exchange. The shares would come from some of the
company’s founders and other shareholders and did
not raise any new money for Betfair.
The IPO was priced at £13 a share, valuing the company at
£1.39bn – a little shy of the £1.54bn
valuation implied by Softbank’s 23% (now 10%)
investment in 2006.
At the moment, most of Betfair’s profits
(£17.8m pre-tax in the year to April 2010, from revenues
of £341m) are generated from its sports betting business.
Forward earnings are predicted to be around
Betfair’s was the first successful sports betting
platform to use an exchange model, in which punters bet with
each other, rather than with a bookmaker. Betfair merely reaps
commission on successful bets.
The company gained critical mass in this kind of sports betting
as a first mover, and it seems it wants to do the same again
with the financial CFD market.
Betfair’s USP will be to offer an exchange model
for CFDs which will be centrally cleared and focused on the
This is its first breakthrough. Initially the structure will be
that LMax operates an MTF, with LCH.Clearnet as clearing house.
The clearing members of the MTF will be LMax and other
liquidity providers – not the retail and wholesale
customers themselves. But it is a step in the right direction
towards a fully centrally cleared market for retail and
Betfair’s second breakthrough is that it has
solved the issue of risk by selling its order flow to its
liquidity providers, including Goldman Sachs (which owns 12.5%
of LMax). In theory, this opens the market up to other
institutions and hedge funds that would require a centrally
cleared contract. They could all be trading on the same
platform and matching against retail customers on multiple
products and asset classes.
Unfortunately, as the exchanges will tell you, relying on
market makers for liquidity and tight execution spreads will be
an uphill struggle.
Furthermore, it is not likely to be cheap for retail customers,
as they will have to pay the exchange commission, and the
project is significantly delayed. LMax was incorporated in
At the moment Betfair seems to be planning to offer, initially
commission-free, a wholesale platform to a retail customer base
that in all truth would probably rather carry on just hitting
and lifting bids and offers, as long as the spreads are tight
However, few would doubt that this is clearly the right
direction for the entire financial derivatives trading market.
The breakthrough will be an exchange or MTF that offers one
platform with multiple leveraged products, covering many asset
classes, for all types of wholesale and retail customer types,
while allowing for full price discrimination – meaning
that brokers can charge different commissions to different
customers based on relationships or volumes.
Besides this, LMax will offer real time margin calculations and
pre-trade risk, with low latency web access. The list goes on,
but the innovation and pure arrogance of the technical solution
is quite overwhelming.
Notwithstanding Betfair’s bold step, once the
exchanges are able to innovate and implement these kinds of
technical solution, they are ultimately best placed to solve
and handle all the issues discussed.
Indeed, this is a golden opportunity for the exchanges to
finally offer a truly retail product direct to the retail
market, and enter the global CFD space, profiting from a
leveraged instrument that has so far passed them by.
For too many years the bookmakers have pushed beyond their
remit and even beyond the remit of the old member firms
– driving, as with LMax, right into the
However, exchanges have the complex skills required to offer
centrally cleared CFDs on a regulated, electronic, low latency
market, with all the infrastructure and resilience this
business requires. It would seem high time for them to fight
The good news
So where are the exchanges and MTFs? Chi-X has already
announced a centrally cleared CFD product for FTSE 100
equities. At first this is likely to attract only
But Chi-X has a robust electronic marketplace with all the
regulation it needs to enter the highly profitable retail
market (barring a few additional permissions). It just needs to
develop the operations and software associated with offering a
More important – and again, this is something where
the larger exchanges have a real competitive advantage over the
likes of Chi-X – is accessing global distribution
networks. This is after all a global product.
Perhaps even exchanges putting together joint ventures with
some of their members and using the brokers’
global or at least European retail distribution networks would
be a move in the right direction.
It seems inevitable that the MTFs and exchanges should now make
the final step needed to offer these products to the retail
Imagine – an exchange or MTF actually telling its
shareholders that fees and margins have started increasing, and
that its products have entered a global growth, high margin and
Instead of MTFs aiming for a £50m valuation (or
£300m if you believe their own rhetoric) based on market
share and the prowess of their IT departments, they can start
aiming for £1bn valuations based on good, old-fashioned
profits and the strength and agility of their business
Unfortunately for the pure derivatives exchanges, the problem
of a booming and fully accepted centrally cleared wholesale and
retail CFD industry is a lot more serious. Admittedly,
exchanges in the US – where CFDs on all products
except FX are banned – will be spared for now. But
with a product that looks set to have all the advantages of a
futures contract, including transparency and CCP counterparty
risk, but with the additional upside of an intuitive and
tailored product, not to mention fungibility, who will be left
to trade futures?
Perhaps we still have some way to go before the day that FOi
changes its name to CFDi, but come it may...
Simon Brown is founder of Cambridge Quants, a consultancy in
the UK. He has previously been a consultant for NYSE Euronext;
co-founder of Altex-ATS, an OTC derivatives MTF; and head of
proprietary automated software at Refco. He started his career
in the City as a pit broker/trader at GNI after leaving British
Telecom Research Laboratories. The author has never worked for
any spread betting company, but does consulting work on CFDs
and associated clearing for companies including exchanges and