CFD liquidity is what allows CFD trading to take place. It is created by a company that produces pricing for CFD contracts and is willing to both buy and sell those contracts.
If that sounds confusing then just remember, a CFD is effectively a bet – it is a financial derivative that allows you to speculate on whether the price of an asset is going to rise or fall, without you ever owning that asset.
For that process to happen, you need two things – pricing and a counterparty. Pricing is the price at which your ‘buy’ or ‘sell’ trade in a CFD will be executed. The counterparty is a company that is willing to buy and sell those contracts.
For that to be viable, you need companies that create ‘buy’ and ‘sell’ prices. Those prices are derived from the price of the underlying asset. For example, if you trade a CFD on Tesla shares, the price of that CFD will be derived from the price of Tesla shares. A liquidity provider takes the price of those shares and then uses it to create a price for the Tesla CFD.
You also need a company that is willing to act as a counterparty to those CFD trades. In other words, if you use a CFD to speculate that the price of Tesla shares are going to go up or down, the counterparty takes the other side of that trade.
CFD liquidity is effectively the creation of this price and the willingness of a company to take the other side of CFD trades.
CFD liquidity – creating a price
The first component of CFD liquidity is the creation of a price. It can be easy to forget it but regardless of whether you are trading CFDs on shares, FX pairs, or indices, you are trading a CFD on those underlying assets.
The price that you trade those CFDs at is almost never a ‘look through’ price. By that we mean, if you trade a CFD on Tesla shares, you are unlikely to ‘buy’ or ‘sell’ at the exact price that you would get if you were to buy those shares directly.
Instead, a CFD liquidity provider has to make various changes to the price of that underlying asset in order to create ‘buy’ and ‘sell’ pricing for CFDs. Those changes vary depending on what the underlying asset is and how the contract component of the CFD is constructed, particularly as it pertains to leverage.
For example, creating a CFD for currency pairs is not that difficult because there is a clear spot price, FX markets tend to be liquid, and simple lot sizes. In contrast, creating a CFD price for indices is more complicated
Regardless of what the underlying asset is, the most common step a company that creates pricing for CFDs will make is to widen the spread at which the underlying asset is trading.
CFD liquidity provision and market making
The reason for that is due to how CFD liquidity providers manage risk. Remember that a CFD is like a bet. You go long if you think the price of an asset will go up or go short if you think it will go down. But you never own that asset.
For that to happen, someone has to take the other side of your trade. That is the second component of CFD liquidity – a company willing to take CFD prices and then use it to act as counterparty to trades at those prices. If this didn’t happen then CFD trading couldn’t take place.
A company that is willing to play this role is typically called a liquidity provider in the CFD industry. This is effectively market making and it is what creates CFD liquidity. Although we’ve used the word ‘bets’ in this article because it makes things easier to understand conceptually, a process akin to this is what facilitates trading in all financial markets.
For example, when you trade stocks on an exchange, you are usually trading against a market maker – a company that makes money by buying and selling stocks. Similarly, if you go to a bureau de change to get some cash to go on holiday, that shop will buy currency at a low price and sell it at a higher one.
Managing CFD liquidity risk
For CFD providers, as with other market makers, the risk of taking on CFD trades is that you can end up being on the wrong side of winning trades. For example, let’s say you have clients that trade $100m worth of Tesla shares with you via CFDs and they are all long – meaning they all bet that the price will go up.
If the price of Tesla shares does go up then you are going to be losing a lot of money. You have taken the losing side of a winning bet. So what can you do to prevent yourself from losing money? You go to the underlying market and buy the Tesla shares.
That means if the shares go up in value then it doesn’t matter that you are on the losing side of the Tesla bet. The loss from the CFD trade is offset by the gain in the shares you bought.
But this takes us back to why CFD liquidity providers widen the spread when they create a price. If they priced their CFDs on Tesla shares at the same price as the real shares, they would end up being flat or, more likely, losing money when they went to hedge their exposure.
The widening of the spread means that they can deal in CFDs at worse pricing than the underlying market, so that when they go to hedge they can still capture the difference between the CFD pricing they are offering their clients, and the pricing which exists in the underlying market.
CFD liquidity and CFD liquidity providers
A significant point to note here – and one that can often cause confusion – is that there are actually very few CFD liquidity providers that create pricing from underlying markets and go to hedge in those underlying markets.
A lot of companies purporting to offer CFD liquidity are actually just taking the pricing of other companies, recycling it to their clients and then taking the other side of trades. So if you think of the two components of CFD liquidity as defined here, creating pricing and actually taking the other side of trades, they are only engaging in the latter, not the former.
There are numerous reasons for this but it is typically due to cost and the level of sophistication that the liquidity provider has.
With regard to cost, it is expensive and capital intensive to hedge in underlying markets. For example, if you are trading the futures markets you are going to have to pay a lot in trading fees and put down sizeable amounts of cash to meet margin requirements. To give an example of this, in 2023, the publicly-traded CFD broker CMC Markets spent over $50m on hedging costs.
In terms of sophistication, creating a CFD price is often not an easy thing to do and requires a level of technical expertise that many firms simply don’t have. This is particularly the case for more complicated price derivation, such as making an index CFD price out of an index futures contract.
As a result, many companies do not have the financial means or human capital to create pricing for CFDs. This is why there are very few companies that are ‘true’ CFD liquidity providers, in the sense that they both create a price from an underlying market and make a market on those prices.
How CFD liquidity works
CFD liquidity is ultimately about price generation and the willingness of a company to trade on those prices.
CFD prices are formed from the underlying asset on which the CFD is based. That could a currency pair, company’s shares, or an index future.
The second component is trading. For liquidity to exist, there needs to be a company that is willing to buy and sell CFDs at the prices that have been created. The company that is willing to provide this service is providing the liquidity that enables trading.