Everyone loves the mellifluous language that prime of prime providers use to market their wares, which often ends up sounding like a wrestling announcer that’s really into trading. For example…
The tier-1 PB liquidity we offer is so deep that we make the outer echelons of the Great Barrier Reef look like your kid’s paddling pool. Nothing is recycled here and every drip of liquidity we feed you from our tier-1 PBs is their best skew possible. We break that tier-1 bank skew liquidity up into customised, carefully chiselled, unique, tier-1 dark pools, fed by proprietary big data AI machine learning, that you can execute against with machine-gun like rapidity. We’re out here looking like Dick Van Dyke in Mary Poppins, sweeping the top of book at our tier-1 PBs so that you don’t even see one micro tick of slippage. Etc. etc.
Another common thing you see among these providers is the claim that they provide services to hedge funds and family offices, not just retail brokers. How ‘legit’ are these claims though? There are a few theoretical reasons to be sceptical of them:
- Providers have, until comparatively recently, placed a huge emphasis on their FX offering. Although it may have started to change in the past couple of years, FX trading has not been a popular strategy among hedge funds since the GFC. In other words, PoPs from the CFD space are marketing a product that isn’t particularly popular among hedge funds and then saying they are trying to attract hedge funds.
- Many providers appear to have no exchanged-traded derivatives offering. These are basically the defining products that hedge funds want to trade, so if you aren’t offering them it is hard to understand how you would attract hedge fund business. Similarly, few hedge funds appear to trade CFDs.
- The typical claim that providers make is that hedge funds may struggle to open an account that gives them a prime broker-type service. However, opening an account with Interactive Brokers as a small fund manager doesn’t seem that difficult. As IB offers the product set you are after, why not open an account with them?
We can go through these points individually, starting with the first.
The only justification I heard for the emphasis on FX was that some hedge funds may want access to Hotspot and that PoP service providers could act as a conduit to do so. No one else asked gave a meaningful response to this question or ignored it.
However, the main providers that offer a more complete set of products (eg. cash equities, futures, options) also seem to have this service. So although the FX service might be useful, it is hard to see the attraction if it is the only service you are offering and I can get it elsewhere, along with all the other products I want.
“[Hedge funds] would be more likely to gravitate towards a provider that can give them the ‘full package’,” said one executive at an LP. “There isn’t much desire to have a mix of platforms for trading different asset classes from what I’ve seen.”
As that hints at, the second problem highlighted above was the fact many providers don’t offer futures or options, so it might make sense for a hedge fund to trade with a PoP provider offering these products, but it’s harder to see why they would use one that focuses on CFDs. Is that analysis correct?
“A very small number of people occasionally use CFDs to take short positions in equities,” an executive at a large broker-dealer, who helps structure trades, told me. “Aside from that, I’ve never seen demand for them among the family offices or hedge funds we work with.”
This would fit broadly with what you see in the listed funds space in the UK. If you look through the fact sheets of closed-ended funds offering hedge fund-type strategies (eg. BHMG, RICA) then you can see that they use derivatives like options, futures and FX forwards to build their strategy. But some equity funds do take short CFD positions on indices or individual equities (THRG is probably the most famous example of this).
Having said that, there are reasons some hedge funds may end up using CFDs. The main one appears to be purely down to size. Some smaller providers may not have or want to put up the margin needed to take positions in the futures market, for example.
“You have to remember that what qualifies as a hedge fund is really broad,” said the LP executive. “So obviously if you are dealing with the top end, you are going to be able to put down margin and access exchange-traded markets, monitor those positions and so on. But you have smaller players that don’t want to put down so much margin, so it’s like other CFD providers in that sense.”
The executive at the broker-deal expressed similar sentiment.
“You know, there is this tendency to think of a hedge fund manager as a guy who got a PhD from Oxford, and he’s made this amazing algo to cash in on the markets and now he’s making billions with a massive team of quants,” said the same executive at the broker-dealer. “The reality is there are a lot of these small players, often people you wouldn’t expect at all, who have managed to scrape together some money to manage and want to use an alternative strategy. The same is true in the family office space, especially in Switzerland. So not everyone is like Brevan Howard or whatever, and I can see that those smaller guys might end up using CFDs.”
For the team at IG Prime, there are apparently other reasons as to why hedge fund providers come to them. In simple terms, these are to do with trading costs and the ability to use your margin more dynamically.
“CFDs have evolved into a retail focused instrument, and the equivalent for institutional investors is the portfolio swap,” said Max Hayden, Global Head of Prime Brokerage Sales at IG Group. “IG Prime was launched over three years ago to be a targeted synthetic prime broker, building off its existing retail technologies to create swap-based execution, financing to the hedge fund and proprietary trading community. Swap counterparties are more abundant than traditional cash prime brokers and they are used extensively by the institutional community to trade synthetical securities which ordinarily attract additional taxes and duties.
The benefits of developing a swap product out of a retail business, as IG Prime has done, is that the single account provided gives multi asset/product accessibility, covering equities, indices, FX, listed derivatives, which in turn supports natural margin offsets, which is not always supported by larger investment bank prime services.”
Our final point was the fact that it’s not that hard to open an account with a provider that will give you market access to a wider range of products. When you look at the PoP-type providers that sit in the CFD space, the providers that can do this are Saxo, Interactive Brokers and (maybe?) Finalto.
Again, this just takes us back to the fairly simple point that we started with – if you want futures and options, these companies will provide you with access to them. Others don’t do it. So if you need futures and options as a hedge fund, why would you go with another provider?
I suppose you could then ask, ‘why choose one of these providers over the other?’ but some of the people I spoke to pushed back on the notion that it was always a simple question of ‘plug and play’, with hedge funds usually wanting more tailored services to suit their needs.
“Ultimately, yes, if you don’t have things like futures and options, you are probably going to struggle to get a lot of hedge fund clients,” said the LP executive. “But this is very much a relationship-driven industry, right? So if you are able to provide a client with all the set up they want, all the tools they want, you’re on the phone when they need you, then those things go a long way too.”
This was something that Hayden echoed.
“[IG Prime’s] attentive client service and business development support are key differentiators for us,” he said. “Hedge fund managers are not motivated by ‘one size fits all’, they want relationships with brokers who understand their business and work with them to create ideal outcomes.”
Taking all of this stuff into account, the answer to the question posed by this can probably be broken down into two answers…
If you are a hedge fund and want futures and options, you will go with a provider that offers those. The reality is that rules out many of the PoP providers in the CFD world.
However, some hedge funds, presumably smaller players, may be happy trading on CFDs and, if that’s the case, then there would be reason to do it. Simple, right?
