Direct Market Access (DMA)

Direct Market Access, or DMA, allows CFD traders to view and interact with the live order books of global equity exchanges. Historically, only the biggest financial institutions used to be able to benefit from Direct Market Access and Level 2 functionality. But the revolution that started with Big Bang over 20 years ago coupled with the vast improvements in technology that we have seen, mean that this level of detail is now available to retail investors.

You can actually change the spread in a DMA — based CFD system with stocks, you become an integral market participant.

DMA CFDs result in an order being passed directly through to the underlying physical market with no dealer or market maker intervention, resulting in real time execution and true market prices. Once the share is bought or sold, it confirms the CFD trade to the trader. In the DMA model, pricing is identical to that in the underlying market so DMA CFDs provide complete order transparency allowing clients so see their orders being hedged in the underlying market, join a bid or offer queue and participate into the opening and closing match out phases. When trading DMA CFDs you receive all the benefits of trading shares with the additional advantages that CFDs offer.

This means that orders are entered directly into the market in exactly the same way as you do through discount brokers with direct access to SEATS. You have the option of hitting the bid/offer, or you can join the buy/sell queue. This has the advantage of potentially getting an entry at a slightly lower price than is possible via a Market Maker. In highly volatile markets you should have the same chance of entry/exit as normal share traders. Of course, this is also dependent on the software platform that you are using.

Broadly speaking, there are two versions of the order book. Level 2 is the London Stock Exchange’s most detailed data-feed and what professional traders use. If you want it, you will normally have to pay so make sure that it’s worth your while. One complication is that Level 2 order books work differently, depending on the stock being traded, so you will need to understand the differences. FTSE 100 stocks trade on SETS, small stocks and Aim shares trade on SEAQ — using market makers — and most FTSE 250 stocks trade on SETSmm, a hybrid of SETS and SEAQ.

A key advantage of DMA over a market maker driven platform is that it allows you to save on the big offer spread; say Tanfield (TAN.L) was trading at 52-56p instead of buying at the offer of 56 you could place a buy order on the order book at 54p which would then be the best bid in the market leaving it with a good possibility of a better fill (since you would save 2p per share).

One of the obstacles to DMA trading is the cost of Level 2 data (the live order book). At present, the LSE charges private investors around 20 a month for the full Level 2 data feed. Note that guaranteed stop-losses are not available with Direct Market Access so you must have the time to watch the markets for hours on end if need be and wait for the right moment. This means that Direct Market Access dealing is best suited for frequent traders (5 times a week or more).

It is worth noting that DMA trading is a highly decentralised, as the capacity to view or affect price information is equally available to all. When you place an order on Level 2 you are effectively communicating with the entire group as this appears on everyone’s screens. This is very much in contrast to an Initial Public Offering (IPO) book-build, where investors are provided a single price by centralised authority and invited to purchase shares. Investors within centralised groups have no information about other trader’s purchases or beliefs about fair value. Thereby group behaviour in decentralised networks is more efficient than centralised groups at solving complex problems, such as the fair value of a stock which in turn boosts the pricing efficiency of the market. As centralised groups are not really efficient pricing mechanisms, this would explain the wide price ranges typically experienced on the day of an IPO floatation.

Direct Market Providers will usually charge a higher brokerage than for spread providers, but the spread itself may exceed the difference in brokerage.

Market Maker

A market maker CFD provider will receive an order from its client and then confirm the CFD trade with the trader. It then has a wide range of options open to them to hedge the underlying position. This includes offsetting orders against other traders, buying shares, buying options, warrants or futures to ensure that it remains in a market-neutral position. In the market maker model, pricing approximates the underlying market.

So Market Maker CFDs are not directly hedged in the underlying physical market; instead it remains the discretion of a dealer or market marker as to whether they hedge a CFD position in the underlying market. As it is up to the discretion of the Market Maker as to whether CFD positions are hedged the provider can be exposed to a significant amount of market risk. This model results in slow order execution and lacks transparency as individual client hedge orders are not directly entered into the physical market. The queuing system is at the discretion of the CFD provider. Furthermore, Market Maker CFD providers are unable to provide partial fills, and will typically only fill client orders once the bid price reaches the offer price or offer price meets the bid price which means that you may be forced to pay a higher price when purchasing or a receive a lower price when selling.

The CFD provider controls the price that is offered. This price and depth usually mirrors the underlying market, but this is not guaranteed. Market Makers add an additional layer into the dealing process which could result in orders not being processed due to the Market Maker process in highly volatile markets.

My understanding is that that to buy there must be stock offered, and to sell there must be stock bid. In other words you must sell at the bid, and buy at the offer. You can not take part in the open and close auctions on the London Stock Exchange.

Let’s briefly explain the two models that have been adopted by CFD providers.

The Benefits of Direct Market Access Include:

• Transparency: see the market depth for every stock and the levels at which other participants are willing to trade.
• Deal inside the market spread: Leave orders inside the current best bid and offer where available.
• Increased order functionality: employ ‘Fill or Kill’ and ‘Execute and Eliminate’ instructions alongside Limit and Market orders.
• Wider range of markets: A limitation on DMA trading is that you can only deal in shares. If you want to trade an index market, for instance, this is not possible with a DMA broker. DMA providers do not usually have a wide range of products either. Because of this, DMA brokers may find it difficult to compete with the much wider range of markets that market makers can offer.

Direct Market Access versus Market Maker