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I try to find out who pays the profit of a lucky CFD transaction. When mrX buys a long CFD with underlying value of 10.000€. Now as I understand the CFD is not covered by actual shares, so mrX doesn't own the refered shares. The refered shares only seem to play the role of random generator of value of the CFD. Now suppose the value of the refered shares rizes to 11.000€, who is paying the 1000€ profit for mrX? I can't imagine the broker, they would not want these risks.

At first I thought: the broker has a mrY buying a short CFD linked to the same shares and with about the same value then mrY pays the profit of mrX, but this chance is too small.

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    $\begingroup$ What's to stop the broker buying an equivalent number of shares in the market? Or futures on said shares and wearing a basis risk? $\endgroup$
    – will
    Commented Feb 16, 2020 at 13:07
  • $\begingroup$ As @will mentioned the broker will usually hedge themselves in some way. Exactly how they do it may be hard to find out. It is an internal business decision. $\endgroup$
    – nbbo2
    Commented Feb 16, 2020 at 21:19

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Usually the broker hedges 100% of the position

  • either he buys or sells the exact same position, it is for instance possible to buy or sell a CFD via Direct Market Access. In this case the client is sending the order to the broker who exactly replicate it.
  • either the broker has the same position in its inventory and simply moves it

You could imagine brokers having so many CFD opened that only the systematic risk remains to be hedged (thanks to diversification) and hence the could simply use one or two Future contracts to hedge the netted position, but I have never heard of it. This is clearly the case for equity swaps. My understanding is that the CFD remains to be the "simplest" possible derivative contract, and everyone is happy with that. As soon as you want to do something a little more sophisticated, you make a swap.

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    $\begingroup$ So if the trader betted right the broker pays the profit from selling the connected shares, and if the trader was wrong he pays for the loss when the broker sells the shares? $\endgroup$
    – Rob Frohwein
    Commented Feb 17, 2020 at 19:41
  • $\begingroup$ @RobF: yes exactly $\endgroup$
    – lehalle
    Commented Feb 23, 2020 at 9:53

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