Prime brokers that offer CFDs (contracts for difference) enable their clients to trade directly on a stock exchange’s order book by buying and selling the underlying shares and wrapping the client’s positions in a CFD. This enables hedge funds to build up large equity positions without having to disclose underlying ownership. Prime brokers may also allow clients with large equity CFD positions to vote on corporate actions by taking instructions to vote a specific way on their client’s behalf.
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What is CFD trading in prime brokerage?
CFD trading in prime brokerage allows hedge funds, asset managers and professional trading firms to gain long or short exposure to shares, indices and other markets without taking ownership of the underlying asset. Instead, a contract for difference (CFD) reflects the change in value of the underlying security between opening and closing the position.
For hedge funds, CFDs can be particularly useful for short selling, leveraged strategies and accessing international equities. Rather than purchasing and holding the underlying shares, the fund trades the economic exposure with its prime broker. Because CFDs are typically traded on margin, the financing terms offered by the prime broker are an important part of the overall cost.
An important institutional feature is the ability to give up CFD trades. A hedge fund may execute an equity CFD through another broker or specialist execution desk and then give up the resulting position to its prime broker. Once accepted, the prime broker becomes the fund’s CFD counterparty and can consolidate the position alongside the fund’s other trading activity.
This means funds can separate execution from financing and position management. They can seek liquidity or better execution from multiple brokers while maintaining a more centralised prime brokerage relationship.
CFDs also differ from physical equities when it comes to custody. Because the fund does not own the underlying shares, there are generally no shares belonging to the fund to place into custody. Instead, the prime broker maintains and reports the contractual CFD position. The prime broker itself may buy, borrow or otherwise hedge the underlying security, but that hedge is separate from the client’s CFD.
Where CFDs are executed elsewhere and subsequently given up, the prime broker can therefore provide a central home for those positions, subject to its give-up arrangements and acceptance criteria.
When comparing CFD prime brokers, funds should consider financing rates, margin requirements, short availability, market coverage, give-up capabilities, counterparty risk, execution flexibility and consolidated position reporting.