'Bucket shop' is an American pejorative expression describing: "an establishment, supposedly for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets, or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain, oil, etc., there being no transfer or delivery of the stock or commodities nominally dealt in".
In contrast with a bucket shop, a broker always "hedges" the investor's bet. Namely it enters into an equal and opposite transaction with a market counterparty.
In case of a winning bet, the broker gets paid from the market counterparty roughly what the broker has to pay the punter. Conversely, with a losing bet the broker pays the market counterparty roughly the amount that it received from the punter.
The broker will earn a commission made up of the difference (spread) between the payment it makes and the payment it receives.
The broker is therefore a virtually riskless counterparty. From the investor's point of view, the only possible risk is that the broker does not get paid by the market counterparty. This is a highly unlikely possibility because the broker's market counterparties are usually financial institutions and other major market players.
CfD platforms invariably tell the world (and their regulators!) that they adopt the brokerage model referred to above.
Unfortunately this is far from the truth.
Several CfD platforms are, in reality, bucket shops. When a punter puts on a bet the platform merely registers it, as the US Supreme Court put it. No corresponding hedge is entered into. So if the bet turns out to be a winning one, the platform must absorb the loss, as there is no market counterparty that will pay it. In case of a losing bet the platform will pockets a windfall, as it has no market counterparty to pay out.
In broad terms this means that, unlike a proper broker that makes money from the spread whichever way the bet goes, the bucket shop has an interest in punters getting it wrong.
This risk is mitigated by the fact the bucket shop's book is naturally made up of opposite bets. That is tantamount a hedge, but the book is never completely balanced.
In order to make the business viable, the bucket shop must make sure that, in aggregate, the losing bets account for more than the winning bets.
The bucket shop does so through a mix of legitimate, semi-legitimate and plain illegal means:
- The bucket shop has its own professional traders who have a directional view of markets. Where the book imbalance is likely to yield a gain, it does not hedge.
- The bucket shop also profiles the individual punters based on past performance etc. Where a punter is classified as a "loser" his punts are disregarded for the purpose of balancing the books and therefore they are not hedged.
- Where the bucket shop gets it wrong (e.g. when there is a black
swan event in the market – an unexpected deviation in
the markets that is impossible to predict ) it will seek to reduce
the number of winning bets or the amount payable under them. It may
do so by:
- Reneging on winning trades, often using the excuse that the trade in question was an attempt by the investor to manipulate the markets or "game" the platform; or
- Taking advantage of asymmetric price slippage. This is the exploitation of latency in trade execution, whereby any loss attributable to the non-timely execution of a client order is made to count whereas any gain attributable to a delay is not made to count.
Also, asymmetric price slippage is built into the system that interfaces with the client. Where no trade is executed because there is no hedge, the platform just makes up a delay that eats into the client's win.
In other words the table is tilted so that the punter does not stand chance against the "house" in the long run.
So next time you come across a spread betting or CfD platform that offer very low or no commission: beware. That platform is probably set on making money at your expense in a concealed fashion!
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
