Electronic retail trading has come a long way in the last three decades, but do traders genuinely understand what is happening in the background to fulfil their trade in nanoseconds? The efficiency of a trader’s chosen broker is directly related to the network of liquidity providers (LPs) it has arranged to execute transaction requests quickly and effectively.
A liquidity provider, often referred to as a “market maker”, ensures that the volume of securities is always present to facilitate either the buying or selling of an asset seamlessly. These intermediaries, whether in forex or the stock market or even in cryptocurrencies, will more than likely be a large global bank or a financial institution like Deutsche Bank, UBS, Barclays, or Citibank. Special aggregation software is used to match, buy and sell requests automatically.
Liquidity providers are always the buyers or sellers of last resort since they guarantee that a market will continue functioning even when no one else chooses to participate. For a trader, broad liquidity in an asset ensures that spreads will be tight and slippage will be non-existent. Brokers, whether full-service or discount, are the intermediaries that provide access to these market makers. If traders wish to elevate their trading strategies to a higher level, they will need to assess the quality of their broker’s liquidity providers.
There are several benefits that liquidity providers bring to the markets they serve. Tighter spreads are given when significant liquidity pools are present. Liquidity providers can also bring stability to a given market when large “whale” traders attempt to move markets with larger volume trades. The insertion of additional liquidity can blunt these efforts on the spot. Lastly, high liquidity also encourages traders to increase the activity in a given asset when buying and selling proceeds smoothly in the absence of slippage. Highly volatile markets, however, can be an exception.
How do liquidity providers work?
Liquidity providers generally fall under two classifications – the very large financial institutions that are the predominant sources of liquidity and the second-tiered players that package the offerings from the players in the top tier, acting as an intermediary for traders and offering additional tools for managing risk and other technological issues. An example of a leading Tier-2 LP is covered in this X Open Hub review.
LPs are like any other business endeavour. They make money by charging for their services, typically a commission on volume or a few pips on the spread. Rebates back to a broker may encourage future usage, as well. Today, the operations of a liquidity provider are driven by aggregation software that executes at light speed to ensure the smooth functioning of every financial market they support.
How does an LP make everything seem so seamless? Each order type is treated separately through a matching process established by the network maintained by the LP. Various protocols have been created to guide the process. However, the execution of an order ultimately involves the location of an acceptable counterparty for the transaction. If none can be found, then the LP will step in to cover the request. If there is a delay, slippage could occur, but system executions today are so quick that a single slip in the process is rare.
Key services offered by liquidity providers
Liquidity providers are always the trader of last resort, but several services are provided by these entities, which would influence choosing them as a solid business partner. Fast order execution is first on the list, supported by a robust telecommunications network that ensures connectivity, stability, and acceptable execution speeds.
The LP must also support a broad base of assets, especially those the broker wishes to offer, and have access to deep liquidity pools to force competitive Bid/Ask pricing models. Platform and risk management tools are also necessities, as well as full compliance with top regulatory agencies.
Liquidity by sector and market
The level of liquidity in global financial markets is not constant. It can vary over time, thereby generating risk regarding how well financial markets work now and in the future. LPs can also vary in the markets they support, and if you are a brokerage, it is imperative to seek out and choose the very best that your market sector offers.
At the top of your decision tree would be that the LP is trustworthy, based on an excellent reputation and track record. Speed of execution and consideration given for accuracy and cost are also key factors, as well as the stability and ease of integration of its operating platform. Lastly, broad asset support and a transparent order book facilitated by Straight-Through Processing (STP) will ensure that performance levels can be monitored in real-time.
Large liquidity providers typically support each of the items listed below, but each sector of the financial market does have its idiosyncrasies.
Commodities: This market is known for its volatility and unpredictability, but LPs in this arena need to be deep in resources, support options and futures contracts. There are several commodity categories, and the degree of liquidity can vary by category as well as within a specific sector. A good example is in the energy sector. Oil futures are much more liquid than those for coal.
Forex: The undisputed largest market in the world is the forex market, topping $7.5 trillion in turnover each day without a trading floor or daily time cutoffs. The Interbank Market participants, consisting of major global banks and other financial institutions, are the forex liquidity providers for brokers, which can access each LP directly.
CFDs: CFD trading has gained popularity due to its low margin requirements, but it is a derivative in that the broker does not access the underlying asset market. In this case, the LP must support a broader set of possibilities since they are not for a specific forex pair or share of stock. Broker options will depend on which CFDs are supported.
Indices: A liquidity provider in this area must maintain Bid/Ask spreads that represent the actual value of a multitude of underlying assets and provide quick execution speeds. A broker’s choice will depend on the number of indices to be covered. For example, X Open Hub offers tight spreads and ultra-fast execution speeds on 25+ indices.
Shares & ETFs: LPs once again maintain the integrity of the Bid/Ask price model by ensuring that trades are executed when individual trader support may be lacking. Since ETFs are groupings of stocks in a single portfolio, the liquidity provider has the additional task of ensuring that prices reflect true value, even when certain issues are in flux.
Cryptocurrencies: Cryptos are relatively new to the investment scene and have evolved slightly differently. Market makers tend to be the exchanges willing to offer Bid and Ask prices on a token while being aided by a host of crypto liquidity providers in the background acting as a bridge and mediator to connected brokers.
It is also essential to accept that liquidity providers are not perfect. As with individual traders and brokers, the LP community must also react and adapt to changing economic and geopolitical situations, which can affect global liquidity considerations. Organizations like the International Monetary Fund (IMF) constantly monitor specific metrics, which provide a perspective on how global liquidity in our financial markets is trending over time.
The graphic below presents how these standard measures have changed since 2013 for equity, sovereign bond, corporate bond, and forex markets. These metrics may include Bid/Ask spreads, market depth, turnover ratio, trading volume, and return-to-volume ratios. As displayed, global liquidity has been deteriorating and slowing over the pre and post-Covid periods.
Source: IMF.org
Summary
Liquidity Providers are the backbone of today’s modern electronic trading environment. They ensure that trading requests are executed quickly and within acceptable spread parameters. If and when a market is turbulent, or participants have withdrawn from the trading arena, LPs are always there to be the trader of last resort.
Choosing the best ones in a particular sector or market depends on several variables, but the top performers have excellent track records. Be sure to review execution speeds, the depth and breadth of product offerings, applicable pricing models and spread history, ease of integration, non-latency experience, and platform tools. Each liquidity provider listed in the above table excels in these areas and is worthy of your consideration.
Having gained a degree in economics, Alan entered the world of financial services starting his career in London and then moving to New York for a number of years. His first post at a City bank saw him establish a reputation as an forex trader. Having recently returned from New York after eight successful years, Alan is now a prosperous trader in his own right concentrating on commodities and forex.
