Liquidity Provider

A liquidity provider is an individual broker or an institution working on both sides of the transaction. They have an integral role in quoting both a buy or a sell price for a particular set of asset classes with the sole objective of registering profit on the bid/ask spread. They enable market participants to trade swiftly without the need to find other individual traders.

They act like an intermediary in the different financial markets, buying large volumes of securities to issue and then distributing them in batches to other firms to make them available for retail investors. It adds stability to the markets and creates a market for an asset by offering their held securities and simultaneously buying more of them. They also ensure that traders can buy and sell securities at any time at an agreed price.

A liquidity provider can be an individual broker or a financial institution operating with the capacity of a market maker to make a profit by working on both sides of transactions. Companies hire them to optimize share trading, minimize trading spreads, reducing price volatility and trading volume. In exchange, the overall illiquidity discount declined and narrowed the divide between market and intrinsic value. The practice of offering the held securities and buying more of them pushes the sales volume higher. It also gives the investors the luxury of not waiting for another investor to sell.

The market liquidity providers add their orders through a trading platform to trade directly with other participants. The platforms are typically electronic communication networks designed to offer anonymous trading. The LPs’ orders are matched with other market participants at the same price while the liquidity providers remain invisible. This process again is called order matching, which is common in multiple financial markets such as Forex, stocks and crypto markets. Once matched, the order gets executed. Without liquidity providers, both the availability and liquidity of securities cannot be guaranteed, ultimately decreasing the any time trading ability of traders.

The liquid providers have three functions: reducing spread, balancing out large orders and underwriting initial public offerings (IPOs). Tier-1 liquidity providers are at the top and are usually major investment banks and large Forex departments. Still, apart from those, there can be several types of LPs, such as hedge funds, market makers, a high-frequency trading firm, commercial banks, central banks, foreign investment managers, high net-worth individuals and even retail traders. The core objective of liquidity providers is to offer liquidity in all market conditions continually, and their business model does not rely on securities prices.

Small and mid-cap companies appoint liquidity providers because they have a smaller trade volume compared to the other listed companies with a large market capitalization, but there are factors to consider while selecting a liquidity provider -

• Check and verify the liquidity package which simply means to acknowledge the assets and liquidity offered. Before choosing a liquidity provider, it is important to check if the needs are satisfied.
• A liquidity provider should offer swift trade executions with slippage or requotes. Such a factor always helps when a market news causes an impact.
• Another important factor is the authenticity of the liquidity provider. The companies must ensure that they are regulated similarly to other brokers and are operating with the best industry practices and acknowledging jurisdiction.
• Liquidity providers should have an efficient reporting system that is automated and in compliance with regulatory requirements.
• Pricing again plays an important role in the selection of liquidity providers. The pricing should include swaps, competitive spreads and low commissions on either side.
• A unique selling point for most of the liquidity providers is the market depth. The higher the number of trade orders, the better the market depth offered.
• Another key factor is the software and compatibility. The liquidity provider should be easy, technologically advanced and competent to operate in different markets.
• Fast data feeds with price data are another important factor. Price feed should reflect real time prices from exchanges and shall not have delays.

Below are two examples of liquidity providers -

Example #1 

For instance, in the currency market, there is Jack, who is a liquidity provider in Forex and is willing to buy EUR/USD at the price of 1.3500. So, Jack would then add an order to an electronic communication network (ECN) that matches this particular price. Now, suppose there is John, who is another market participant who is looking to purchase EUR/USD at the same price of 1.3500. Then, both orders will be matched, and the trade will be executed.

In case no other market participant is willing to buy the EUR/USD at that price. Jack’s order will remain in the ECN, waiting for the matching market participants. Now, this is a very simple LP example, but in the real finance world, there are many other aspects associated with it, and there are different types of LPs in different financial markets.

Example #2

Al Ramz Capital announced the appointment as the new liquidity provider for Abu Dhabi Ports Company. The LLC will begin independent trading for Abu Dhabi Ports within shared parameters and in adherence to regulatory guidelines from May 2024. Al Ramz is a licensed market maker on the Dubai Financial Market and Abu Dhabi Securities Exchange (ADX).

Al Ramz is widely recognized for its services; it was founded in 1998 as a UAE-domiciled public joint stock company and offers an array of services such as asset management, security margins, brokerage, corporate finance and research analysis. The CEO of the company expressed his gratitude and appreciation in the announcement.

The advantages of a liquidity provider are -

• Liquidity providers make trading cost-effective and swift.
• Create markets for asset classes, ensuring the perpetual availability of securities for trading.
• Allow small or mid-cap companies to compete with large capitalization listed companies.
• It encourages price stability by reducing spreads between ask and bid prices and limiting price volatility.
• Through the efforts of liquidity providers, the markets become more efficient.
• LPs increase market activities, which allow traders to take advantage of price discrepancies.

The disadvantages of a liquidity provider are -

• Liquidity providers are prone to slippage, depreciation and impermanent losses
• For some small or mid-cap companies, the LPs can be expensive to appoint.
• There are software issues, functionality problems and errors in the automated system.
• If not regulated properly, there are compliance risks associated with liquidity providers.
• LPs can affect the overall returns of the companies due to slippage and requotes.

The main differences between liquidity providers and market makers are -

• Liquidity providers source quotes from multiple entities to maintain market liquidity. In comparison, market makers create markets for specific assets offering bid and ask prices using their capital.
• LPs have agreements with brokers and aggregators, but market markers have contracts with trading platforms or exchanges.
• LPs offer direct access to the interbank currency market, but market makers only get involved with specific markets or instruments.
• Liquidity providers work to earn spreads and facilitate trading. In contrast, market makers are more interested in profits from spreads by taking market risks.