Are Liquidity Providers Important?
Liquidity providers in the financial markets are generally “market makers” or underwriters, who hold a substantial amount of a financial asset. Ideally, they bring price stability to the markets, by ensuring proper distribution of these assets to both retail and institutional investors.
The foreign exchange market sees daily transaction volumes of over US$5 trillion. Its liquidity is unmatched by other capital markets around the world. So, what is forex liquidity?
The Concept of Forex Liquidity
Forex market liquidity can be defined as the ability of a valued financial instrument to be converted into currencies within a specific time period. The availability of liquidity providers in the form of big banks, foreign investment managers, multinational corporations, high net-worth individuals and hedge funds, makes the market deep and smooth. Traders are able to get in and out of positions quickly because there is high availability of currency reserves. This is desirable for every player in the market, since greater liquidity means lower spreads and costs of trading. As a result, price stability is ensured. The forex markets can usually absorb large orders, without affecting the price of any currency.
An illiquid market would be volatile and have price gaps. Various events, such as unexpected news releases, economic reports, wars and political instability, can lead to liquidity issues in the forex markets too. This makes the role of liquidity providers very important, since they provide liquidity under all market conditions. They take on a substantial amount of risk and use the valuable information available to them to offer competitive spreads.
“Tier-1” Liquidity Providers
When a liquidity provider acts as a market maker, they are acting as both buyer and seller of an exchange rate or a given asset class. They literally try to “make a market” for currencies and other financial assets, while offering up their holdings for sale and actively buying simultaneously. In the currency markets, they take positions in currency pairs that can be offset by another market maker, or simply be adding to their books to be liquidated at a later point.
Functionally, this bridges the gap between market players in a market that can support higher trading volumes. Long-term traders can buy and sell currencies, without having to wait for another similar investor to do to the same. Many forex market makers keep an eye on call levels and orders for clients, and execute market orders on their behalf.
Large investment banks with big forex departments and commercial banking giants fall under the “Tier-1” level of liquidity providers in the forex market. They are considered the core liquidity providers, who can send orders to the markets at prices that best reflect the available information, along with the risks associated with transactions of holding a currency pair.
Big commercial banks are hugely involved in big corporations that require extensive foreign exchange transactions on a regular basis. This makes them one of the largest liquidity providers in the forex markets. They have different business models, which makes them capable of servicing the market in a variety of ways. For example, banks can facilitate large transactions, while Proprietary Trading Firms (PTFs) optimise price discovery for clients.
Examples of Tier 1 liquidity providers, who still remain highly active in the forex industry are Deutsche Bank, Morgan Stanley, UBS, Barclays, Societe Generale and Credit Suisse. Some of the clients of these providers include high net-worth individuals (HNWIs), smaller banks, large companies and hedge funds.
“Tier-2” Liquidity Providers
This is the second level of liquidity providers, who operate at the over-the-counter, inter-bank level. They are primarily market makers, who service clients from dealing desks. Most of these institutions are prominent forex brokers and commercial banking names, who serve retail clients. Almost 50% of all transactions in the financial markets are serviced by inter-bank liquidity providers, but small traders and companies cannot send their transactions directly to the banks, due to limited availability of technology and capital.
Tier-2 providers quote buy and sell prices on currency pairs to both professional counterparties and non-professional counterparties who demand quotations through their company’s dealing desk. Through such transactions, they ensure proper architecture in the forex market, where there is always a buyer or seller present to fulfill the trade orders of retail clients.
How do Liquidity Providers Make Money?
Liquidity providers make the market smoother and robust to handle high trade volumes. But, what do they get in return?
They receive compensation in the form of a differential between the bid and ask price of a currency pair. This is known as the dealing spread, and a provider charges it as a reward against providing liquidity as a service. Individual traders, unless extremely wealthy, will mostly likely use services from Tier-2 liquidity providers. The STP/ECN DMA broker will create the lowest possible spread, on the basis of quotations from Tier 1 providers, and add their own commission to the inter-bank spread data. These commissions are reflected on trading platforms.
Alternatively, a broker can also provide the raw inter-bank rates to retail clients, which does happen in a few instances. Tier 1 liquidity providers are so big that their profits do not affect retail traders.
Why is it Important to Choose the Right Liquidity Provider?
Market depth is a term used to denote the amount of trade volumes that can be carried out at a given price level. Lower volumes are associated with prices close to the current rates, while the farther we move from these rates, the greater is the volume increase. Brokers who are connected to a large number of liquidity providers will have a suitable “market depth.”
This means less slippage for traders. Slippage is a term used to quantify the difference in price of trade execution to that of entering a transaction. The amount of slippage ultimately adds to the cost of trade. The speed of a trading platform is also a factor in avoiding slippage.
Thus, brokers who have partnered with high quality liquidity providers and robust trading terminals are usually preferred by retail clients.