A liquidity provider is an individual or institution which acts as a market maker in a given asset class. This means that the liquidity provider will act as the both the buyer and seller of a particular asset, thus making a market. For instance many stock exchanges have liquidity providers who make the commitment to provide liquidity in a given equity. These liquidity providers make the commit to providing liquidity in the hopes that they will be able to make a profit on the bid-ask spread.
Liquidity providers theoretically ensure greater price stability and also improve liquidity by making it easier for traders to buy and sell at any price level. By making a market liquidity providers an important service and take on a significant amount of risk, but are still able to profit from the spread or by positioning themselves on the basis of the valuable information available to them.
Liquidity Providers Forex
In the world of Forex the majority of global liquidity is provided by a number big name investment banks (referred to as Tier 1 liquidity providers) that make markets in all the available in currency pairings. These investment banks all have currency trading desks where traders quote both Buy and Sell prices in the currency pairings they offer. It is thought that these major liquidity providers in fact lose money on the majority of the trades placed with them, due to the very tight spreads on offer. However Tier 1 liquidity providers are then able to use this order book info to their own advantage ultimately allowing them to turn significant profits.
Those interested in getting a better understanding of the workings of a Tier 1 liquidity provider, should watch the above interview with Batur Asmazoglu who provides some enlightening commentary on the functioning of tier 1 liquidity providers.
Unless you are a massive whale, as a retail trader you will never directly deal with a Tier 1 liquidity provider but will instead deal with a brokerage or prime brokerage that has an established relationship with one or more Tier 1 liquidity providers. Tier 1 Liquidity providers will only enter to relationships with institutions and individuals they know to be financially sound, in order to reduce their counterparty risk. This means some STP retail brokerages have an even looser connection with Tier 1 liquidity providers passing their trades through a company which has established relationships with various prime brokerages and tier 1 liquidity providers. This is partly why the spreads on offer for retail traders tend to be significantly wider than those available to institutional traders.
Brokerages operating a Dealing Desk are taking on the role of a liquidity provider themselves by allowing clients to both Buy and Sell currency. These Dealing Desks make money through the Bid-Ask spread, as well as hedging client’s positions internally or in the underlying market. Often these smaller Dealing Desks often rely on the fact the majority of retail traders lose money in order to turn a profit. This is why many retail traders prefer to trade with a STP/ECN brokerage as this model doesn’t involve any possible conflicts of interest.
In many cases the term Liquidity Provider is synomous with the term Market Maker, with liquidity providers making a making by quoting both sell and buy prices in a particular instrument. In Forex when someone talks about liquidity providers they are generally referring to a Tier 1 Liquidity provider or a company/prime brokerage which has a relationship with a Tier 1 Liquidity provider.