Every successful Forex trader knows that liquidity is crucial when trading on the market. But who provides liquidity? It is essential to know precisely who the liquidity provider is and what role they play in the Forex market.
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What Does Liquidity Mean?
Liquidity refers to the amount of money readily available to meet debt obligations or make investments. The concept refers to how quickly cash can be converted from a financial asset or security without significant losses.
A company’s liquidity indicates its flexibility in meeting its financial obligations and unexpected expenses. The liquidity of an individual is the same. When a person’s liquid assets — cash savings and investment portfolio — exceed their debts, their financial status improves.
Concept of a Liquidity Provider
Market participants that make purchases and sales of assets are called liquidity providers.
An institution or individual acting as a foreign exchange market maker is said to be a Forex liquidity provider. Market making refers to acting as both a buyer and a seller in the Forex market for a given class of assets or exchange rate.
It is not uncommon for the terms liquidity provider and market maker to be synonymous as both trades are in the same business line and make their money through the spread, commissions, and slippages. They both decide whether to take the risk on the other side of the trade or pass it on to different liquidity providers.
Role of Liquidity Providers
By taking positions in currency pairs, the liquidity provider assists in stabilizing trading prices by either offsetting positions with another market maker or adding positions to the book of the market maker for liquidation at a later time. In addition to watching orders and call levels for clients, many Forex market makers also conduct market orders on their behalf.
Trading orders are generally placed with a brokerage and then passed to liquidity providers (banks, investment institutions, and other market makers) for execution, and the brokerage charges a fee on the trade. This is how transparent Forex trading should work.
As a result, sometimes brokers act as counterparties by fulfilling trade orders by matching their trading orders with those of another customer or from their inventory, thus serving as traders in the transaction.
Tier 1 and Tier 2
Liquidity providers can be classified into Tier 1 and Tier 2. It’s the Tier 1 providers who lead the list, as they deal with the largest banks and funds in the world, including Barclays, Morgan Stanley, BNP Paribas, UBS, and many others. Such providers require the lowest spreads and provide the highest liquidity.
The interbank market is an arena where Tier-2 providers operate. Generally, they have dealing desks, and they are market makers. Many of these firms are well-known Forex brokers and commercial banks that specialize in retail clients. The majority of financial markets transactions are supported by interbank liquidity providers, but small traders and companies are unable to send their transactions directly to banks due to technological and capital limitations.
Tier-2 providers offer quotes on currency pairs to both professionals and non-professional counterparts through their respective companies’ dealing desks. Hence, through such transactions, they help guarantee the integrity of the Forex market, where buyers and sellers are always present to fulfill retail clients’ trade orders.
How Online Forex Brokers Work
The average trader will never have direct access to a Tier 1 liquidity provider unless they are incredibly wealthy and trade enormous amounts. Instead, these individuals will access the Forex market via an online broker or via a Tier 2 liquidity provider like a bank or payments firm that accepts retail clients.
Reputable online brokers usually fulfill the majority of their orders via at least one Tier 1 liquidity provider. These institutions will only partner with financially stable providers to reduce the counterparty risk.
To execute trades, online Forex brokers are typically connected to an ECN/STP platform. An ECN is an electronic communications network, while an STP is a straight-through processing network. No dealing desk brokers are used in the NDD model, which implies that all transactions are routed straight to Tier 1 liquidity providers.
In a dealing desk, brokers allow clients to conduct transactions through their system while taking the other side of the trade and transferring as much risk as needed to professional counterparties. They act primarily as market makers and profit from the fact that most retail traders lose money when they trade.
Market makers, which operate in multiple currency pairs, increase the market’s liquidity, lowering trading costs for traders and stabilizing market prices.
There is, however, no question that it is better to have as many liquidity providers as possible competing for your orders. This differs from a low-quality retail market maker or a fake ECN/STP broker, who operates exclusively on their liquidity. You will always receive the best prices and orders execution only if more liquidity providers compete for your orders.
With an ECN/STP broker, the trader has complete peace of mind that their trades are ultimately executed by a Tier 1 liquidity provider, meaning the Forex broker taking part in the trade does not get involved in it.