This article will focus on a brief description of who liquidity providers are, the various categories of liquidity providers as well as their role in the financial markets.
Who is a liquidity provider in the forex market? A forex liquidity provider refers to an individual or a corporate entity that provides services of being a buyer and a seller of exchange rates in various currencies traded in the forex market.
The range of movements of currencies in the forex market is quite small, usually in the order of 1/10,000ths of a point. Therefore, a large amount of money is required to be able to buy or sell currencies. In the case of the forex market, the role of liquidity providers is to put in place conditions that ensure the stability of prices of currency pairs by taking buy or sell positions in these currencies, from where these positions can be sold off to other lesser trading entities such as market maker brokers.
Different Types of Forex Liquidity Providers
What are the various kinds of liquidity providers in forex?
There are basically two types of liquidity providers in forex: Tier 1 and Tier 2 liquidity providers.
The Tier 1 liquidity providers in the foreign exchange market are at the apex of the food chain. This class of liquidity providers is populated by the biggest banks in the world with large forex departments. These banks provider price quotes for all currency pairs, and they actually make the markets for forex brokers and retail clients who use the ECN platforms. The Tier 1 liquidity providers usually offer pricing to the market maker brokers, who in turn offer some mark-up pricing to their retail clients using the pricing from liquidity providers as the benchmark. The Tier 1 liquidity providers make their money from the difference between their buy and sell prices and not by trading as counterparties. Commissions on the buy and sell sides of the trades are also a second source of income for liquidity providers.
The Tier 1 liquidity providers are usually large banks with branches on a global scale. Examples of liquidity providers include:
- Deutsche Bank
- Commerzbank AG
- BOfA Merrill Lynch
- BNP Paribas
- Effex capital
- Royal Bank of Scotland
- Morgan Stanley
- Goldman Sachs
- Societe Generale
- Credit Suisse
- Royal Bank of Canada (RBC)
- ABN AMRO
Who are the clients of the liquidity providers? Some of the potential clients of liquidity providers include large corporations, hedge funds, individual high net-worth clients and smaller banks. Some of the corporations services by the liquidity providers have to undertake large scale cross-border currency transactions (e.g. to fund mergers/acquisitions), while some may be looking to trade some of their money over the long term. This involvement of large banks in providing forex for corporations means that they are usually the only financial institutions that can remain liquidity providers in the forex market.
Price quotations from liquidity providers are not fixed; a trader will see that price quotes from several liquidity providers are different, albeit within a price band. Spreads are also variable.
The Tier 2 liquidity providers operate at the level of the interbank forex market. They function strictly as market makers that provide pricing to retail clients using a dealing desk. Market makers, according to the definition of the US Securities and Exchange Commission, is a company which is read to sell or buy an asset at a publicly quoted price on a regular and continuous basis. With regards to the foreign exchange market, a “market maker” performs the market making function for currency pairs. Most of the forex brokers found online today as well as several banks offering commercial and investment banking services are full-fledged market makers. As a rule, they buy and sell forex positions to the end clients, who constitute the retail end of the market. In this manner, they function as counterparties to the trade. In this manner, they also enhance the architecture of the forex market in terms of trade executions, ensuring that there is always a buyer or seller to fulfill the trade orders of the retail clients at any point in time.
How do market makers make money? They make their money from the compensation they receive from the price differential between the bid price and ask price of a currency pair. This is known as the spread, and is taken from the accounts of the retail traders as soon as the trade orders are executed. By acting as counterparties, they also receive profits from losing trades in the market.
Retail traders typically trade forex with a few hundreds or a few thousands of units of one currency or another. This is not enough to maintain the desired liquidity in the forex market. This is where the role of the market makers is highlighted. Their operations in the market greatly enhance the liquidity in the market. Market makers can be described as the intermediaries between the retail traders and the big banks that function as liquidity providers in the market. Increased liquidity leads to cheaper trading costs, lowers spreads and enhances trade volumes.