What is Liquidity Provider (LP) of Forex market? Why is it important?

The term “liquidity” is understood as such a condition of certain goods, resources, securities at which they can be acquired or realized quickly and without essential losses in the price.

The highest level of liquidity are cash assets.

Liquidity = Trading Volume in the market

The main indicator of liquidity is trading volume.

The more transactions are concluded with one or another asset, the higher its liquidity.

The daily volume of trade in the FOREX market amounts to trillions of US dollars, which exceeds many times the volume of the world stock market.

That is why the FOREX market has the highest liquidity.

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Faster and Accurate Execution with more Liquidity

In practice FOREX trading «liquidity» means, first of all, the ability to quickly sell or buy one or another currency in the necessary volume.

Therefore, tools, which can be quickly sold or buy call highly liquid, and assets, the sale or buy of which takes a lot of time is low-liquid.

Liquidity provides market-makers – large participants of the market (such as banks), the more market-makers provide liquidity of the company, the higher the probability that the transaction will be possible to perform, regardless of the time and the trading sessions in the different countries of the world.

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Banks aggregate Market Liquidity

The aggregator (provider) of liquidity is the large participant of the market uniting in a network the largest banks of the world, financial institutions, and the funds, forming a pool of a stream of the prices, quotations, and news to smaller participants of the market such as brokers, the dealing centers, etc.

In keeping with its business model, XM carefully selects the best in the world liquidity providers and concluded with each of them of a cooperation agreement to provide the customers with access to the widest possible liquidity and qualitative execution of orders at the best prices on the FOREX market.

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Is liquidity a key indicator?

When talking about brokers, liquidity and order execution quality are the most involved places. Brokers are often asked who their liquidity provider is. Liquidity providers determine the execution of traders’ orders. So, the answer to this question is obvious. The term liquidity refers to the pool of funds. It is composed of banks, funds, and other market participants, and can raise funds or do reverse transactions. Once a trader buys a financial product, there must be many liquidity providers who can sell the financial product.

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What is liquidity?

In the foreign exchange market, especially for brokers, the meaning of liquidity is broader. Including internal liquidity provided by market makers and external liquidity provided by liquidity providers. When using external liquidity, the broker’s client list is handed over to a certain liquidity supplier, indicating that this supplier’s price has the most advantage. Of course, the supplier may not always be able to give the best price, because, in the process of dropping the order to the supplier, market conditions have already changed rapidly.

There are many ways for brokers to establish internal or external liquidity pools. To establish external liquidity, the key is that the broker must have a good balance sheet. The larger the brokerage, the more choices are available. The best way is to cooperate with a large bank and become your own institutional broker. In the foreign exchange market, the following banks are eligible to act as institutional brokers: BNP Paribas, ABN AMRO, JPMorgan Chase, Bank of America, Citibank, UBS, and Deutsche Bank. So the question is, what are the conditions for cooperating with these banks? Before opening a dedicated line for a broker, the bank will investigate the size of the broker and measure the customer’s transaction risk. Once the cooperation is successful, you can fully enjoy multiple liquidity quotations, and you can use accounts opened in large banks when dealing with multiple liquidity quotation providers. After the “Black Swan” incident of the Swiss Bank in 2015, some banks closed the institutional brokerage business, and some banks raised the threshold for cooperation. For example, before the “black swan” incident, the brokers required to cooperate with assets reached 10 million U.S. dollars, but now the brokers are required to have assets of more than 20 million U.S. dollars.

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Liquidity is not just a number

If small brokers want to obtain external liquidity, there is only one way, and that is to open a separate account with each liquidity provider, deposit funds, and perform re-settlement operations. If price concentration occurs, the broker does not need to hold long-term orders and short-term trading orders from the two liquidity providers. To some extent, brokers can reduce the number of hedging orders.

The size of the broker determines whether the liquidity is sufficient and the quality of order execution. In fact, the most important thing for a broker is to choose a suitable liquidity provider. For a client of a large foreign exchange merchant, ten liquidity providers are quoted for it, and the transaction experience obtained is not necessarily better than the service obtained in a small foreign exchange merchant. The aforementioned order execution quality refers to order execution speed, quotation smoothness and continuity.

So when choosing a broker, is it enough to know its liquidity provider to judge its trading environment? the answer is negative. First of all, institutional banks like Citibank have extensive liquidity created by traders. Even if two brokers provide orders at the same time, the execution of the orders is completely inconsistent. The reason is that Citibank divides the fund pool into a system transaction pool and a general retail pool. What’s more, even two brokers in the same sub-pool, the order execution services they receive are not consistent. This explains why the quotes obtained by the two brokers are different after placing the same number of orders.

In addition to profit and net position restrictions, liquidity providers are also subject to other restrictions. One of the limitations is the number of orders that can be executed simultaneously. Simply put, the popularity of each dedicated fund pool is 2000 transactions per second. This means that after the first batch of 2000 orders are executed quickly and without slippage, the remaining orders may not be traded at all.

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Liquidity has its limitation

Liquidity is a commodity with its own limitations, and timing also affects it. Of course, liquidity providers sometimes activate internal hedging trading systems to internally digest some of the liquidity. But if there are thousands of orders that emerge within milliseconds, in theory, suppliers cannot digest these orders internally in a short time. Liquidity suppliers turn these orders that cannot be hedged and digested in a short time into “poisons”, But many traders still have doubts about this. If the supplier accepts the order at this time, it will not be profitable. When the market fluctuates sharply and the spread changes suddenly, the liquidity in the “poison” fund pool is basically used.

Let’s talk about the sufficient liquidity generated by the trader’s momentum. What often plays a key role is market depth and handicap liquidity. Simply put, the liquidity provided by liquidity providers is hierarchical. After the first batch of quotations with competitive prices is issued in a small amount, the quantity will increase immediately after the second batch is issued, and so on. The upper limit of the level has long been determined by the market depth and total trading volume. When providing services to retail brokers, the second-level price and smaller spreads are used. At any time, the total liquidity transaction volume provided by each supplier at a time will not exceed 10 million to 20 million. . This explains why the price fluctuates sharply whenever there is a major market situation, only part of the customer’s order will be filled, and the rest is either slippage or unable to place an order. At the same time, what still needs to be considered is whether banks, brokers, fund institutions, etc. are willing to accept orders. When the market price fluctuates sharply, many retail or unmentioned professional traders cannot judge the trend of the market. Therefore, there is no perfect liquidity supplier in the market and will take orders while completely ignoring risks. Neither the world nor the financial market is perfect. Everything has its limitations.

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