When it comes to trading, the presence of a liquid market is a necessity for profitable transactions. Higher liquidity in a financial market makes for an easier transaction flow and more competitive pricing. Liquidity provision is therefore essential for effective trading in both the Forex and other asset markets. Companies who provide liquidity are known as liquidity providers.
There are several kinds of market participants that provide liquidity to the market, with the result of increasing the transaction volume. Included are central banks, key commercial and investment banks, large corporations, hedge funds, Forex brokers and high net worth individuals. Futures market makers, high frequency traders and hedgers additionally contribute liquidity.
The main role of a liquidity provider is to act as a market maker, increasing the transaction volume and lowering volatility in the markets. This is done by providing more assets and ensuring an uninterrupted flow between demand and supply. As liquidity providers are connected with the world’s largest financial institutions and brokerages, they are able to provide the best buy and sell prices, resulting in the lowest spreads possible.
The top liquidity providers in the Forex market are called Tier 1 liquidity providers. These comprise the largest investment banks with large Forex departments, who also offer a range of complementary services to their clients. Tier 1 liquidity providers are able to offer the tightest spreads with substantial opportunities to make profitable trades. However, individual traders cannot get direct access to a Tier 1 liquidity provider. Access is usually gained via an online broker who is connected to one or more Tier 1 liquidity providers used to fill their orders. Tier 1 providers partner only with other providers who are financially stable so as to minimise their risk.
Forex brokers normally access an Electronic Communications Network/Straight Through Processing (ECN/STP) network to execute their trades. Others operate a No Dealing Desk (NDD) whereby their transactions are sent to a Tier 1 or secondary liquidity provider directly. These brokers assume the role of a liquidity provider by enabling their clients to buy and sell on their platform. In such a case, the broker takes the other side of the transaction, offloading excess risk with relevant counterparties as required. Some traders prefer not to use brokers who are market makers. This is due to what they see as a potential conflict of interest since the market maker takes the other side of the customer's trade and thus stands to benefit financially should the client lose money. Using an ECN/STP broker, means the trader is certain the trade is being executed by a Tier 1 liquidity provider with the Forex broker not involved in any side of the transaction.
Many Forex brokers tend to connect with several liquidity providers so as to secure better dealing rates and spreads. In this way, they are able to offer their clients the best price possible.
Liquidity providers make their money from the difference between the bid rate and the ask rate, known as the spread that they charge to their clients. In markets with low volatility, liquidity providers earn from small spreads times by the many large volumes of assets traded. Some liquidity providers are even able to offer zero spreads, earning their money from fees based on the volume of assets that are bought and sold by traders.
On a final note, Prime of Prime (PoP) brokers have become increasingly popular. These are companies who built a strong relationship with a global prime broker. They can then provide their liquidity services to other Forex and crypto brokers as well as other financial service firms. If you are looking to find one one of the best liquidity providers in the industry, B2Broker is a PoP broker and an established name and one of the go-to providers.
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