When it comes to finding a reliable source of liquidity, you have two main options to choose from. In this blog post, we will briefly discuss both options in order to give you a basic understanding and encourage further research.
Liquidity providers are crucial financial institutions that assist brokers and exchanges in completing orders by offering bid and ask prices in the market. They play a vital role in connecting brokers with major banks and funds, enabling smaller players to access large pools of liquidity. In the Forex market, there are two types of providers: Tier 1 and Tier 2. Tier 1 providers are typically large banks like Bank of America or JPMorgan Chase, which provide significant amounts of liquidity to the market. Tier 2 providers, on the other hand, are smaller companies that have access to Tier 1 providers. They offer personalised services and lower costs for order execution.
Brokerages that utilise liquidity pools are known as NDD or STP brokers. They directly route orders to banking and institutional liquidity providers, guaranteeing traders the best prices and narrower spreads. In the crypto industry, LPs contribute their assets to a “liquidity pool” and provide liquidity to decentralised exchange platforms. In return, they receive rewards in the form of LP tokens. Traditional liquidity-providing companies also operate in the crypto market, granting smaller exchanges access to these pools.
Market makers play a crucial role in the industry, consisting of major banks, institutions, and funds with considerable economic sway. Their primary objective is to enhance market liquidity and ensure the smooth functioning of financial markets by buying and selling significant amounts of money and currencies. While stock trading is the most familiar for market makers, they also actively partake in other markets such as Forex. It is customary for prominent stock exchanges to have their MMs support their operations. In the Forex market, brokers operating under the Dealing Desk (DD) model are commonly referred to as market makers. These brokers trade against their customers using their assets, which may be viewed as unfair and carry potential risks.
How Important is it?
Liquidity is a vital component of strong markets as it directly impacts the volume of trades. When markets have high liquidity, transactions can be executed quickly and at fair prices. Conversely, illiquid markets make trading assets at their true value challenging. Holding positions in volatile markets for extended periods can negatively impact investment portfolios. Low liquidity markets have the potential to significantly impact the entire market, unlike high liquidity markets, where multiple transactions can occur simultaneously without major consequences. Therefore, liquidity is necessary for all markets but also carries risks for exchanges and users.