Liquidity providers and market makers are two types of financial intermediaries that play an important role in the global financial markets. It can be said that both provide liquidity, but there are some key differences between them.
What is a Liquidity Provider?
A liquidity provider is a financial entity or institution that supports brokers and exchanges in executing orders. They offer bid and ask prices in the market to provide liquidity which helps financial services companies fill orders efficiently and swiftly. This helps in keeping markets orderly and preventing sudden price changes.
Liquidity providers act as a bridge between brokers and the largest banks and funds. By connecting these two parties, liquidity providers are able to provide access to deep pools of liquidity for smaller players.
If we speak about the Forex market, there are two types of liquidity providers: Tier 1 and Tier 2. Tier 1 liquidity providers are typically the largest banks in the world, such as the Bank of America or JPMorgan Chase, which provide large amounts of liquidity to the market.
Tier 2 liquidity providers are smaller companies that have access to Tier 1 liquidity. They typically provide liquidity to brokers and high-net investors that don’t have access to the larger Tier 1 institutions. These providers can offer more personalized services and lower costs for executing orders.
Brokers that use liquidity pools offered by liquidity providers are called NDD (No Dealing Desk) or STP (Straight Through Processing) brokers. STP brokers do not take the opposite side of their client’s trades but instead route orders directly to the banking and institutional liquidity providers. This ensures that traders receive the best price available in the market at any given time. STP brokers also offer tighter spreads than traditional market makers, as they have access to deeper pools of liquidity.
If we speak about the crypto industry and the DeFi sector in particular, liquidity providers are users who lock their assets into a smart contract called a “liquidity pool” and thus provide liquidity to the decentralized exchange platform. In return, they get rewards in the form of LP tokens.
However, there are also traditional liquidity-providing companies that are present in the crypto market. They offer smaller exchanges access to pools of assets from major crypto trading platforms such as Binance, Coinbase, and others.
What is a Market Maker?
Market makers are usually large banks, funds, and institutions that have a big influence on the market. These entities have significant amounts of money and currencies that they use to buy and sell in large quantities in order to make financial markets more liquid and ensure their proper functioning.
Market makers can be institutions, but they also may be traders and investors with very big volumes of assets. The most common market for market makers is the stock market, but they may also trade on other markets, like Forex.
It is common for large stock exchanges to have their own market makers to support their operations. As an example, the New York Stock Exchange, one of the largest in the world, specifies a number of institutions as their lead market makers and describes them as “ETP holders or firms registered” to trade securities on the exchange.
In the Forex market, brokers working under the DD (Dealing Desk) model are commonly called market makers. Such brokers do not refer client orders to liquidity providers like NDD brokers — instead, they trade against their customers using their own assets. Since these brokerage models are less transparent than NDD, traders frequently refer to them as “unfair” and risky.
Essentially, market makers make money by varying the bid-ask spread between the best bid and best ask prices of the asset. They buy low and sell high. However, widening the spread can reduce trading activity, which increases the risk for market makers.
Why Liquidity is Important
Market makers and liquidity providers offer the same essential service — liquidity. Liquidity is crucial to the strength of any financial market and refers to the volume of trades on an exchange.
High liquidity means there are enough buyers and sellers present to complete transactions quickly and at market prices. On the other hand, illiquid markets make it difficult to trade assets at their intrinsic value and can cause discomfort for buyers and sellers. Holding positions in volatile markets for extended periods can harm your portfolio.
Low liquidity markets also create another problem where a single transaction can significantly impact the entire market. This is unlike high liquidity markets, where many transactions can occur simultaneously without affecting the market significantly. Therefore, every market requires liquidity, which can be dangerous for exchanges and their users.
Liquidity is essential for any financial market. Both market makers and liquidity providers offer an important service to the markets: ensuring that buyers and sellers can easily execute trades at fair prices.
Essentially, an institution can be a market maker and liquidity provider at the same time to provide both efficient trading and market access for their customers.
Market makers are responsible for providing liquidity in the marketplace by setting bid-ask spreads. They facilitate trades between buyers and sellers, helping to narrow the spread. Liquidity providers, on the other hand, supply large amounts of assets to the market in order to ensure smooth price movements and reduce volatility. Both types of roles are important for ensuring efficient trading and a healthy market.
via: Information Nigeria