What exactly is a liquidity provider?
In our previous blog, we defined liquidity as the ability of market participants to trade what they want, when they want, at a mutually agreed-upon price for a specific quantity. We discussed why liquidity is critical for risk management and capital development. We also discussed the factors that contribute to a liquid market, such as a large number of participants, a high traded volume, and a relatively balanced and deep order book.
This week, we’ll look at another important factor that contributes to market liquidity: liquidity providers. We’ll be focusing on how principal trading firms (PTFs) contribute to liquidity provision as principal traders.
The most liquid, lowest-cost markets are those in which there are no barriers to participation by a wide and varied range of market participants by using a variety of strategies and holding periods.
As we discussed last week, intermediaries are important for providing liquidity because they connect buyers and sellers across time and allow supply to meet demand in a timely way. Liquidity providers can be on either the buyer or seller side of a transaction. They bridge the gap between market participants by entering and holding positions. They literally create a market for an asset in this manner. This allows long-term investors to buy or sell stock whenever they want without having to wait for another long-term investor to do the opposite; it allows farmers to hedge against a drop in crop prices and food production companies to hedge against an increase in ingredient costs.
Liquidity provision is commonly understood as acting as an intermediary by trading in and out of relatively short-term positions on a continual basis. Liquidity providers typically send orders to the market at prices that reflect available asset price information, including the risk associated with transacting and holding that asset. Liquidity providers distinguish themselves by providing liquidity in all market conditions, not just when they want to accumulate or close out longer-term investment positions.
Banks, financial institutions and principal trading firms act as liquidity providers (PTFs).
In today’s markets, banks, financial institutions, and principal trading firms (PTFs) all serve as liquidity providers. These liquidity providers’ various business models and capabilities enable them to serve the market in a variety of ways. Banks with large balance sheets, for example, may carry more inventory and be able to facilitate larger transactions in a given asset. PTFs, on the other hand, benefit investors by preserving tighter bid/ask spreads, providing consistent market liquidity, and optimising price discovery across products and asset classes. PTFs accomplish this by effectively processing market information from a variety of public sources and deploying capital in an efficient manner.
In order to facilitate risk transfer and efficiently match buyers and sellers during continuous trading, modern markets require diversity among liquidity providers.
There is also a wide range of strategies and approaches among PTF liquidity providers. Business models range from mostly passive liquidity providers to quantitative firms that generally trade actively, with each representing a share of activity. Even within a single firm, trading strategies are frequently mixed. PTF holding periods vary as well: depending on the strategies used, PTFs may hold positions for seconds, minutes, hours, or days.
All of these strategies help to increase liquidity in our markets, which we’ll explore in greater detail in our next article.