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How Do Forex Liquidity Provider Work

 

liquidity provider 1A liquid market is very essential especially for Forex traders to make swift trade transactions at low costs. Hence, before looking at how Forex liquidty providers work, it is important to first understand the meaning of liquidity.

For any investment, liquidity refers to the speed at which an investor can exchange his/her investment into cash. For instance, real estate investors will typically take five days to complete a transaction while others may take months on end.

In the Forex market; it is the ability to exchange one currency with another fast and smoothly without sudden changes in the exchange rate. Higher liquidity in the Forex market reduces the costs of trading such as spread and slippage.


So who is a liquidity provider in the Forex market?

A Forex liquidity provider is essentially someone willing to take the two sides of a trade (buy and sell) by readily offering the two Bid and Ask quotes (usually with a spread).

To understand this clearly, let us look at an example;

If you walk into a Forex bureau seeking to exchange your pounds for dollars, you will be readily provided with a price quote to complete the transaction. The Forex bureau takes the exchange rate risk on your behalf and for your convenience making a profit from the spread between their selling and buying prices. The Forex bureau is able to make this transaction since it gets it currencies at a better price (smaller spread) from a larger banking institution. In this example; the Forex bureau has played as your liquidity provider while the larger bank has played as the Forex bureau’s liquidity provider.


Liquidity Providers in Forex Trading

Practically, a Forex liquidity provider will provide Forex prices that are streamed through your online trading broker’s platform for instance Metatrader 4 or Ctrader. The online trading broker will add onto the spread offered by the liquidity provider as well as decide the commission to charge before passing the price quotes onto the traders so as to make a profit. This way, your broker just passes on the exchange risk to the liquidity provider.

liquidity provider 3

In short; the liquidity provider offers liquidity to your Forex broker; who in turns passes on this liquidity to you as a trader with a mark-up on the spread. In this model, the liquidity provider will either be taking the opposite side of the positions taken by the online brokers’ traders or in turn pass the exchange rate risk to a bigger liquidity provider (tier one liquidity provider). Tier one liquidity providers are usually large banks/investment banks and are not available to retail traders due to the higher amounts of trading volume required in order to deal with them. For this reason, retail traders have to use online trading brokers to perform their transactions. Popular tier one liquidity providers include;

  • Nomura 
  • DeutscheBank
  • UBS
  • RBS
  • Barclays
  • GoldmanSachs
  • Commerzbank
  • MorganStanley
  • SMBC
  • HSBC
  • BNP Paribas
  • Natixis
  • Credit Suisse
  • Bank of America
  • Cyti
  • JP Morgan Chase

Online Forex brokers that do not take the foreign exchange risk by passing their traders’ positions to a liquidity provider are known as STP (Straight Through Processing) or Non-Dealing brokers and usually operate an A-Book. Large STP Forex brokers and prime brokerages dealing with Tier 1 liquidity providers are able to offer very tight spreads to their traders as they are able to access currency prices at a much higher wholesale level.

On the other hand, your online Forex broker may act as your liquidity provider taking on the foreign exchange risk by taking the opposite side of your trades. This type of online Forex broker does not pass on its client’ trading orders on to a liquidity provider and is usually referred to as a Dealing Desk broker or a Market maker. Such a broker operates a B-Book. There is usually a conflict of interest as the broker not only makes money from the spread (Bid – Ask difference) but also profits when the trader loses and vice versa through hedging the trader’s positions.


Recap

  • The term ‘liquidity provider’ is often regarded similar to ‘market maker’, however, in the world of Forex trading it is often used in reference to tier one liquidity providers or brokerages that pass on their foreign exchange risk directly to a tier one liquidity provider.
  • Tier one and other large Forex liquidity providers operate a B2B (Business to Business) model where they offer their liquidity to online Forex brokers and other relatively smaller financial institutions.
  • Online Forex brokers operate a B2C (Business to Consumer) model offering their services directly to traders. Forex brokers that operate a Dealing Desk (Market maker) offer liquidity directly to their traders without passing on the foreign exchange risk and hence act as a liquidity provider.
  • Most online Forex brokers are turning to the STP (Straight Through Processing)/ Non – Dealing Desk model as many Forex traders tend to avoid Market Making/ Dealing brokers due to the conflict of interest where the broker takes the opposite side of their trades.
  • The Forex market experiences high liquidity especially in the major currency pairs, however, liquidity issues may be observed occasionally in minor and exotic currency pairs. High impact economic releases may also interfere with the market’s liquidity causing high trading costs (spread widening). Lack of enough liquidity during such events may also lead to large and sudden price changes as observed in the 2015 Swiss Franc crash as a result of Switzerland removing the Swiss francs’ cap on the Euro.liquidity provider 4
  • Higher liquidity in the Forex market ensures a smooth flow of transactions adding to the competitiveness of the pricing which in turn reduces trading costs such as the spread. There is approximately $5.1 tillion transacted daily in the Forex market (based on the Bank for International Settlements, 2016). The most liquid currency pairs are EURUSD, USDJPY, USDCHF, GBPUSD and AUDUSD respectively. Traders will find high spreads in exotic pairs that experience thin liquidity.
Read 1569 times Last modified on Thursday, 07 February 2019 09:31

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