Who is a liquidity provider and what do they do?
If you have been trading forex for any other market for even a little while, you might have come across the term; liquidity provider. As the name suggests, this is an institution or a firm that offers liquidity for the market in question. Liquidity is nothing but the ability with which you can easily convert an asset to cash. In some cases, it is also defined as the ability to convert one asset into another.
Among all the asset types, cash is the most liquid of all. This is the reason why that currency or cash is so widely used. Using cash, you can buy an asset such as real estate and you can also convert is back, by selling the real estate property. The person or persons who are willing to buy the property are liquidity providers, as an example.
In retail forex trading, when you place a market order and exit after a few pips, the very reason you are able to do this is because of the availability of liquidity. Without this liquidity, you would not be able to trade. In some cases, you might but you would be able to trade only at a worse price that what you want to buy or sell at.
How does a liquidity provider fit into forex?
Your forex broker is not just the only one in the retail forex market. Behind the forex broker is a pool of liquidity providers. These are made up of dedicated liquidity providers or LP and also a network of interbank markets.
Of course, your forex broker cannot tap directly into these markets. They go through a prime brokerage service. This prime brokerage service comprises of multiple forex brokers. Thus, by bringing in more volume, the forex brokers are able to plugin and take advantage of the additional liquidity.
What happens when liquidity dries up?
When liquidity dries up, it simply means that there aren’t enough buyers or sellers in the market. This means that you are stuck with your position. The only way to get out is at a price that is quoted to you and this can often be disadvantageous to you.
Secondly, when liquidity is dry, you won’t be able to close your position. Think of this as you wanting to sell your house. But no one is willing to buy. You end up either selling the house at a loss, or you have to continue to hold on to the property.
This is similar with the liquidity in the currency markets. A very good example is that of the Swiss franc crash. During the time, the CHF was pegged to the EUR and was heavily defended by the Swiss national bank. As a result, there was a lot of liquidity at the peg.
But once the SNB said that it would no longer defend the peg, it took away the liquidity, leading to heavy losses among traders. As you can see from the above, liquidity is something that traders take for granted, but it is infact quite an important element when it comes to trading.
