As science progresses and communication technologies develop, economic and financial processes become increasingly globalized. The emergence of electronic trading systems made possible the creation of global trading floors, the largest of which today is the Forex market.
Participants of such trading floors are usually different economic entities geographically located at any point globally. Thanks to such financial institutions, today’s Forex market is the most liquid and has a daily turnover of trillions of dollars. On the other hand, trading transactions are also simplified, the volume of available liquidity increases, and opportunities for capital investment are expanded. This allows banks, brokerage companies, and investment funds to offer clients a wide range of financial products and services, meeting any risk profile. However, when it comes to the functioning of the entire market, providers of FX liquidity, responsible for keeping the trading process running smoothly, come into play.
In this article, we will explain what Forex liquidity providers are and what types they are divided into. You will also learn how liquidity providers create liquidity in the Forex market. In the end, we will talk about the main criteria that must be considered when choosing a Forex liquidity provider in 2023.
Who is a Forex Liquidity Provider?
To understand who a Forex liquidity provider is, you need to be aware of what liquidity is. In a nutshell, it is the ability to quickly buy/sell goods (currency) at the market price. If there is no such an opportunity, the liquidity is considered low. The lower the difference in prices (both spread and occupancy of the limit order book) and the more trades are made per unit of time, the better the liquidity and vice versa.
A Forex liquidity provider (LP) is often a particular company with trading assets in its own accounts, which helps brokers and other companies to fill clients’ orders. This firm works with both buyers and sellers. LPs are market organizers; this factor also explains their second name: market makers. Those vendors who achieve success in their work are quite influential on exchanges. They form trade volumes of the asset. If such an organizer has a lot of trading time, he will eventually attract maximum attention.
The liquidity provider can be the one who is ready to offer the market an important component, namely liquidity. Classical stock exchanges get this indicator from market makers, which can be investment organizations, as well as trading companies and institutional investors (among them are hedge funds and large banking organizations), which have large volumes of assets in circulation. Their job is to enable the prompt execution of transactions on the floor for other market players and clients of brokerages.
Liquidity is created through the provision of offers that support order positions that are executed by traders. In most situations, liquidity providers are regulated and monitored by the relevant state authorities, which check them for compliance with international norms, country laws, and requirements.
Classification of Liquidity Providers in The Forex Market
Today, all Forex liquidity providers are divided into two levels: Tier 1 and Tier 2. Below we will consider their main features, differences, and principle of work.
Tier 1 Liquidity Providers
ECN (Electronic Communication Network) is a huge electronic communication network that connects the largest liquidity providers. Tier 1 providers include huge international banks such as Morgan Stanley, Bank of America, Goldman Sachs, J.P. Morgan, Barclays Capital Bank, Citi Bank, Nomura, and others. The biggest liquidity provider in the Forex market is Deutsche Bank, UBS bank follows it, and Barclays Capital is the third biggest liquidity provider.
Also among the significant Forex liquidity providers are international financial exchanges trading futures, options, and other financial instruments. These include London International Financial Futures Exchange, CME Group (Chicago Mercantile Exchange), CBOE (Chicago Board Options Exchange), ICE (Intercontinental Exchange), European Options Exchange Deutsche Terminboerse, Singapore International Monetary Exchange, and others.
Large hedge funds, mutual funds, and investment companies also trade on the ECN network. Because these banks and funds trade large volumes on various exchanges, there can not be one accurate price of a financial instrument at a single moment. For example, on different futures exchanges, the price of the same gold can be slightly different, which is normal. Of course, the arbitrage algorithms are trying to keep the price approximately the same at all exchanges in order not to allow earning on the difference in rates between the exchanges, but because of time delays to keep the price the same in 100% of cases is impossible at this time of technology development, so there is a small gap on the price between the exchanges.
Tier 2 Liquidity Providers
The majority of Forex brokers (more than 90%) need access to the liquidity of Tier 1 and specified exchanges because Tier 1 providers work only with large volumes. Therefore, there are smaller providers of liquidity of Tier 2, who act as intermediaries between brokers and Tier 1 institutions. Among this category’s liquidity providers are LMAX Exchange, Currenex, Integral, CFH Clearing, Hotspot FX, Refinitiv FXall, FXCM Pro, and Swissquote. Most Forex brokers with NDD technology work with such providers.
When a Forex broker has direct access to a Tier 2 liquidity provider, it is called an STP (Straight Through Processing) broker. It is a model of outputting clients’ orders directly to the liquidity provider without any dealing intervention. When the Forex broker directly connects to a large Tier 1 liquidity provider (a big bank) or to the pool of several smaller Tier 2 liquidity providers (there are some), he is called a DMA (Direct Market Access) broker. When the Forex broker has direct access to the pool of liquidity of large providers of Tier 1, which is ECN or interbank, such brokers are called ECN brokers.
How Do Liquidity Providers Generate Liquidity in the Forex Market?
Modern technology has simplified processes in many areas of human activity, including market trading. Today, modern software is responsible for creating liquidity; the aggregation process is done automatically and quickly. So, a liquidity aggregator is software that allows brokers to get the necessary bids at the best prices collected from different liquidity providers.
When the trader sends a market order, his order will be immediately executed. Moreover, if the order is small, it can be “overlapped” at the expense of the broker’s clients (usually, they are large Forex brokers). It is only possible to send 0.1 lot to the liquidity provider if the broker himself has clients who will be on the opposite side of the deal. If the order is large, it can be generated in a larger order pool and sent to the liquidity provider, who will already find a counterparty for this order. However, if the counterparty is not found (which happens very rarely), he, if possible, will send it to his pool of Tier 2 or ECN. In this case, if there is no suitable counterparty at the current moment in time for the current volume, the deal will be executed at the nearest possible price, and your order will “slip.” But the process of sending and processing the order will happen so quickly that you will not feel the difference between the deal with the client of the broker or the deal with the provider.
The aggregation of client limit orders takes place through the FIX (Financial Information Exchange) protocol. It allows two types of order execution: FOK and IOC. FOK (Fill Or Kill) execution means the complete execution of an order at a given price if an offer from the liquidity provider matches the price and volume. No other option is allowed. IOC (Immediate Or Cancel) allows both full and partial executions at a given price, after which the remainder of the order can be filled at a different price. Sometimes liquidity aggregators are also called providers because small brokers work through them. Such brokers are called STP (Straight Through Processing).
The market price is constantly looking for balance, moving until the buying volume overlaps the selling volume. If, for example, the interest is not compensated (the seller cannot find a buyer), then there is not enough liquidity — on the chart, it looks like weak volatility or several non-overlapping gaps. Such a market has many problems: slippage, spread widening, and transactions at unprofitable prices. That is why the role of liquidity providers is of paramount importance and can be traced in the process of trading not only on Forex but also on any other financial market.
How to Find Forex Liquidity Provider: Evaluation Criteria
Now that you know who the Forex liquidity providers are and what kinds of these important market players exist, it’s time to know what criteria you need to consider when choosing a reliable liquidity provider.
In order to find a solid FX liquidity provider, you first need to do your research and identify your needs. After that, you should look up the ratings of the best liquidity providers on the Internet and conduct a comparative analysis to see which one suits you best. Once you find a few suitable options, you need to make evaluations of the liquidity provider’s performance criteria based on this list.
Technology is one of the most critical criteria for working with a liquidity provider. The provider must be equipped with the latest and most advanced technology. The objective is to ensure that the trading process runs smoothly and that you get the best service possible. You may check their website to see if they have any information about their products and services. In addition, you may contact the provider directly and ask them about their services. Having a clear idea of what the provider is like and determining whether or not they are worth the time and effort will be helpful to you.
- Adherence to Regulations
The next criterion to consider is whether the provider adheres to the laws and regulations. This is important because you need to ensure your money is safe and that the company follows all the rules. It is advisable to first consult the regulatory authority in the country where the service provider is based. The information you gather will give you an idea of how well the provider is being monitored and what kind of oversight they are subject to. Furthermore, you can check the provider’s website to determine if it contains any information regarding compliance with regulations. You can contact the provider directly if you would like further information regarding the provider’s compliance policies.
Reputation is the foundation of any kind of business. There are a lot of providers out there, and not all of them are created equal. When selecting a provider, it is essential to ensure that they have a good reputation and are known for providing high-quality services. Several methods can be used to accomplish this. You should first visit an online forum and read what others have to say regarding the provider.
Furthermore, you can contact the provider directly and ask them any questions regarding the service. Finally, you should analyze independent reviews of the service provider. Thus, it will be possible to judge the provider based on all these factors and decide whether or not it is worthwhile to work with them.
- Financial Stability
The financial stability of the liquidity provider guarantees timely and complete fulfillment of the company’s obligations to its customers. A provider’s financial stability can be assessed in several ways. To begin with, you should take a look at their financial statements. By doing so, you can gain a better understanding of their overall health. As a second option, you can contact rating agencies. They provide an indication of companies’ financial stability, which can assist you in selecting a provider whose products and services are of high quality. Lastly, check with the regulator in the country where the provider operates. This information will give you a sense of how well the provider is being supervised and what type of oversight they are subject to.
There is a lot of value in ensuring you get the best deal possible when buying a product. To assess the pricing of a product, you can take a number of steps. One of the criteria to consider when it comes to finding a good Forex liquidity provider is the pricing of its services. If you are interested in knowing how much the provider charges, you can contact them directly or look up the price on a comparison website. Having a sense of what other providers are charging for a similar service will assist you in making a decision.
Liquidity is necessary for effective trading on the currency market as well as on any other market. A low level of liquidity can lead to sharp fluctuations in quotations for a currency pair. For example, if an institution like a bank receives a very large order, that transaction can have a noticeable impact on the market in the short term.
While the importance of liquidity providers in the foreign exchange market cannot be underestimated, brokers who provide liquidity as market makers can often have a conflict of interest with their clients because they take positions opposite to their clients’ positions and can profit when clients lose. Therefore, before selecting a Forex liquidity provider for ongoing cooperation, you should carefully analyze all of the above criteria and make an informed choice based on your requirements and preferences.
By Michael Saichuk