The rise of trading platforms throughout the 2020s has made working with multiple liquidity providers (LPs) less of a perk and more of an essential consideration in the eyes of traders, and brokers have been challenged to adapt fast. 

The pursuit of larger liquidity pools, competitive pricing, tighter spreads, and rapid trade execution have all forced Wall Street to adapt quickly to modern pressures, and the success of brokers depends on partnering with the right LP. 

But how are providers chosen by brokers? And what qualities are most sought after when it comes to achieving frictionless trading? Let’s take a deeper look into the complex and symbiotic relationship between brokers and liquidity providers:

The Backbone of Wall Street

Liquidity is what drives every global financial market. It plays a key role in the buying and selling of assets for institutional and retail investors alike, paving the way for faster transactions at more advantageous prices. 

Effective LPs also allow access to a wider range of financial instruments, like more esoteric currency pairs, and lesser-trodden asset classes. This can help more brokers provide alternative investment opportunities to clients at an attractive cost. 

With the rise of technologies like artificial intelligence and machine learning, liquidity providers have been challenged to provide increasingly sophisticated and bespoke solutions to facilitate modern strategies like passive investing at one end of the spectrum and high-frequency trading (HFT) at the other. 

Additionally, the emergence of alternative asset classes like cryptocurrencies, CFD, and forex has challenged more providers to overhaul their technology infrastructure, meaning that no two LPs are likely to offer the same quality of service to brokers. 

Brokers and LPs Need Each Other

Although it may sound like brokers need liquidity providers to function, it’s more like a symbiotic relationship between the two parties.

When a trader places an order with a broker, it requires a counterparty to execute it. This causes the broker to reach out to its network of LPs to discover the best price and execution conditions for the client. 

The liquidity provider that can best meet this demand at an advantageous price will be contacted. The LP will then analyze the order and market conditions before agreeing to act as the counterparty to action the trade, which either involves buying or selling an asset. 

Following this agreement, the broker will forward the provider’s costs to the trader. If the rates are satisfactory, the trade is executed and the assets are moved. 

For their roles in making the trade happen, both the broker and LP take a profit for their troubles. The broker charges a commission fee to the trader, while the liquidity provider earns profits when buying or selling the assets at a profitable price. 

Choosing the Right LP

But how can a broker choose the right liquidity provider for trades? There are many considerations to be made when picking a beneficial LP, including factors like liquidity depth, pricing, locality, and reputation. 

Different brokers can have different priorities when seeking out a functional liquidity provider. Some retail brokers opt to utilize institutional brokers in a move known as prime of prime for their liquidity needs. However, in more saturated markets, due diligence can go a long way for ambitious brokers. 

According to insight from Finance Magnates, many brokers seek out publicly-listed companies for liquidity services because their financial reporting requirements can help to provide greater transparency ahead of private LPs. 

This can cause the selection process to become a drawn-out process, and may even cause some brokers to miss out on low-cost, technologically advanced LPs due to their unlisted status, but the advantages in terms of clarity and sustainability are clear. 

While pricing and cost structure are also essential considerations for brokers choosing the right LP, regulatory compliance has become another leading factor in the pursuit of liquidity. 

As more investors demand access to unconventional assets like cryptocurrency, choosing LPs that operate under the supervision of reputable authorities like the SEC, FINRA, and CFTC has become vital in providing clients with a more reliable and consistent quality of service. 

Liquidity Comes in Different Tiers

Because liquidity providers can be vastly different in structure and size, it’s also important for brokers to understand whether they require a Tier 1 or Tier 2 LP. 

Tier 1 liquidity providers are the largest market players to choose from and usually consist of internationally focused banks and hedge funds that can offer high volumes of liquidity, particularly when it comes to executing forex trades. 

For instance, Deutsche Bank, Morgan Stanley, and Barclays are all examples of reputable international players when it comes to Tier 1 liquidity providers in the FX landscape. 

On the other hand, Tier 2 LPs are smaller in size and often act as more of a bridge for smaller brokers and Tier 1 providers to work with one another. 

Most brokers will work with Tier 2 providers because of their accessibility to firms of all shapes and sizes. 

For brokers seeking the most adaptable ways to action the trades of clients, it’s worth looking at the capabilities of both Tier 1 and Tier 2 LPs, with many liquidity solutions offering price curation, quote book optimization, and multi-stream services to help improve the efficiency of trades. 

Partnering With The Right LP

Brokers and liquidity providers are vital components in the modern investment landscape, each helping to provide unprecedented levels of convenience and efficiency to traders on a global scale. 

For both, building the right relationship with their financial counterparts is imperative, and can’t be taken lightly. 

In taking the time to conduct the right level of due diligence and assessing prospective LPs, more brokers have the freedom to pass the benefits down to clients. This can help to maintain higher levels of efficiency even as financial markets continue to evolve and the pursuit of low latency carries on presenting fresh challenges to hurdle. 

Without either, trading as we know would likely be very different. As such, it’s crucial to understand how they both work before you start trading. Understanding how they work can help you to make better decisions when trading and can also help you to avoid making costly mistakes.

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