Almost every week, I am asked “Is it ok to use a Market Maker as a liquidity provider?” The debate has always existed between the Principal and Agency business models for retail traders, but this gets much more interesting when you look at it from a liquidity provider standpoint. There are quite a few LPs in existence, and their business models are typically ECN, MTF or a pure Market Maker.
Market Makers can make effective LPs, but they need to understand their place in the food chain. The Market Maker is providing a liquidity service and the broker is actively onboarding and retaining clients. If the broker manages its risk effectively, it may not be getting rid of all the flow to the Market Maker. This can be a big sticking point because the Market Maker LP isn’t just getting a “big juicy book of retail clients”. Effective risk management for a broker means getting rid of tough flow and creating a consistent revenue stream. If a Market Maker is on the other side of this, they need to be prepared to manage their own risk effectively as well as have a proper technology infrastructure to facilitate and price any type of flow that is sent their way.
If you are considering using a Market Maker as an LP, I strongly suggest you have a conversation with their head of dealing. It is important to understand how they are managing the flow. Any head of dealing will be willing to have an open and honest conversation about what they can and cannot handle. They will also want to know what type of flow they can expect. It is really important to be upfront and honest about what you will be sending down their pipe. They shouldn’t expect you to disclose this on a daily basis, but once a month it is a healthy conversation.
Important questions to ask the LP:
Are you able to get rid of your flow and still produce revenue?
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This is the single most important question you need to ask. The LP may be banking on you losing money, but that certainly will not be the case. This will cause a huge strain on the relationship and will eventually force the LP to cut ties.
Do you have spread caps?
This is one of the huge advantages of using a Market Maker LP. The Market Maker should be able to eliminate spread spikes and provide a smoother price than other types of LPs.
How do you throttle your price?
Price throttling is very common among LPs. This is helpful if a broker is subscribing to this price, because not all platforms can handle a massive influx of ticks. Throttling ticks will help with performance, but over-throttling can open a up massive arbitrage risk to both the Market Maker LP and the broker subscribing to the pricing.
The relationship between a broker and LP can be very intimate. There needs to be an understanding that this is a business relationship and both sides need to make money. There also needs to be an understanding from the LP that the broker is the customer and the broker’s focus is going to always be 100% on its own book. In summary, there are advantages and disadvantages to using a Market Maker as an LP and these need to be measured. The key advantage is spread control and the largest disadvantage is the risk of the Market Maker LP not being able to manage their risk effectively.