A liquidity provider (LP) constitutes either individual and/or institution that functions as a market maker in a given asset class.
Broadly speaking, liquidity providers will act as the both the buyer and seller of a particular asset, thus making a market.
In the equities space, many stock exchanges rely on liquidity providers who make the commitment to provide liquidity in a given equity.
These liquidity providers commit to providing liquidity in the hopes that they will be able to make a profit on the bid-ask spread.
In doing so, these entities theoretically ensure greater price stability and also improve liquidity by making it easier for traders to buy and sell at any price level.
Market liquidity providers also oversee an important service and take on a significant amount of risk.
However, these are still able to profit from the spread or by positioning themselves on the basis of the valuable information available to them.
Analyzing Liquidity Providers Relationship with Brokers
In addition, liquidity providers also delivering interbank market access to retail brokers.
They are typically large multinational investment banks, or other financial institutions that can be non-bank entities.
Each liquidity provider is streaming executable rates to the broker whose aggregator engine is selecting the best bid and ask and streams it to clients to deliver the best possible spread.
The broker is the direct counterparty to all trades executed with the liquidity provider and typically only uses them to offload flows which it finds uneconomical to internalize.
That said, some brokers are sending all of their flow to liquidity providers.
Liquidity providers have a set of characteristics which are determining their suitability and reliability - such are order rejection rates, spreads, and latency.
Brokers which aren’t monitoring the flow adequately are risking to deliver to their clients’ bad fills, which consequently result in customer complaints since the customer is consistently not getting the displayed or requested price.