The Difference Between Liquidity Provider and Market Maker

Sometimes, when individuals mention phrases like market maker and liquidity provider, they mean the same thing. Both are integral to providing liquidity and ensuring the trading process runs smoothly. 

Even though the two are similar, there are some important distinctions that should be noted. The purpose of this article is to describe the main differences between them, as well as their respective functions and importance in the trading industry.

How Do We Define Them?

Market makers are organisations that provide markets with liquidity by guaranteeing consistent trade volumes. They fall into two categories: speculative and institutional. 

Under some contracts, regulated businesses that provide services to exchanges and trading platforms are known as institutional market makers. Furthermore, speculative MMs willingly take up that role in decentralised marketplaces.

Operating Principles of Market Makers

MMs establish and stick to the ask and bid prices for financial products on an exchange or trading platform, usually within a predefined spread. 

These prices are open to traders, who can place orders based on these quotations. MMs match orders or take the other side of deals to maintain constant liquidity and promote trading.

Liquidity Providers 

Large players that supply markets with substantial volumes of assets or currencies to help with trade are known as LPs. Examples of these players include banks and financial institutions. This group includes retail speculators, multinational corporations, banks, hedge funds, central banks, and managers of foreign investment projects.

They give brokers access to quotation pools and other services in the Forex trading industry, such as Electronic Communication Network (ECN) connections, Direct Market Access (DMA), and Straight Through Processing (STP).

Operating Principles of LPs

Electronic trading platforms are used by LPs to continuously obtain quotes and place bids for a variety of financial assets. The trading platforms of connected brokers or financial institutions offer these prices.

Deal execution is facilitated by brokers providing traders with access to the LP’s prices. The LP’s technology matches orders with the best pricing, ensuring quick execution and little slippage.

What’s the Distinction?

By providing quotes, completing orders, and connecting brokers to the interbank market, LPs are responsible for guaranteeing that markets have an adequate amount of liquidity. 

This function is necessary for both stable prices and efficient trade. Conversely, market makers build exchanges for certain financial goods by using their capital to issue quotes, facilitate trade execution, and promote price discovery.

Agreements and Regulatory Oversight

LPs are subject to stringent regulatory oversight to maintain market stability and typically sign agreements with aggregators or trading platforms to secure their market access. Similar regulations apply to market makers, particularly to those who are institutionalised, guaranteeing that they stick to industry norms.

Objectives and Motivations

Supporting trading activity and making money from spreads on a high number of trades with low margins are LPs’ main objectives. Although market makers also want to make money through spreads, they are more likely to assume market risks, frequently enduring large price swings and maintaining positions for extended periods of time in order to optimise profits.

Market Exposure and Trading Volume

Because LPs have direct access to the foreign exchange market, they are able to trade a wide variety of currencies. Market makers operate under the constraints of specific instruments or markets as outlined in their agreements, giving them a more narrowly focused approach.

Benefits for Investors from LPs and MMs

Market makers and liquidity providers help to maintain price stability. They minimise abrupt price swings by lowering the price difference between the buying and selling prices and ensuring constant ask and bid prices.

Cutting Down on Transaction Fees

The decrease in transaction costs is a significant benefit for investors. These organisations reduce the bid-ask spread, which lowers the cost of purchasing and selling assets.

Enhancing Market Access

Investment markets are made more accessible to investors, and a greater variety of assets can be traded, even in less liquid markets, thanks to the efforts of MMs and LPs.

Risk Management

Through their capital and assumption of the risk, MMs also play a critical role in managing market risk. As a result of this risk absorption, the trading environment is more stable and investors are protected from sudden movements in price.

Final Remarks

It’s critical for brokerage owners to collaborate with trustworthy liquidity suppliers. By preserving market liquidity and stability, these organisations provide investors with safer trading environments.

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A heavy gamer, there's nothing that Faith loves more than spending an evening playing gacha games. When not reviewing and testing new games, you can usually find her reading fantasy novels or watching dystopian thrillers on Netflix.

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