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How do crypto liquidity providers work

December 11, 2023

Global financial markets have undergone a profound transformation over the years, significantly influenced by technological advancements. This evolution has notably impacted price discovery and the dynamics of liquidity provision, altering the landscape of market participants.

Regulatory frameworks and exchange policies often govern liquidity provision mechanisms in traditional markets, aimed at bolstering investor confidence and ensuring market integrity. 

Traditionally, liquidity was ensured by specialists and market makers who were obliged to maintain fair and orderly markets by regularly providing buy and sell quotes for specific assets. In return, they often received certain benefits from the trading venues. The past two decades have witnessed significant shifts in market operations due to technological advancements, new trading strategies, and regulatory reforms. This shift has seen a move from primarily manual, centralized trading to automated, and frequently fragmented markets. 

Consequently, the role of market liquidity providers has evolved. In many jurisdictions, this function has transitioned from formal market makers to various types of market players often referred to as "liquidity providers," which could include institutional players, brokers, or automated electronic trading firms using low-latency algorithmic models. 

These entities, although not bound by formal market-making obligations, may still receive benefits like rebates for their liquidity provision, particularly when they meet specific thresholds set by market operators. In the world of crypto markets, liquidity provision operates in a similar manner, but with differences due to the types of market participants involved and regulatory framework.  Traditional financial institutions often lag behind due to uncertainties surrounding rules and regulations. On the other hand, newly emerged crypto native players, such as proprietary funds, algorithmic traders, and companies connected to traditional electronic trading firms, play a more significant role. 

What are liquidity providers?

In TradFi, the term "liquidity provider" lacks a universally accepted definition and its formal usage varies across jurisdictions. In certain legal frameworks, liquidity providers are identified as investment firms that engage in the provision of liquidity as part of their regular business activities, without being contractually obligated to do so. However, not all trading venues recognize 'liquidity provider' as an official role. In these cases, liquidity provision programs are typically exclusive to formal market makers.

In other jurisdictions, the scope of what constitutes a liquidity provider is broader. For instance, some U.S. trading venues classify any exchange member placing non-marketable orders for execution as a liquidity provider. Additionally, certain trading venues have established liquidity provider schemes. These schemes often offer incentives to participants who reach specified liquidity provision thresholds, encouraging active engagement in the market and enhancing overall liquidity.

Liquidity providers vs maker makers: what’s the difference?

The distinction between liquidity providers and market makers primarily hinges on their obligations and roles within financial markets. Typically, a market maker is an entity that actively deals on its own account, consistently offering buy and sell quotes in a trading venue. These entities are usually registered and operate under stringent rules or contractual obligations. As we mentioned above, in many jurisdictions, market makers are recognized as registered intermediaries, authorized by competent authorities and subject to rigorous vetting processes to ensure their credibility.

Market makers often have specific duties to fulfill, such as consistently providing liquidity on both sides of the order book and ensuring minimum execution sizes for certain transactions. Their role extends to sustaining liquidity for designated assets.

Conversely, liquidity providers are not bound by such precise obligations. They are not necessarily required to engage in the market, particularly under extraordinary or volatile conditions. Their participation and trading decisions are typically motivated by incentives, fees, cost structures, technical access conditions, as well as opportunities for liquidity and arbitrage. Unlike market makers, who have defined roles, liquidity providers operate more flexibly, influenced more by market dynamics and potential benefits rather than mandated responsibilities.

What do liquidity providers do?

Ensuring Seamless Trading

Liquidity providers (LPs) ensure the seamless execution of trades in the crypto markets. By consistently adding buy and sell orders, LPs create an environment where transactions can be completed efficiently, regardless of the prevailing market demand. This is particularly important during times when trading activity is low, and finding a counterparty for a trade could otherwise be challenging. The presence of LPs ensures that there are always sufficient orders in the market, thereby aiding in the smooth execution of trades.

Strengthening Price Stability

One of the fundamental roles of LPs is to bolster the market's liquidity, which refers to the ease with which assets can be bought or sold. In a liquid market, characterized by a high number of buyers and sellers, executing trades becomes relatively straightforward. Conversely, in illiquid markets, finding a party willing to trade at a specific price point can be difficult. Low liquidity often leads to volatile price movements, as even minor shifts in supply or demand can significantly impact asset prices. LPs mitigate these fluctuations by injecting a steady stream of buy and sell orders, which helps in maintaining stable and predictable pricing.

Reducing Price Slippage

Price slippage, the discrepancy between a trade's expected and executed price, can be a significant concern in crypto trading. This phenomenon is often the result of low liquidity on an exchange or extreme market volatility. LPs play a vital function in curbing slippage by bridging the gap between buyers and sellers. They provide the necessary market depth, ensuring that orders are filled promptly and closer to the intended transaction prices. This reduces the impact of slippage, especially in fast-moving markets, and contributes to a more efficient trading environment.

How do LPs generate liquidity in the market?

In the crypto market, liquidity providers and market makers play a crucial role in ensuring liquidity and stability, similar to their function in traditional financial markets. They are integral to the operation of a dynamic and efficient trading environment, constantly providing buying and selling quotes for cryptocurrencies. This consistent quoting process ensures that a two-way market is always available, which is vital for maintaining market fluidity.

Liquidity in the crypto market, much like in traditional markets, can be asymmetrical. It tends to be higher during bullish phases but may become sparse during bearish trends, or when the majority of participants lean towards either buying or selling. In the crypto sphere, market makers, such as crypto-focused institutions, hedge funds, and proprietary electronic trading funds, often have smaller capital reserves compared to a set of market makers in traditional markets. This can partly explain why crypto markets tend to be more volatile, as these market makers have a limited appetite for longer-term risk-taking and are unable to hold large amounts of digital assets on their balance sheets. Consequently, they may struggle to absorb large quantities of digital assets during periods of market stress. This strategy requires strong financial resilience, which may be lacking in the still-developing crypto market.    

In mature and liquid crypto markets, the presence of multiple competing market makers typically ensures a more efficient and stable environment. This competition among market makers contributes significantly to liquidity and price discovery in the market, leading to enhanced market stability. In this context, market makers are invaluable in adding depth and efficiency to the crypto trading landscape.

The impact of crypto liquidity providers

Liquidity providers offer several key benefits which enhance market efficiency and stability, especially in the volatile crypto market. Let’s delve into some of their primary strengths:

Trading Cost Reduction

One of the fundamental advantages of liquidity providers is their ability to decrease the bid-ask spread. Bid-ask spread, the difference between the buying and selling prices of financial instruments, can significantly impact trading costs. Liquidity providers, by introducing a multitude of limit orders, help narrow this spread. Reduced spreads mean lower total trading costs for market participants.

Market Stabilization

Financial markets, particularly in the realm of crypto, are often subject to significant price fluctuations. These can be exacerbated by large-scale trades from “whales” or investors with substantial capital. Such large orders can create market imbalances, leading to rapid and potentially destabilizing price changes. Liquidity providers mitigate this risk by injecting liquidity into the market, thereby buffering the impact of these large trades. This stabilization is relevant for maintaining a healthy trading environment and protecting smaller market participants, especially those engaged in margin trading.

Boost in Trading Activity

Trading activity and liquidity are interdependent; high liquidity typically encourages increased trading activity. Traders are more inclined to engage in a market where assets can be bought or sold quickly, without incurring significant costs due to spread and slippage. Liquidity providers contribute to this environment by augmenting the volume of pending orders in the order book. This increased volume makes the market more attractive to traders, fostering a more vibrant and active trading ecosystem.

Liquidity Providers vs Liquidity Aggregator: what’s the difference?

Liquidity providers are entities that inject capital into the market to ensure sufficient liquidity. They achieve this by placing an array of buy and sell orders at various price levels. This activity is critical for ensuring that transactions can occur smoothly and efficiently, especially in markets where large volumes of assets are traded. LPs effectively reduce the spread and enhance price stability, making the market more attractive for all participants, including individual traders and institutional investors.

Liquidity marketplaces like FM Marketplace, on the other hand, play a different role. They act as aggregators, pooling liquidity from multiple LPs into a single, accessible platform. This aggregation makes it easier for liquidity takers – banks, brokers, payment providers, OTC desks, and others – to access liquidity without having to connect with LPs individually, typically resulting in a segregated experience.

These marketplaces streamline the process of securing liquidity, offering a one-stop solution for accessing the best available prices from various providers. By consolidating liquidity, they also help in reducing slippage, a critical factor for large volume trades common among institutional players.

In a typical liquidity aggregation model, the liquidity provider sends quotes to the aggregator while maintaining control over the execution process, enabling them to reject orders if needed. Consequently, one of the common drawbacks of liquidity aggregators is a higher rate of order rejections, which ultimately results in a decline in trade execution quality. In high volatility scenarios, such “last-look” rights elevate risks considerably for liquidity takers.

At Finery Markets, we offer FM Marketplace as a crypto ECN solution that offers firm crypto liquidity with no last-look execution. We have achieved so by implementing a distinctive market structure where execution takes place on Finery Markets’ side, thus ensuring firm quotes to liquidity takers even under the most fluctuating market conditions.

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