Liquidity Provider vs Market Maker: What is The Difference

The sphere of the capital markets is a complex system of interrelated elements which work together to ensure the stability of the trading process with various kinds of financial instruments. One of the elements of this complex system is liquidity, which is provided through the work of liquidity providers and market makers. But what are these important capital market players, and what is the difference between them?

This article describes who the liquidity providers and market makers are, how they influence the financial markets and how they differ from each other. In addition, the article will tell about the advantages of cooperation with each of these liquidity sources.

Financial entities known as liquidity providers lend funds to financial services firms to perform transactions on markets. These institutions may be represented by private investors or international companies. The process of liquidity provision involves entering a high number of limit orders in the order book, which maintains market equilibrium in the event that a substantial amount of financial assets is bought or sold. The spread, or the gap between the most recent best purchase and sell prices, as well as trading costs, are decreased as a result of increased liquidity, which benefits trading on the financial market.

In most cases, liquidity providers are prominent capital market participants that have access to a network of funds, financial institutions, and the world’s largest banks that comprise a liquidity pool or quotation pool. From this pool, LPs provide liquidity for other market players, such as dealing centers and brokers, within the market price flow.

Generally, large enterprises and banks are considered the main suppliers of quotations in any financial market since they possess big volumes of funds. For example, J.P. Morgan and Morgan Stanley are some of the most giant and important liquidity providers in the financial markets today.

Market makers are generally regarded as high-volume traders, such as investment banks, or brokerage firms, that literally “make a market” for assets, striving to ensure market liquidity at any price. Advancements in market-making have a significant impact on the entire financial industry. The financial system has slowly evolved toward an increasingly automated process over the past two decades. A key element of that transition is the replacement of traditional market makers with computer programs that make decisions in fractions of a second using sophisticated algorithms.

A market in the modern sense was formed with the emergence of market makers. Artificial intelligence is today’s market making, facilitating a smooth flow of concluded deals and providing instant liquidity through mathematical algorithms. There has definitely been a breakthrough in the trading world with automated programs that can process up to a million orders simultaneously. These systems have expanded the possibilities for trading systems and have enabled the development of new technologies to increase the liquidity of the market.

Today, in any financial market, liquidity providers and market makers are responsible for supplying the financial markets with a stable flow of funds, ensuring the reliable functioning of the trading process with the support of trading volumes. Both these systemically important participants of market relations perform the same task in the broad sense of their functionality. However, in a narrower sense, there are certain differences between them, which we will discuss below.

Financial market participants who act as market makers are those who keep the markets active by continuously preparing to conclude trades with other market participants. A market maker may also be described as a trader who, based on an agreement, is responsible for the maintenance of the price, demand, supply, and/or volume of trades of financial instruments, currencies, or goods.

Tier 1 and Tier 2 groups are two categories into which market makers can be categorized.

The market makers in this group are the biggest commercial banks. They are sometimes referred to as institutional market makers (IMM), collaborating with stock exchanges, reaching agreements, and accepting commitments to ensure asset turnover and supply and demand equilibrium. These suppliers include businesses that manipulate interest rates, foreign exchange rates, and commercial banks. Large banks, trading floors, brokerage firms, sizable funds, and wealthy individuals might all be among them.

Market makers in this group function with their own liquidity. They work under the B-book model, taking the other side of their customer’s trades and do not pass the orders to liquidity providers.

Regarding the different types of market makers, it is essential to note that exchange participants fall under the category of speculative market makers. These market participants (such as tiny banks and private investors) own such substantial quantities of assets that a reasonable price impulse is created when they deal.

Third-party market makers are an alternative to traditional market makers. As opposed to liquidity providers, the “party” in this situation is typically a hedge fund, and they act as arbitrageurs to gain liquidity from other exchanges by hedging their positions in other markets. Market makers negotiate a deal with the exchange they trade, typically requesting a specific amount of profit in exchange for supplying liquidity. The exchange often makes up the difference following the agreement if a market maker’s profit falls below the predetermined threshold.

The difference between the best supply (the highest price a buyer will pay for an asset) and the best demand (the best, or lowest, selling price of the asset) prices is where they derive their income, which is a measure known as the bid-ask spread. Alternatively said, paying a low price for an asset and then charging a high price for it. However, the exchange amount declines as the spread increases, increasing the amount of money the market maker will make from a particular transaction. As a result, there is an increase in the amount of time between trades, which raises the risk. Other market makers now have time to earn money off the position (perhaps before the original market maker can). 

Liquidity providers and market makers, despite their differences, have the same function – to provide liquidity to the capital market in order to ensure the stability of the trading process by maintaining the necessary level of trading volume. In both cases, the use of liquidity services has its advantages, which are as follows:

Working with liquidity providers is the key to increased trading activity in any class of financial instruments in any market. Since high liquidity maintains the stability of the trading process, the main component of which is trading volume, liquidity providers and market makers provide price support in cases of serious fluctuations as a result of buying or selling large volumes of an asset, which can negatively affect not only the state of this asset but also the market as a whole.

Market stability means the situation when the total percentage of all assets on the market is not subject to serious fluctuations as a result of various reasons. It directly affects the attractiveness of a particular market on the part of investors because the higher the volatility of assets, the higher the concerns and doubts of trading participants about the advisability of investing in an asset whose price changes too quickly. This also applies to margin trading in high-risk instruments such as derivatives.

Liquidity providers and market makers can stabilize sudden market price movements, usually by placing pending orders, and thereby protect investors from unexpected losses.

Increasing liquidity of traded assets, such as currency pairs, crypto coins, or CFDs, leads to an increase in the trading volume of buy or sell transactions as well, resulting in such indicators as the spread automatically decreasing, which also influences the degree of slippage. Slippage is when a transaction is initiated at a price that is known in advance but may open at a completely different price, both for better and for worse. Liquidity providers and market makers, providing liquidity, ensure a situation in which the appearance of a spread is practically excluded, especially for popular trading instruments.

Like liquidity providers, market makers are the backbone of any market, forming necessary conditions for the proper functioning of all trading elements. Supplying liquidity to the market, they maintain the essential level of trading volume to execute transactions for buying and selling assets quickly and conveniently.