In our last blog, we discussed liquidity and defined it as a measure of market participants’ ability to trade what they want, when they want, at a mutually agreed upon price for a specific quantity. We explained why liquidity is important to risk management and capital development. We also addressed the factors that contribute to a liquid market, including a high number of participants, a high traded volume, and a relatively balanced and deep order book.
This week, we’ll discuss another key factor that contributes to liquid markets: liquidity providers. As principal traders, we’ll be focusing largely on how principal trading firms (PTFs) contribute to liquidity provision.
The most liquid, lowest-cost markets are those where there are no barriers to participation by a wide range of market participants, using a mix of strategies and with a variety of holding periods.
As we mentioned last week, intermediaries are critical to providing liquidity because they connect buyers and sellers across time and enable supply to meet demand in a timely fashion. Liquidity providers can be on either side of a transaction, as buyer or seller. By entering and holding positions they bridge the gap between market participants. In this way, they quite literally make a market for an asset. This allows long-term investors to buy or sell stock whenever they want to, without having to wait for another long-term investor looking to do the opposite; it allows farmers to hedge against a drop in crop prices and food production companies to hedge against a rise in the cost of ingredients.
Liquidity provision is commonly understood as acting as an intermediary by continually trading in and out of relatively short-term positions. Liquidity providers tend to send orders to the marketplace at prices that reflect available information regarding asset prices including the risk associated with transacting and holding that asset. The hallmark of liquidity providers is that they continually provide liquidity in all market conditions, not just when they desire to accumulate or close-out longer term investment positions.
Banks, financial institutions, and principal trading firms (PTFs) all act as liquidity providers in today’s markets. The different business models and capabilities of these liquidity providers allow them to serve the market in different ways. For instance, banks with large balance sheets may carry more inventory and be able to facilitate larger transactions in a given asset. PTFs, on the other hand, serve investors by maintaining tighter bid/ask spreads, offering reliable market liquidity, and optimizing price discovery across products and asset classes. PTFs do so by effectively processing market information from many public sources and efficiently deploying their capital.
Liquidity provision in modern markets requires diversity among liquidity providers to facilitate risk transfer and efficiently match buyers with sellers during continuous trading.
There is important diversity of strategies and approaches among PTF liquidity providers as well. Business models vary from mostly passive liquidity-provider firms to quantitative firms that generally trade actively, each representing a share of activity. Even within a single firm, there is often a mix of trading strategies. Holding periods also vary: depending on the strategies operated, PTFs may hold positions for seconds, minutes, hours or days.
All of these strategies contribute to liquidity in our markets, which is a topic we’ll explore in greater detail in our next blog.