Is liquidity a factor?

One of the major topics among traders is brokers’ liquidity and execution quality. One common question that clients ask their broker is who your liquidity providers are. It is a quite logical question as the service quality of a liquidity provider is one of the key factors that affects how client’s orders are executed. The word “liquidity” generally refers to a pool of interests from banks, funds and other market participants to absorb or take the other side of a trade. When a client is interested in buying a financial instrument, there is a number of liquidity providers who are willing to take the other side of the trade – sell a financial instrument.

What is liquidity?

The meaning of liquidity has a very broad meaning on the Forex market, especially among brokers. You could have internal liquidity provided by a market making broker (often referred to as “b-booking” or internalization) or external liquidity provided by a number of external liquidity providers (“a-booking” or externalization). With external liquidity a trade received by a broker from its client is transmitted to one of the broker’s liquidity providers, usually according to the best execution policy which means that the liquidity provider indicating the best available price should receive the order. Of course, it does not necessarily mean that the liquidity provider will be in a position to provide the best execution because a lot could change on the market, while the order gets transmitted to a liquidity provider.

There is a number of ways for a broker to create its liquidity pools consisting of either internal or external liquidity. When it comes to external liquidity, one of the key determining factors is the balance sheet of a broker. The bigger the broker the more options are available. One of the best options available is when a broker has a prime brokerage relationship with any of the major banks. On the Forex market, the banks that act as prime brokers are normally BNP Paribas, ABN Amro, JPMorgan, Bank of America, Citibank, UBS and Deutsche Bank. The first question that is asked when a broker approaches any of the prime brokers is how big their balance sheet is. This question pops up because in order for a bank to provide a credit line to the broker, the bank needs to analyse and determine how risky the client is. The cool thing about having a prime broker is that you can have as many liquidity providers as you want, and all your trades with different liquidity providers end up on your settlement account that you have with a prime broker. After the Swiss National Bank crisis in 2015, some banks walked away from prime brokerage business, and some of the remaining institutions raised their requirements. For example, before the SNB event, you could have established a prime brokerage relationship with a balance sheet of 10 million USD, but after the event the banks raised the requirement to over 20 million.

Not just numbers

The broker with a smaller balance sheet has only 1 option if it wants to deal with external liquidity providers. It has to open accounts with each of the liquidity providers separately, deposit funds and engage in re-balancing operations. If price aggregation is used, you could end up with a situation, where you have a short EURUSD position with one liquidity provider and a long one with another. So at some levels the broker needs to even out these hedged positions.

It does not necessarily mean that a broker with a bigger balance sheet has deeper or better liquidity and execution quality. In fact, one of the most critical tasks for a broker is picking the right liquidity providers. Clients of a large broker with 10 liquidity providers could well experience worse execution quality than a smaller broker who has just a couple of liquidity providers. By execution quality I primarily mean order execution speed, slippage metrics and consistency.

But is it really enough to know the liquidity providers, in order to make conclusions about a broker’s trading conditions? The answer is no. First of all, banks like Citibank have a large number of universal and custom-made liquidity pools available for brokers. So even when 2 brokers are both connected to Citibank, their execution quality might differ greatly. The reason is that one of the Citibank feeds could be designed for algorithmic trade flow and the other for neutral retail flow. Moreover, the execution might differ between the two brokers even if they use exactly the same liquidity pool. This could be the case when the amount of orders sent out by the two brokers differs greatly.

Besides margin and net open position (NOP) limits, liquidity providers also have other limits. One of these limits is the amount of orders that can be simultaneously executed. Roughly speaking this would be about a couple of thousand orders per second per dedicated liquidity pool. So while the first 2,000 orders might get executed fast and with marginal slippage, the remaining orders might not be executed at all.

Inherent limitation

What we need to understand is that liquidity is a commodity and it is limited. Time also comes into play. Sure, the liquidity provider can internalize some of the flow, but at a certain level one needs to starts hedging incoming trades. If thousands of orders arrive within milliseconds, then, logically speaking, a liquidity provider has a very slim chance of finding a hedging counterparty. What clients often do not understand is that some liquidity providers classify certain flows as toxic. That means that by accepting this kind of flow a liquidity provider has almost zero chances of ever making money. Liquidity pools designed for toxic flows always come with wider spreads and less available liquidity.

When going back to universal and custom-made liquidity pools, one factor that always comes into play is market depth and top-of-the-book (TOB) liquidity. To put it simple, the liquidity that liquidity providers give out comes in layers. The first available price is normally available in small amounts, the second more and so on. The maximum number of layers in the market depth is usually also predefined and the total volume available as well. In the retail brokerage space, that is sub-second execution speed and tight spreads, the total volume of available liquidity at any given time per one pool of one liquidity provider does not generally exceed $10-20 million. This explains why often during economic news releases or unusual volatility excessive slippage occurs. It also explains why a number of clients’ orders get executed normally and the rest might witness excessive slippage or even rejections. You always have to consider that the other side of a trade (bank, broker, fund etc.) has to be willing to accept the order. During volatility, retail and not to mention professional market participants do not see how the price is going to move in the future. So one should not think that there is magical all-knowing liquidity provider out there who accepts all orders without considering the risks involved. Our world and our financial markets are not perfect. Everything around us has its limits.

Go small before investing big

So again, does it make sense to ask or even know who are the specific liquidity providers of a broker? For a better understanding of the broker’s operations it does make sense to know who are the liquidity providers. However, in reality, more important than the names is the average execution quality – pricing, execution speed, slippage and other factors. In reality, the average execution quality of a broker having just a few liquidity providers could be considerably better when compared to a broker who lists dozens of liquidity providers on their website. Therefore, a reasonable approach is always to test a broker with a small account and once confident, invest more.

An important thing to remember is that liquidity is a commodity, the bigger your orders get, the more focus you have to put on the broker’s liquidity as it is limited. Setting up liquidity pools is probably one of the most sophisticated tasks that brokers are dealing with. A lot also comes down to relationships that a broker has with banks and other liquidity providers. There is no such thing as the best liquidity, rather a liquidity with less limits and overall issues.

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