"Much like clients looking for a broker," says Alexey Trifonov, Head of Dealing at Libertex, "the biggest difficulty brokers have when searching for a liquidity provider is the sheer number of potential partners in the marketplace today."

Indeed, the CME Group lists two dozen Tier 1 FX liquidity providers, with over a hundred Tier 2 liquidity providers and aggregators. As market fragmentation grows, so is the number of liquidity providers.

This growth exemplifies their key role in the FX (and CFDs) market structure, as the quality of liquidity that brokers get and consequentially deliver to traders is a critical aspect of the business.

With a deep recession in the cards, the latest upheavals in crypto, and refined attention from regulators to the retail trading ecosystem, Finance Magnates spoke to several market participants to discuss brokers' current requirements and challenges.

Who's Who in Liquidity for Brokers

As the name suggests, liquidity providers create markets and make them "liquid". They do this by constantly buying and selling currency pairs and other offered financial instruments, providing brokers with price feeds and the ability to execute leveraged FX and CFD orders.

Brokers can work directly with banks or large-scale electronic trading firms (often called NBLP, or Non-Bank Liquidity Providers, with XTX Markets being a prominent example), or tier 1 liquidity providers. Conversely, they can tap tier 2 LPs: brokerage houses specifically serving the retail industry, often part of financial groups with retail brokerage arms themselves.

Thanks to such LPs relationships, brokers can send their clients' trades to the market (and collect a fee), in a Straight Through Process (STP) model. They can also take the other side of the trade and make the market themselves (with many brokers combining the two in a hybrid model).

Whatever the model and the liquidity type brokers opt for, choosing and maintaining the right partners is an arduous process that can take months.

How Do Brokers Choose Liquidity Providers?

There are many considerations for brokers, varying according to their region, size, and ambitions. Some of the parameters are reputation, liquidity depth, pricing competitiveness, range of financial instruments, technology infrastructure, and regulatory compliance.

"I want to be specific about the liquidity setup; if the setup is mainly facing a Prime Broker and Tier 1 liquidity providers, what we look for are elements like fill rate, speed, last look, liquidity bands, full amount feeds," Equiti Group's Global Head of Brokerage Sales, Mohammad Isbeer, explained. "We then create our liquidity pools for our retail broker clients with the focus being to make a specific pool that meets the needs of their type of flow."

Usually, pure retail brokers tap the services of institutional brokers, also known as prime of prime, to access liquidity. In a saturated market, due diligence makes for a big part of the process.

"This makes the initial selection process a multi-stage, months-long affair, and then come to the additional challenges of ensuring the company's financial stability and record of compliance with your specific regulatory framework," said Trifonov from Libertex.

Moreover, multiple brokers confirmed to Finance Magnates that they prefer publicly-listed companies for liquidity services, as they need to submit regular financial reports, making them much more transparent than private players.

Trifonov pointed out that this requirement often led brokers to "miss out on some really healthy companies with better conditions and technological capacities because they are unlisted."

Evolving Requirements

The requirements for liquidity have changed significantly over the years, With the emergence of demand for cryptocurrencies, an influx of retail trading and technological advancement.

"Trading has evolved tremendously in the last ten years", added Isbeer. "The need for customized liquidity has changed; artificial intelligence (AI) and machine learning models have become part of the business, and liquidity needs to be tweaked and managed. Pricing engines must also be current in handling these types of flows and aggressive trading styles".

On top of that, brokers pointed out the changes in market dynamics that impact liquidity requirements. "The growth of passive investing has led to increased demand for liquidity in certain asset classes, such as ETFs. Similarly, the rise of high-frequency trading (HFT) has increased demand for fast and reliable access to liquidity," Despallieres from Vantage said.

However, several liquidity providers agreed that the fundamental requirements remained the same, despite all the changes in the industry.

"Price and execution remain the key criteria. However, the range of products offered by Liquidity Providers has expanded, and LPs are looking at offering additional instruments to differentiate themselves. There has also been a shift from the majors and more of a move to metals," said Lars Holst, Founder and CEO of GCEX.

"Clients want to partner with a responsive broker who can deliver a wide range of products from a single API."

Jeff Wilkins, the Managing Director at iS Risk, which is part of iSAM Securities, added: "What is required is what puts the broker in the best position to service their clients and maintain the stability and profitability of their businesses.

And that comes down to what it always has and likely always will: high-quality liquidity from an institutional grade provider and a minimization of counterparty risk."

"There are occasions where loosely regulated liquidity providers can make waves in the market with certain enticing offerings, such as credit, crypto funding, and higher leverage, but ultimately these providers have short life spans. Brokers want to know their money is as safe as possible and that they are trading with the best-in-class providers."

In addition, regulations played a role in shaping liquidity as, Isbeer said:" Since Swiss National Bank (SNB) removed the price floor in euro/swiss in 2015 and followed by Covid-19 pandemic in 2020, the prime brokerage space has been changing; liquidity has become scarcer while demand for it has increased significantly. Equiti, as a liquidity provider, focuses on capitalization to fill that gap, which keeps on growing."

Crypto Still a Thing

For all the conundrums, plunges, and institutional loss of trust, crypto is by now an integral part of brokers' offerings. Besides the crypto-specific exchanges, traditional brokers offer crypto instruments to tap into the lucrative trader base.

"As a new generation of traders and investors emerges, we have seen an astronomical increase in interest in cryptocurrencies and digital assets at large", said Trifonov. "The upshot of this has been that brokers now have additional concerns when beginning cooperation with an LP. These include verifying the provider's liquidity for crypto instruments in terms of the variety of available cryptocurrency pairs, its liquidity book, and trade execution — all of which could be significantly different from typical instruments".

"The popularity of crypto has not necessarily changed the demand for trading as the industry originally anticipated, but it has increased the demand for crypto as a utility," Wilkins said. "Retail brokers tend to be high-risk, low-reward clients for banks, so many new entrants into the space have difficulty obtaining proper banking solutions. This is where the utility of cryptocurrencies comes into play. However, liquidity providers should be cautious if a broker struggles to obtain a proper banking relationship."

Holst, whose company provides crypto liquidity, said the demand for crypto spot and CFD increased significantly as the asset class went mainstream. However, existing liquidity providers struggle with the technology infrastructure necessary for cryptocurrency liquidity.

Also, the downturns in the cryptocurrency market, including the FTX scandal and long-running crypto winter, have impacted liquidity demand.

"Since the crypto winter and FTX failure, there has been less interest in cryptos, and spreads from LPs and exchanges have generally widened. Market Makers are now very competitive, and we see an increased level of interest again from funds and brokers looking to access this aggregated liquidity," said Tom Higgins, the Founder and CEO of Gold-i and Crypto Switch. "Many crypto LPs have gone or widened their spreads. The market makers that remain are now more competitive compared to exchanges."

The Need for Multiple Liquidity Providers

Liquidity is crucial for brokerage operations. Any disruption in liquidity providers' services will also decrease the brokerage offerings. While working with a single liquidity provider is possible, brokers can benefit from working with multiple providers. But, this decision also depends on whether a brokerage is a market maker or a simple intermediary.

Both brokers and liquidity providers agree that every broker should have a primary liquidity provider and at least one backup. This can also eliminate the challenges during market volatility when spreads widen.

"Multiple liquidity providers offer access to a broader range of liquidity sources, which includes different asset classes, regions, and trading venues. This diversification of liquidity sources can help mitigate market risk and reduce dependence on a single provider," Vantage's Despallieres added. "Working with multiple liquidity providers also enables brokers to compare pricing and select the best available pricing for their trades. Brokers can leverage price competition among different providers to get better pricing for their clients, resulting in increased profitability and competitiveness."

However, there are drawbacks to onboarding too many liquidity providers. Brokers should give each liquidity provider enough volume to strengthen the business relationship.

"I would recommend against aggregating prime of primes since many use the same underlying LPs," said Isbeer. "This creates the risk of double hitting. In addition, because there is no central clearing of orders, it may create issues with margins and financing. However, access to a minimum number of multiple LPs is a necessity, with the liquidity offered segregated on the basis of the LP's particular strengths, asset class, specific currency pairs, groups of clients, etc."

What's Next for Liquidity Providers?

Though demand for trading is growing, consolidation is happening in the liquidity space, as brokers only want to work with reputed names. "I believe the LP market in FX will consolidate even more. In the crypto space, smaller exchanges will disappear, and market makers will grow in strength. The future is bright!" said Higgins.

Also, the demand for crypto liquidity is pushing the liquidity providers to enhance their technology infrastructure and product range. This will have a significant impact on the services of the industry over the coming years.

"On the crypto side, I firmly believe we will see an uplift in the products. The next wave could be security tokens, and I also think NFTs will become much more mainstream. Staking will become a key trend, too. In FX, we will see less leverage, more risk controls and regulations," Holst added. "Clients will look for multi-product offerings, which is why it is so important that LPs have the right technology in place to support clients wishing to move freely across a broad product range."