The term ‘liquidity provider’ is used to describe an individual or institution that has entered into a commitment to act as a market maker for a given asset class. In short, this means that the liquidity provider acts as both the buyer and seller of a particular asset, which results in the making of a market.
Many stock exchanges choose to work in tandem with a liquidity provider(s) in order to guarantee liquidity of a specified security. The motivations behind having a liquidity provider work in two ways:
1. The entity that has sought out a liquidity provider secures liquidity for their desired security
2. Liquidity providers commit to providing liquidity with the aim of making a profit on the bid-ask spread
In theory, liquidity providers ensure greater price stability and improve liquidity by making the buying and selling of a security easier at any price level. It is important to note that liquidity providers incur a great deal of risk, but are able to profit from their position given that valuable information is made available to them.
MiFID II regulations defines ‘liquidity providers’ as “firms that hold themselves out as being willing to deal on their own account, and which provide liquidity as part of their normal business activity, whether or not they have formal agreements in place or commit to providing liquidity on a continuous basis.”Players in the financial industry often use the terms ‘liquidity provider’ and ‘market maker’ interchangeably. This is because liquidity providers and market makers operate within the same line of the business and usually turn a profit through spread, commission or slippage. They also agree to accept risk by taking their position on either side of a trade or by agreeing to pass this on to another liquidity provider.