The term ‘non-bank liquidity provider’ may not be new, but recent months have seen the phrase being used ever more liberally in corners of the foreign exchange markets. Richard Elston, head of institutional at CMC Markets Connect – the brokerage’s recently rebranded B2B division of CMC Markets – discusses what’s driving the evolution of this narrative, and why care needs to be taken not to misuse such a powerful term.
What’s the difference between a liquidity provider and a prime broker?
The fundamental difference between a liquidity provider and a prime-of-prime broker is the fact that the latter is only pulling in liquidity from external sources, passing this through some form of aggregation engine then allowing others to tap into it. Once that liquidity pool is exhausted, transactions can no longer be executed at that price. This is distinct from a true liquidity provider who will construct a price ladder by looking across the market, but is independently making the decision as to how much liquidity they are willing to offer. That can result in the presence of greater market depth, or indeed the ability to make a price in an asset when others simply cannot quote.
Why are some brokers now badging themselves as LPs?
To answer this, we need to look at the evolution of the Prime-of-Prime market. As legacy Prime Brokers scaled back their offerings almost a decade ago, the idea of Prime-of-Prime was hatched. This would enable the larger brokers to act as intermediaries, re-establishing a link for the smaller market participants back to the Prime Brokers. The Prime-of-Prime arrangement was best suited to those entities with some natural or internal flow, along with depth on their own balance sheet. They had the necessary weight to deal with the Prime Brokers, whilst also being able to handle administrative and risk elements of the relationship, in return for a modest dollar per million fee.
That situation created an opportunity for a number of smaller brokers to step in, claiming to offer Prime-of-Prime, but instead of drawing liquidity directly from Prime Brokers, they were recycling it from other market participants. With limited balance sheets to support the trades, filling prices in faster moving markets became problematic, market impact saw a meaningful increase and the convoluted up-stream arrangements risked contention if two independent parties tried to hit the same line of liquidity simultaneously.
The term Liquidity Provider carries a nuanced meaning to the market and it may be one that isn’t yet fully appreciated. It seems that some liquidity recyclers have realised this and may be looking to benefit more by association.
Is this a problem?
In a word, yes. For the market to develop in an orderly manner there needs to be some degree of consensus as to what the relevant terms mean. There’s some criticism that the Prime-of-Prime terminology was misappropriated, moving away from the intended stance of someone who was acting as intermediary between a Prime Broker and A.N. Other party. As such it seems key that liquidity providers do exactly what it says on the tin, bringing their own liquidity to the market, rather than just aggregating what is offered by others. With only a few entities having the combination of natural flow, strength in their balance sheet and access to sufficient price feeds to deliver legitimate value by badging themselves as liquidity providers, it’s critical that we see proper delineation here. These providers must be able to deliver the promised liquidity at the agreed price points whilst minimising or eliminating market impact. Any blurring of the lines here risks a re-run of the Prime-of-Prime misappropriation and the increase in trade costs from those operating around the periphery will do nothing to improve market quality.
Does PoP still have a role?
Absolutely. Prime-of-Prime still has a key role to play for those market participants who are mandated to obtain prices only from Prime Brokers and as an example this is something that can often be requested by hedge funds. It also ensures that larger brokers who need to maintain minimum order volumes with Prime Brokers have a facility for doing this, whilst potentially providing some additional revenue. However, it’s worth noting that in isolation this income is far from lucrative and attention needs to be paid to ensuring that intermediaries who focus on this as their only revenue line aren’t left padding spreads to remain commercially viable. Trade cost analysis tools will reveal this, but it’s only going to be realised after the event.
Where does this leave CMC Markets Connect?
Our ongoing investment in technology, combined with our significant natural flow means that we are able to sculpt liquidity to meet the needs of individual clients. We recognise the importance of minimising market impact and with our internal flows representing a critical mass this is something we can mitigate, although being a liquidity provider in our own right allows us to take this one step further. As a result, we are able to fulfil that role of a Non-Bank Liquidity Provider, offering counterparties access to over 10,000 different assets, with price construction and market depth supported from our natural, internal flow.
High profile incidents have seen liquidity squeezed on occasion recently. How did you perform?
If we go back to the Gold dislocation in March of 2020, this was the first real test of our ability to continue making a market where others had pulled up the proverbial drawbridge. That combination of natural liquidity, plus our access into a wide array of price feeds made it possible for CMC to continue constructing and quoting a spot price throughout the dislocation both via our own platform and our API feed. This was backed up with access to the COMEX futures contact, a combination which in turn worked to feed liquidity into an otherwise constrained market.
A similar situation was repeated in January of 2021 when a rush of retail investors into Silver saw similar liquidity issues emerging, although through our array of internal and external sources, CMC Markets clients were able to continue receiving quotes and trading when others were left struggling.
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