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Industry demarcation – Liquidity providers versus prime-of-prime brokers

Industry demarcation – Liquidity providers versus prime-of-prime brokers

The term ‘non-bank liquidity provider’ may not be new, but recent months have seen it used more liberally in corners of FX markets. Richard Elston, head of institutional at CMC Markets Connect – the recently rebranded business-to-business division of CMC Markets – discusses what is driving the evolution of this narrative, and why care needs to be taken not to misuse such a powerful term

What is the difference between a liquidity provider and a prime broker? 

Richard Elston, CMC Markets
Richard Elston, CMC Markets

Richard Elston: The fundamental difference between a liquidity provider and a prime-of-prime (PoP) broker is the fact 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, which will construct a price ladder by looking across the market but independently make the decision of 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 liquidity providers? 

Richard Elston: To answer this, we need to look at the evolution of the PoP market. As legacy prime brokers scaled back their offerings almost a decade ago, the idea of PoP was hatched. This would enable larger brokers to act as intermediaries, re-establishing a link for the smaller market participants back to the prime brokers. The PoP arrangement was best suited to 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, while 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 PoP 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 upstream 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 may be one that isn’t yet fully appreciated. It seems some liquidity recyclers have realised this and may be looking to benefit more by association.


Is this a problem?  

Richard Elston: Yes. For the market to develop in an orderly manner there must be a degree of consensus on the relevant terms. There’s some criticism that the PoP terminology was misappropriated, moving away from the intended stance of someone acting as intermediary between a prime broker and another party. As such, it seems key that liquidity providers do exactly what they say on the tin: bring 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 sheets and access to sufficient price feeds to deliver legitimate value by badging themselves as liquidity providers, it’s critical we see proper delineation here. These providers must be able to deliver the promised liquidity at the agreed price points while minimising or eliminating market impact. Any blurring of the lines here risks a rerun of PoP misappropriation; and an increase in trade costs from those operating on the periphery will do nothing to improve market quality.


Does PoP still have a role?     

Richard Elston: Absolutely. PoP still has a key role to play for market participants mandated to obtain prices only from prime brokers. For example, this can often be requested by hedge funds. It also ensures larger brokers who need to maintain minimum order volumes with prime brokers have a facility for doing this, while potentially providing additional revenue. However, it’s worth noting that, in isolation, this income is far from lucrative, and attention must be paid to ensure 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? 

Richard Elston: Our ongoing investment in technology, combined with our significant natural flow, means we are able to sculpt liquidity to meet the needs of individual clients. We recognise the importance of minimising market impact. 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 the role of a non-bank liquidity provider, offering counterparties access to more than 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?  

Richard Elston: Looking back at the gold dislocation in March 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 via both our own platform and our application programming interface feed. This was backed up with access to the Comex futures contact – a combination that worked to feed liquidity into an otherwise constrained market. 

A similar situation was repeated in January 2021 when a rush of retail investors in 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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