Buy Side and Sell Side Liquidity – How Does It Work?

• Introduction
• Buy-Side Liquidity: Who They Are and What They Need
• Sell Side Liquidity: Providers, Structure, and Incentives
• How Buy-Side and Sell-Side Interact in Practice
• Soft-FX Solutions: Bridging Buy- and Sell-Side Needs
• Liquidity in Crypto vs. FX: What’s Different?
• Trends and Innovations in Liquidity Infrastructure
• Conclusion: Building Liquidity-Resilient Platforms
• FAQ's

Introduction

Without a doubt, ‘liquidity’ is one of the most common words used in the context of financial markets. It is often described as the blood that keeps trading alive in a functioning market. However, liquidity also carries an important meaning for individual traders and companies.

The issue liquidity addresses can be thought of along three dimensions, namely: order depth, which implies size of orders at varying prices; volume, in this case, the amount of trading activity; execution ease such as speed and costs. Markets that are liquid enable significant trades to be done at prevailing market prices with little to no market slippage and impact.

Illiquid markets are characterized by the lack of punters providing liquidity causing the order books to be thin, the wide bid ask spreads, and an order depending price quit volatility where even slaps queuing suffers or small jobs are executed.

There are those providing liquidity, who pay and sell assets, thereby providing them to transact. These are the market makers, banks, and other players that quote and place orders. Along with them, there are those who consume liquidity. They try to execute trades for investment, hedging, or speculation purposes.

Buy-Side Liquidity: Who They Are and What They Need

On the other side of this divide are the entities constituting the “buy side” of the market. They are mainly looking to procure assets as part of an investment or operational plan.

Important actors on the buy side include:

• Hedge Funds: These sophisticated investment firms ]use diverse and complex trading strategies across different asset classes.
• Asset Managers: They firms manage investment portfolios on behalf of institutional and retail clients such as pension funds, mutual funds, and endowments.
• Large Corporates: These corporations perform foreign exchange transactions to facilitate international trade, hedge foreign exchange risk, or manage their treasury operations.

For these buy-side participants, several priorities are paramount when interacting with the market.

• Price Discovery: They expect accurate asset valuations in the market which need to be based on actual trading activity.
• Execution Quality: Attainment of the set trade size with optimum pricing is critical. This includes controlling slippage, the difference between the trade price and execution, and avoiding a high market impact.
• Anonymity: Protecting anonymity poses different challenges for different organizations. In the case of large institutions, executing important orders while preserving anonymity is important.

Although liquidity market services face no significant barriers, the following issues can be noted:

• Slippage: Large orders in fast-moving and/or illiquid markets face varying levels of slippage, which can result in profitability erosion.
• Market Impact: Buy and sell orders of large contracts also have the ability to shift the market demand pricing against them, which diminishes the effectiveness of their strategy.
• Latency: In tactical high-frequency trading, to bad news, the speed at which orders are sent and performed becomes very important.

Sell Side Liquidity: Providers, Structure, and Incentives

The "sell-side" includes parties that primarily focus on selling assets or providing them with the means to trade.

The most relevant parts of this group are:

• Banks: Important financial institutions of the region encompassing the area that trade heavily in many markets, acting as market makers in virtually all classes of assets, constantly issuing bids and asks prices.
• Market Makers: Individual people or firms that profit by quoting both buy and sell prices and capturing the spread between them are known as Market Makers.
• Brokers: People or firms that connect buy-side participants to sell-side participants and execute trades are known as Brokers. Some brokers also act as liquidity providers.
• Liquidity Providers (LPs): A more general term which includes banks, market makers and anyone who provides any sort of quotes and is willing to take the other side of the trade are known as LPs.

The sell side works on several important motives and incentives:

• Spreads: The revenue from the bid and ask price (the difference between the asking price and bid price) is considered one of the major revenue sources for a lot of sell side participants. Smaller spreads are better for the buy-side.
• Quoting: Pricing at which sell-side firms are ready to sell an asset are always relayed to other market players who wish to buy those assets.
• Risk Warehousing: Exit market participants assume inventory and manage the market risk associated with the trade to a sell-side counterparty.

A variety of layers are generally established among liquidity providers:

• Tier 1 LPs: This includes large and reputable banks that have substantial capital and direct access to the inter-bank market.
• Synthetic LPs: These providers assimilate liquidity from diverse sources such as Tier one banks and other market participants.

How Buy-Side and Sell-Side Interact in Practice

There are many trading venues and intermediaries like the following that facilitate interaction between the buy side and sell side:

• Matching Engines: These are the heart of all stock exchanges and ECNs, where buy and sell orders are matched automatically according to set criteria of time and price prioritization.
• Electronic Communication Networks (ECNs): Systems that directly connect buyers and sellers thus facilitating anonymous trading which costs less compared to using traditional exchanges.
• Prime Brokerage Infrastructure: These are the main brokers of institutional clients and offer a variety of services to them such as executing trades including clearing, settling, and custody of the trades.

They frequently provide access to a wide range of liquidity providers via a single access point.

• Liquidity Aggregation Along with Routing: To achieve the most favorable pricing as well as optimal execution quality, buy-side clients and brokers use liquidity aggregation services which consolidate quotes from numerous LPs.

We should also differentiate between the institutional and retail market models.

• Institutional Markets: Defined by larger order volumes, access to interbank FX liquidity, and more advanced execution strategies. Market participants usually connect via prime brokers, ECNs, or directly with Tier 1 LPs.
• Retail Markets: Generally characterized by smaller order volumes and access via retail brokers who aggregate liquidity from a limited number of providers. Execution may be indirect and involve dealing desks.

Soft-FX Solutions: Bridging Buy- and Sell-Side Needs

Liquidity in Crypto vs. FX: What’s Different?

While liquidity principles have universal application across various asset classes, the dynamics of cryptocurrency markets vary quite a lot in comparison to the FX markets:

• Market Venue Fragmentation: The crypto markets are fragmented due to having several exchanges and trading platforms leading to dispersed liquidity.
• Absence of Centralized Clearing: The greater portion of the crypto market lacks a central clearing mechanism which introduces counterparty risks and impacts the efficiency of liquidity provision.
• The Increased Use of Internalization & Synthetic Liquidity Models: Fragmentation due to regulatory conflicts has resulted in more synthetic liquidity solutions alongside broker-driven internalization models for crypto.
• How Soft-FX Caters to Both Ecosystems: Soft-FX adapts for both domains and provides ultimate tailored solutions for FX and crypto environmental differences.

Trends and Innovations in Liquidity Infrastructure

Technological progress along with shifting market frameworks continues to foster change within the landscape of liquidity provision and consumption:

• AI Algorithms for Execution: The adoption of artificial intelligence and machine learning is rapidly accelerating within the field of execution algorithm design, enabling the development of systems capable of real-time market assessments.
• Comparison of DEX and CEX Liquidity Models: The decentralized exchange (DEX) model is disrupting centralized exchange (CEX) models with new automated market makers (AMM) liquidity provisions.
• Institutional Engagement with DeFi: More mature elements of decentralized finance (DeFi) are attracting greater interest from institutional participants, which may lead to the incorporation of DeFi liquidity pools into conventional trading systems.
• Prospects: Tokenized Order Books and Hybrid Liquidity Models: We can expect new hybrid models combining the best attributes of centralized and decentralized systems to emerge.

Conclusion: Building Liquidity-Resilient Platforms

In every trading business, regardless of being on the sell or the buy side, success requires access to liquidity. Focusing on execution quality when routing orders is most key to transparency and security in the liquidity solution.
On the other hand, however, partial liquidity consistent access is offered by Soft-FX including strong risk management tools and their uncomplicated connecting system.

FAQ's

Q1: What’s the difference between buy-side and sell-side liquidity?
A layman in the buy-side aims to execute orders while the sell-side claims to provide liquidity through prices and fills the orders. Differing motivational incentives exist for each side.

Q2: How can brokers ensure access to deep liquidity?
A: Best execution while obtaining partial fills is possible if a liquidity bridge aggregates prioritizing best quotes from partially filled multiple LPs.

Question 3: Why is liquidity different in crypto markets?
A: Extreme decentralization within cryptocurrency poses challenges requiring aggregate smart routing enhancing execution precision.

Question 4: How does Soft-FX help trading businesses?
A: Soft-FX constructs arrangements with their clients for liquidity sourcing, advanced order routing, aggregation, and execution placing clients at a beneficial position.