Market Makers and Liquidity Providers Explained

Every time a retail trader places an order, someone is on the other side. Understanding who that counterparty is, how they operate, and what motivates their behaviour is directly relevant to the quality of execution a trader receives, the way spreads are set, and why prices behave the way they do under different market conditions.

Market makers and liquidity providers are the firms and institutions that supply the continuous bid and ask quotes that make financial markets function. Without them, a trader wanting to buy EUR/USD would need to find another trader wanting to sell at exactly the same moment and at exactly the same price. The existence of market makers means that a counterparty is always available, at a price, and that price is the spread.

The earlier articles in this series on execution quality, slippage, and liquidity examined what happens to trading costs when liquidity retreats. This article covers the structural reason behind that behaviour: who the liquidity providers are, how they make money, and why their rational self-interest produces the market dynamics that active traders need to navigate.

What a Market Maker Does

A market maker is a firm that continuously quotes a price at which it will buy an asset and a price at which it will sell it. The difference between those two prices is the spread. By standing ready to transact on either side at any time, the market maker provides the immediacy that makes markets liquid: a trader can enter or exit a position at any moment without waiting for a natural counterparty.

The market maker’s revenue comes from the spread. If the market maker buys at 1.08498 and simultaneously sells at 1.08503, the 0.5 pip difference is captured as profit on a matched round-trip. Over thousands of transactions per day, that margin accumulates into a substantial revenue stream.

The market maker’s risk is inventory accumulation. When more traders want to buy than sell, the market maker ends up holding a net long position it did not intend to hold. When more traders want to sell, the market maker accumulates a short position. Managing that inventory and hedging the resulting exposure before the position moves adversely is the core operational challenge of market making.

The spread is the compensation for bearing that inventory risk. When inventory risk is low, the market maker can offer a tight spread. When inventory risk is elevated, because a large directional move is possible or because the market maker has already accumulated significant one-sided inventory, the spread widens to reflect the higher cost of providing liquidity under those conditions.

The Difference Between Market Makers and Liquidity Providers

The terms market maker and liquidity provider are often used interchangeably, but they describe slightly different roles in the market structure.

A market maker is committed to providing continuous two-way quotes in a specific instrument. On regulated exchanges, designated market makers may have formal obligations to maintain quotes within specified spread limits for a minimum period during the trading session. In return for this commitment, they typically receive certain benefits from the exchange, such as reduced transaction fees or priority in the order queue.

A liquidity provider, in the broader sense used in OTC markets such as retail FX and CFD trading, is any firm that supplies bid and ask quotes to brokers. Major banks, electronic market-making firms, and specialised trading firms all function as liquidity providers in this context. They supply quotes to brokers via aggregation platforms, and the broker combines them to construct the price displayed to retail clients.

A retail CFD broker typically accesses liquidity from multiple providers simultaneously and uses technology to select the best available quote from the pool at any given moment. The tightness of the spread offered to the retail client reflects both the quality of the broker’s liquidity-provider relationships and the depth of competition among those providers at the time of the quote.

When volatility rises, and liquidity providers widen their quotes or step back from the market, as covered in here [Why Liquidity Disappears During Market Stress], the broker’s ability to offer tight spreads degrades because the input quotes it aggregates have widened. The retail spread is ultimately a function of the wholesale liquidity the broker can access, and that wholesale liquidity has limits under stress.

How Market Makers Hedge Their Exposure

Understanding how market makers manage their inventory provides insight into why certain price patterns occur, particularly around large trades and during periods of directional market movement.

When a market maker executes a trade with a retail or institutional client, it acquires inventory. A market maker that has sold EUR/USD to a buyer has a short EUR/USD position. To manage that risk, the market maker has two options: wait for an offsetting trade from another client, or hedge the position in the interbank market by buying EUR/USD there.

In liquid markets with balanced order flow, the market maker can often cross the trade internally against another client order without needing to hedge in the external market. The spread earned on both sides represents pure profit with no external execution cost. In directional markets where order flow is one-sided, the market maker must hedge externally, and the cost of doing so in the external market affects the spread it is willing to offer on subsequent trades.

The practice of internalising client order flow, crossing trades between retail clients without going to the external market, is one aspect of the A-book versus B-book distinction in retail brokerage. A broker running an A-book model routes all client orders to external liquidity providers. A broker running a B-book model takes the other side of client trades internally, managing the resulting exposure through hedging or by netting it against other client positions. Many retail brokers operate a hybrid of both, routing larger or more sophisticated orders to the external market while internalising smaller flows.

The model affects execution quality in specific ways. A-book execution means the client’s trade competes with institutional order flow in the same pool, with execution quality dependent on the depth of the external market. B-book execution means the client’s counterparty is the broker, and execution quality depends on the broker’s internal policies around fill rates, slippage, and price improvement.

The Bid-Ask Spread as a Signal

The spread at any given moment reflects the current liquidity and the market maker’s risk assessment. A spread that is tighter than usual signals deep liquidity and balanced order flow. A spread that has widened signals either reduced liquidity, elevated volatility expectations, or one-sided order flow that has increased the market maker’s inventory risk.

Monitoring spread behaviour provides a real-time read on market conditions that complements price action. Before submitting an order in a fast-moving market, checking whether the spread has widened substantially from its normal level is a simple filter that identifies whether the cost of transacting at that moment is elevated relative to normal conditions.

The articles on The Real Cost of a CFD Trade and Understanding Slippage in Fast Markets both noted that the spread is not a fixed cost. It varies with market conditions. The market maker’s behaviour is the mechanism through which that variation occurs. When a market maker widens the spread, it is communicating that providing liquidity at that moment carries elevated risk, and the trader is paying for that elevation whether they recognise it as such or not.

The Role of High-Frequency Trading Firms

High-frequency trading firms have become significant participants in the market-making function across many asset classes, particularly in equities and equity derivatives. They operate at speeds beyond human traders’ reach, executing thousands of trades per second and holding positions for fractions of a second.

Their effect on market quality is genuinely mixed. On one hand, their continuous presence in order books adds liquidity and tightens spreads during normal conditions. They are among the most aggressive providers of tight quotes in liquid instruments, and competition between HFT firms drives spreads tighter than would be possible with human market makers alone.

On the other hand, their liquidity is conditional. HFT firms are among the first to withdraw quotes when conditions become uncertain, contributing to the liquidity retreat that occurs around data releases and during stress events. The apparent depth of liquidity they provide in normal conditions can disappear rapidly when their algorithms detect elevated risk, which is one of the structural reasons why the spread-widening around major events can be both rapid and substantial.

For retail traders, the presence of HFT in the markets they access through CFDs and spread betting is mostly indirect. The HFT activity occurs in the underlying exchange markets and affects the wholesale liquidity that retail brokers aggregate. The tightening of spreads in normal conditions benefits retail traders by improving pricing. The rapid withdrawal during stress events contributes to the cost increases that occur around the events covered in [Reading an Economic Calendar with Precision].

Prime Brokerage and the Institutional Liquidity Chain

The liquidity chain that ultimately delivers a price to a retail CFD trader extends through several layers of the financial system, and understanding that chain provides context for why retail execution quality varies between brokers and why institutional traders access better pricing than retail ones.

At the institutional level, major banks and large trading firms access the interbank FX market directly, transacting at the tightest available spreads with other institutions of equivalent scale. Below that, regional banks and institutional brokers access wholesale pricing through prime brokerage relationships: agreements with major banks that allow them to transact using the bank’s credit and infrastructure in exchange for fees and margin deposits.

Retail brokers access the market below the prime brokerage tier, either through direct relationships with liquidity providers or through white-label aggregation services that compile quotes from multiple sources. The spread available to a retail trader reflects the spread available to their broker, plus the broker’s own margin, which reflects the broker’s position in this access hierarchy.

Brokers with stronger prime brokerage relationships and better access to technology infrastructure can secure tighter wholesale spreads and offer better retail pricing as a result. The execution quality discussion in a previous article [Execution Quality: The Gap Between the Price You Aim For and the Price You Get], identified this as one of the structural factors that differentiates platforms. The institutional liquidity chain is the mechanism behind that difference.

What This Means for How Traders Choose a Platform

The market structure described above has practical implications for platform selection that go beyond comparing headline spread figures.

A broker’s headline spread in normal conditions represents only one dimension of the execution quality it delivers. The depth and quality of its liquidity provider relationships determine how that spread behaves when conditions change. A broker that accesses thin or poorly connected liquidity may offer a competitive normal-conditions spread while delivering significantly wider spreads and higher slippage during the events that matter most.

The relevant questions when evaluating a broker’s execution quality go beyond the spread during a quiet session. They are about how the spread behaves during data releases, how slippage distributes across different market conditions, whether the broker operates a full A-book model or a hybrid, and what the broker’s execution policy states about how fill decisions are made when the price moves between submission and execution.

Most of that information is available in the broker’s published documentation, though it requires more than a casual reading of the marketing materials to locate and interpret it correctly.

The Bottom Line

Market makers and liquidity providers are the infrastructure that enable financial markets to deliver immediacy and price discovery. Their profit motive, the spread, their risk management behaviour, and their selective withdrawal under stress are not arbitrary features of the market. They are the predictable outcomes of rational actors managing inventory risk under uncertainty.

Understanding who is on the other side of every trade, and what determines whether that counterparty can offer a tight or wide price at any given moment, converts market structure from background context into actionable knowledge. The costs that appear as wider spreads and slippage during volatile events are not random. They follow from the same structural logic that produces tight spreads and clean fills during calm ones.

The next article examines [how institutional traders approach risk]: the frameworks, disciplines, and mental models that professional traders apply to managing large positions in volatile markets, and the aspects of that approach that translate directly to retail trading at any scale.

Darren Clarke is a Senior Trader at Lunaro Financial Services. He has spent 40 years on trading desks ranging from institutional inter-bank FX to retail-focused fintechs and brokerages in the City of London.

Disclaimer:

This material is a marketing communication and is provided for general information and educational purposes only. It does not take into account your personal circumstances, objectives or needs. Any opinions are those of the author at the time of writing and may change without notice. Nothing in this material constitutes (or should be construed as) financial, investment, legal, regulatory or tax advice, or a recommendation to engage in any investment activity. You should not rely on this material when making investment or trading decisions.