To explain liquidity provider, we will start with the basic idea of liquidity. Let’s say you want to exchange currency – in other words, buy a certain amount of a particular currency.
In order for you to buy that currency, there must be someone to sell that currency to you. In order to sell the currency, there must be someone willing to buy that currency off of you.
If there are many people that want to buy the currency that you are selling, then it is likely that you will be able to sell. If there are many people selling the currency that you wish to buy, then it is likely that you are going to be able to buy the currency that you want. When there is an abundance of buyers and sellers in the market, it is said that the market is “liquid”.
There is another way in which a market can be liquid. Let’s say that you would like to buy currency, but instead of there being many individuals selling small quantities of currency, there are fewer sellers that are selling larger amounts of currency. The market is still liquid. These sellers that are selling huge amounts are called liquidity providers because they are actually providing liquidity in the markets – large banks or financial institutions that trade currencies on a large scale.
In other words, they are trading such vast quantities of currency that when you sell, you are likely to be selling to a liquidity provider and when you buy, you are likely to be buying from a liquidity provider. They are trading so much money that there is always a party to trade with.
When it is said that a broker will pass your trade on to a liquidity provider, what this means is that the broker will match your contract up with a liquidity provider, such as a bank or another financial institution, to take the other side of your trade.