The definitions of both liquidity and liquidity provider are always an issue of much debate and often confusion. I've always believed the best definition of liquidity is the ability to transfer an asset into cash (or the other way around). In the context of an exchange, the best measure would be the depth of an order book and how much it would cost to buy or sell a certain number of securities, or in other words the price impact of selling a certain number of securities. Many people confuse this concept with volume, the number of securities traded times the price, which is very different.
When someone enters a limit order on the exchange that doesn't immediately execute (often called a 'passive order' or a 'non-marketable limit order') this action clearly 'adds' to liquidity. It is therefore often called a 'liquidity adding' order. When someone enters an order on the exchange that does immediately execute than that action will remove liquidity. (That is obviously unless the order that was entered is larger than the order that was removed, in which case it could still add to liquidity.
Where it gets truly confusing, even to some experts, as this twitter exchange shows , is when we use the term 'liquidity provider'. This is because a liquidity provider will both add to and also remove liquidity, sometimes evenly spread across their activities.
As an 'upstairs trader' with Goldman Sachs in New York, trading NYSE and Nasdaq stocks in the mid-nineties, I would make markets to clients as well as on the exchange. If a client traded against my price, I would ultimately liquidate any resulting positions by selling against passive orders on the exchange, or any other bids I could identify. Now in the strictest terms, that latter action removed liquidity. Yet, my activities back then were called 'liquidity providing' (or 'market making'). When I was head of European shares trading 8 years ago in London for the same firm, we were pricing blocks of shares for institutional and corporate clients and thereby assuming the risk, an activity sometimes also called facilitation or again 'liquidity providing'. We would often unwind these resulting positions by 'removing' liquidity. That is what a liquidity provider does, he transfers risk from those who cannot bear it to those who want to assume it. Call me old-fashioned, but I think it is rather obvious that liquidity providers need to unwind their positions as well. Otherwise these positions become unmanageable. (In fact, the Volcker rule will make it more difficult for market makers to keep positions for extended periods of time, but that is a different discussion.) The same is true for modern electronic market makers (luckily I have been able to keep up with the times).
Electronic market makers enter passive orders onto the exchange and by doing this add liquidity. Sometimes, they will liquidate any resulting positions and by doing this remove liquidity. Sometimes they may value a security at a higher price than the best offer in the market and the liquidity provider's best bid may again remove liquidity. These actions create pricing efficiencies and I would still characterize them as 'liquidity providing', because they operate in exactly the same manner that traditional liquidity providers have always operated in.
Perhaps there is some logic to this as the word 'adding' is quite different from the word 'providing'. Purely theoretically the word 'provide' (furnish, accommodate) could also imply accommodating liquidity that was already there, i.e. removing it. But that is just semantics.
The views expressed in this blog post are the personal opinions of the author and do not necessarily reflect the official policies or positions of the FIA European Principal Traders Association or the Futures Industry Association.
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