A liquidity provider is a market participant who offers buy and sell quotes on a security to facilitate trading and maintain market order.
Market function and operations
Liquidity providers quote both a buy price and a sell price for financial instruments. These market participants are usually large financial institutions or specialized trading firms. By continuously offering these quotes, they ensure buyers and sellers execute trades without waiting for a matching counterparty to appear organically in the order book.
The profit mechanism for a liquidity provider is the spread. The spread is the difference between the bid price they pay to buy the asset and the ask price they charge to sell the asset. They capture this difference repeatedly during the trading session. They carry inventory risk because the price of the asset might move against them while they hold the position.
This function exists across all major global financial markets. In the foreign exchange market, international banks provide liquidity for currency pairs by quoting exchange rates. In decentralized finance, a liquidity provider is a user who deposits cryptocurrency assets into a smart contract to fund a liquidity pool.
Example
As Elephants building your portfolios, you might look to trade commodity contracts for marula fruit. You place an order to buy 500 marula fruit contracts. Instead of waiting for another trader in the herd to sell exactly 500 contracts at that exact moment, a liquidity provider takes the other side of your trade. The liquidity provider sells you the contracts from their inventory at an ask price of $10.05. Later in the day, a different trader decides to sell 500 marula fruit contracts. The liquidity provider buys those contracts at a bid price of $10.00. The liquidity provider captures the $0.05 spread per contract, and you receive your contracts immediately.