The Growing Reliance on Non-Bank Liquidity Providers
Current market dynamics provide fertile ground for NBLPs to flourish
Once the arch-enemy of banks, non-bank liquidity providers (NBLPs) are now, more than ever before, a vital source of market liquidity and strategic partners of banks.
Non-bank liquidity providers are entities that provide liquidity through trading activities outside of traditional Tier 1 banking institutions. These entities, which include proprietary trading firms, high-frequency trading (HFT) firms, market makers and electronic trading firms, play a crucial role in deepening market liquidity, facilitating price discovery, reducing slippage and improving overall market efficiency.
Non-bank liquidity providers use advanced technologies and trading strategies to execute trades rapidly and efficiently, contributing to the smooth functioning of financial markets. Some of the biggest players in this sector are firms like Virtu Financial, Citadel Securities and XTX Markets, among others. NBLPs can provide banks with competitive liquidity provision, speedy execution, and better cost efficiency for liquidity sourcing (see more below).
According to Morgan Stanley and Oliver Wyman, non-bank liquidity providers now account for 15 to 35% of volumes in spot FX and developed equity markets. We can see the growing influence of non-bank liquidity providers from around 2016, when Tier 1 banks such as JPMorgan, UBS, Deutsche Bank and Bank of America Merrill Lynch transacted a combined 44.7% of the total spot FX volumes on dealer-to-client currencies (D2C) venues compared to more than 60% in 2014.
Examples of Non-Bank-Liquidity-Providers.
Proprietary Trading Firms:
Engage in trading financial instruments using the firm's own capital.
Employ traders to execute trades across various asset classes.
Utilise sophisticated trading strategies and advanced technologies.
Contribute to market liquidity and price discovery.
High-Frequency Trading Firms:
Specialise in executing a large number of trades at extremely high speeds.
Use automated algorithms and advanced technology infrastructure.
Engage in strategies such as market making and statistical arbitrage.
Provide liquidity, reduce trading costs, and improve price discovery.
Market Makers:
Continuously quote bid and ask prices for a particular financial instrument.
Create a market for the instrument and facilitate trading.
Profit from the spread between bid and ask prices and exchange rebates.
Employ various strategies to manage risk and optimise trading operations.
Electronic Trading Firms:
Execute trades electronically using algorithmic trading strategies.
Access multiple trading venues and execute trades with minimal human intervention.
Engage in market making, proprietary trading, and agency trading.
Enhance market liquidity, improve price discovery, and reduce trading costs.
The rise to prominence of non-bank liquidity providers over the last decade has been driven by technological advancements, market structure evolution, and regulatory changes. Using advanced and often bespoke algorithmic technologies, they execute trades rapidly and efficiently, capitalising on market inefficiencies and arbitrage opportunities. Changes in market structure - such as the rising prominence of electronic trading platforms, greater demand for more niche currencies due to the rise of frontier markets and liquidity fragmentation - have provided fertile ground for them to proliferate. Banks have also seized opportunities to use these alternative sources of liquidity to supplement their own bilateral streaming agreements, hedge themselves or to source liquidity for clients away from the interbank market.
Moreover, regulatory reforms, such as MiFID II, have brought NBLPS into closer regulatory alignment, allowing these liquidity sources to co-exist alongside traditional market makers and banks. However, their operations are more opaque than their banking counterparts because they are not (yet) subject to the same degree of regulation, meaning users can avoid any red tape when using them, thus making them more attractive to use. But this lack of transparency potentially increases the likelihood of systemic risks, which regulators are increasingly wary of.
Nevertheless, non-bank sources are playing a crucial role in meeting a growing demand for liquidity provision in today's global financial markets. By offering continuous liquidity, low bid-ask spreads, and rapid execution services, they support the functionality of markets and can provide some respite, particularly during periods of volatility and uncertainty. Additionally, their cost efficiencies, stemming from lower overhead costs and capital requirements, allows them to offer competitive pricing and reduce trading costs for market participants.
Given the current macroeconomic landscape, it is likely that the use of non-bank liquidity providers may continue to rise. The US Federal Reserve is currently in the process of reducing its balance sheet, after expansionary monetary policy during the pandemic saw it balloon to roughly $9 trillion. It is anticipated that in Q2 2024, around $600 billion in reserves may leave US capital markets, due to security maturation and quantitative tightening. As a result, although the wider impact is generally unknown, constituents in the interbank market may be faced with a tighter liquidity environment.
At the same time, US banks (with more than $100 billion in assets) are also facing new capital requirements, with some banks likely to experience a 16 per cent increase in aggregate capital requirements from 2028, subject to formal approval. This is to improve the stability and resilience of the US banking sector, with the collapse of Silicon Valley Bank last year serving a visceral reminder of the systemic risks within the banking sector. As such, non-bank liquidity providers with less exposure to the actions of the Federal Reserve, but also the evolving regulatory landscape, may play an increasingly vital role in the provision of market liquidity going forward and face increased dependence from bank liquidity providers. As such, we may see their relationship further strengthen.
As such, alternative liquidity providers are becoming indispensable players in modern financial markets, shaping market dynamics, driving innovation, and contributing to the overall efficiency and resilience of the global financial system.
Looking ahead, tokenisation has the potential to revolutionise the way financial assets are traded and managed. NBLPs may play an increasing role in tokenised asset markets, facilitating the trading of tokenised securities, commodities, and other assets. Tokenisation can offer benefits such as increased liquidity, fractional ownership, and 24/7 trading, presenting new opportunities for NBLPs to provide liquidity and market-making services in digital asset markets. Additionally, the definition of non-bank liquidity providers may extend to other more crypto-native entities such as stablecoin issuers, which are increasingly providing ‘off-ramp’ services for tokenised securities. For example, payments technology company Circle allows shares of BlackRock’s BUIDL tokenised fund to be exchanged for the stablecoin USDC, which is redeemable on a one-for-one basis against the US dollar.
Additionally, the emergence of decentralised finance (DeFi) platforms and fintech innovations are reshaping traditional financial services by using blockchain, smart contracts, and decentralised protocols. Alternative liquidity providers are likely to explore opportunities to participate in DeFi ecosystems, providing liquidity, trading services, and market-making activities on decentralised exchanges and lending protocols. Additionally, they may collaborate with fintech start-ups to develop innovative trading solutions, enhance market access, and improve the efficiency of financial markets.