Crypto liquidity provider

A market maker posts buy and sell orders on the order book of an exchange all the time and earns the spread between them. A liquidity provider in the institutional sense answers requests from known clients with quotes that only those clients can accept, usually through a request-for-quote system, a chat or a price stream over an interface. Many firms do both, and the two activities feed each other with prices and inventory.

In token markets the term liquidity provider has a third meaning. A liquidity provider on a decentralized exchange deposits two tokens into a liquidity pool and earns a share of the trading fees, which is a passive investment in the pool and carries the risk of losses when the prices of the two tokens move apart.

A request for quote, or RFQ, is the usual route for a block trade in crypto, and it runs in four steps:

1. The client asks for a price, for example to buy 50 bitcoin against euros.
2. The provider returns a firm price that is valid for a short window, often a few seconds.
3. The client accepts, and the trade is agreed at that price.
4. Both sides settle, with the client delivering euros or stablecoins and the provider delivering the bitcoin.

A fund then documents the execution: the manager compares the price with the market at that moment, and the depositary and the custodian confirm that the assets arrived in the wallet of the fund. Banks and brokers often route such trades through an OTC desk, which asks several providers for quotes at once.

Slippage is the difference between the price a trader expects and the price at which the order actually executes. On an exchange, a market order for a large amount takes the best offers in the book first and then fills at worse prices further away, so the average price moves against the buyer. A firm quote from a liquidity provider removes that uncertainty, because the provider fixes the full price before the trade. On a decentralized exchange, the user sets a slippage tolerance, a maximum deviation beyond which the transaction fails.

A provider that delivers bitcoin before it receives euros carries the risk that the client never pays, and the client carries the reverse risk when it pays first. Firms reduce that risk with prefunded accounts, credit lines between known counterparties, or off-exchange settlement networks such as ClearLoop of Copper, where both sides keep their assets with a custodian that settles the trade.

On-chain transfers are final once the network confirms them, so the controls come before the transfer. Counterparty wallet addresses are whitelisted in advance, the ownership of each address is verified, and a change of settlement instructions triggers a delay and a call-back to a known contact. Between regulated firms the travel rule also requires the names of sender and recipient to travel with each transfer.

In the EU a firm that quotes clients and trades with them from its own book provides the exchange of crypto-assets for funds or for other crypto-assets, and it needs a license as a crypto-asset service provider. Article 77 of MiCA requires such a firm to publish a non-discriminatory commercial policy, to publish a firm price or the method for determining it, and to execute client orders at the price displayed when the order became final. The firm also publishes the volumes and prices of the trades it completes, and the market abuse rules of MiCA apply to its trading.

The provider earns the spread between its buy and sell quotes, which widens with the size of the order, the volatility of the asset and the inventory it already holds. For brokers and exchanges, some providers work under fee or rebate agreements instead. A fund asks several providers for quotes at the same moment to check that its price is fair, which is how it shows best execution to its investors and its supervisor.