What it means
A stock exchange needs people willing to buy and sell at all times, otherwise investors struggle to trade at fair prices. Traditional market makers have specific duties to quote prices, but exchanges also use extra participants to deepen the supply of orders.
A supplemental liquidity provider fits into this second group and is usually a high-volume electronic trading firm. The New York Stock Exchange introduced such a role around the time of the 2008 financial crisis, when liquidity in many markets had become thin.
The aim was to encourage firms to place orders at the best available price and to keep doing so throughout the day. In return, the firm received a rebate on trades where its resting order was filled.
To qualify, a firm generally has to meet requirements such as quoting at the best price for a set share of the trading day in a group of stocks. The detailed conditions and rebate amounts are set by the exchange and change from time to time.
A firm that fails to meet them can lose its status or the extra payment. The business model rests on tiny profits repeated millions of times.
The firm earns the bid-ask spread, which is the gap between buying and selling prices, and the exchange rebate, while managing the risk of price moves while it holds shares. Costs include technology, data, exchange fees and capital.
The nuance is that liquidity provided for a rebate can vanish in stressed markets, because firms can withdraw when risk is high. Critics also point out that rebate schemes can distort where orders are sent.
Regulators and exchanges therefore review incentive programmes regularly.
In practice
Real-world examples.
Example
A proprietary trading firm applies to act as a supplemental liquidity provider on a large exchange. Its systems quote at the best price for hundreds of stocks, and it earns a rebate every time another investor trades against its orders.
Example
A pension fund sells $5 million of shares through its broker in a calm market. The presence of liquidity providers means the order is filled in small pieces at prices very close to the quoted price.
Example
An exchange reviews the performance of its incentive programmes after a volatile week. It finds that some providers pulled their quotes during the turmoil, and it considers changing the rules so that rebates depend on quoting under stress as well.
Formula
Calculation
Rebate income = shares executed x rebate per share
Net trading result = rebate income + spread income - costs
Suppose a firm's resting orders are filled for 2,000,000 shares in a day, and the exchange pays a rebate of $0.0015 per share. Rebate income = 2,000,000 x 0.0015 = $3,000. If the firm also earns an average spread of $0.001 per share, that is 2,000,000 x 0.001 = $2,000. With technology and other costs of $4,200 for the day, the net result is 3,000 + 2,000 - 4,200 = $800.Case study
Seen in the real world.
Tidewater Quant Trading is an illustrative, fictional electronic trading firm that decided to become a supplemental liquidity provider for a group of 300 stocks. The finance team built a model to see whether the economics worked after technology and capital costs.
The model projected 40 million shares of filled orders per month with an average rebate of $0.0015 per share, giving $60,000 of rebate income. Spread capture added $35,000, but data, connectivity and staff costs were $82,000, leaving about $13,000 of monthly profit before the cost of capital.
Because the margin was thin, the finance director insisted on risk limits and daily monitoring. In this illustrative story, the programme was profitable but fragile, because it would have lost money if volumes had been a quarter lower. The firm therefore agreed to review the numbers monthly and to withdraw if the margin turned negative for two months in a row.
Watch out
Common mistakes.
- Assuming that a liquidity provider is the same as a traditional market maker, when its obligations and rewards are different.
- Counting only the rebate as income and ignoring technology costs, capital and the risk of price moves while holding shares.
- Assuming that liquidity from such firms will always be there, when it can thin out quickly in stressed markets.
Questions
People also ask.
What does a supplemental liquidity provider get in return?
It typically earns a rebate on orders that are filled, plus the spread between buying and selling prices, if it meets the exchange's quoting requirements.
Why do exchanges use them?
They add extra buy and sell orders at good prices, which makes trading cheaper and smoother for ordinary investors.
Are rebates the same on every exchange?
No, rebate and fee schedules are set by each exchange and change from time to time, so firms must check the current rules.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related