Forex Liquidity | What it is?
Forex traders are often confronted with the concept of liquidity. Currency rates may change under the influence of increased or decreased liquidity. To understand the influence of this factor, you need to know its features in relation to trading in the Forex market. But first, let’s figure out what this term means.
As an economic indicator, the term “liquidity” is characterized by its Latin root “liquidus”, which means fluidity or liquid. The concept of liquidity is applied in the field of trade, exchange and the value of goods. The property of a commodity that determines the possibility of its sale or exchange is called liquidity. The goods are sold quickly at the market price – high liquidity, there is no demand for the goods – low liquidity. The possibility of buying and selling directly depends on the number of market participants. In general, all commodities are divided into four classes of liquidity.
There are the most realizable assets and the most difficult to sell. The rest are conventionally divided into slow-moving and fast-moving ones. In financial markets, the role of goods is played by various assets, primarily currency. And this is the most liquid product. There is a huge number of buyers and sellers in the foreign exchange market. And the liquidity of the foreign exchange market is assessed by the volume of trades and the difference between the purchase and sale prices. The more transactions are made per unit of time and the smaller the difference in prices, the higher the liquidity.
Liquidity providers in the foreign exchange market
In the Forex market, the daily trading volume is trillions of dollars. This means maximum liquidity. But the trading process consists of a huge number of transactions with different currencies. To secure each specific transaction, a counterparty is required who is ready to buy or sell the required amount of currency. Therefore, a significant part of the foreign exchange market participants are large financial institutions, which are called providers or providers of liquidity. They provide the high liquidity of the Forex market.
Liquidity providers can be Forex banks or ordinary banks, as well as large brokerage companies. They accumulate such amounts of funds in different currencies that they can fulfill an application for the required amount at any time. These are the intermediaries through which many brokerage companies and private traders trade. Spread and volatility, which are very important indicators for ordinary traders, depend on the level of liquidity that providers can provide.
Liquidity providers are approached by financial, investment and brokerage companies that serve institutional and private clients. Each such company has its own capital, but it cannot always fulfill the client’s request. If, for example, there are more orders to buy a certain currency than to sell, then the balance does not converge and the intermediary buys the currency from the liquidity provider. Only large banks can ensure the execution of orders for a wide variety of currencies.
Forex liquidity can be thought of as a multilevel system. At the lowest rung are retail buyers – ordinary traders. Their orders are executed only by reliable intermediaries in Russia, which must be included in the reliable rating of Forex brokers and other Brokers.ru lists. These are companies with different amounts of equity capital and methods of execution of transactions. These companies can independently execute client orders or transfer them to a prime broker. A prime broker is the next link in the liquidity system. These are usually larger banks and financial companies. They process orders from their private clients and brokerage companies.
But even these financial institutions do not always have the opportunity to enter the interbank market, since the minimum amount of exchange transactions on it is $ 5 million. Therefore, there are companies – liquidity aggregators. They act as intermediaries between major banks and other financial institutions. The largest global liquidity aggregators are Currenex, Integral, CFH Clearing, KCG Hotspot. They bring together numerous clients to enter the interbank market. At the top of the hierarchy of Forex liquidity providers are the global giants of the banking industry. The most famous are American Bank of America, JPMorgan and Citigroup, British Barclays and Royal Bank of Scotland, Swiss bank UBS and German Deutsche Bank. The largest Russian Forex brokers, for example Finam Forex, are consumers of the liquidity of the mentioned structures.
Impact of liquidity on movement of exchange rates
For the average trader, the amount of liquidity is expressed in spreads and volatility of currency pairs. In a highly liquid market, there are many price changes per unit of time and the price moves slowly, with constant pullbacks. In a low-liquid market, there are sharp price spikes, and there is a significant change in quotations over short periods of time.
One of the factors determining the amount of liquidity is the volume of currency traded on the market. Most of the volume is occupied by the US dollar. Therefore, the most liquid pairs are with the dollar and the main world currencies – EUR / USD, GBP / USD, USD / JPY, USD / CAD, USD / CHF, AUD / USD, NZD / USD. The larger the volume of currencies on the market, the closer the supply and demand prices. This value, called the spread, is the smallest for the most liquid pairs. For example, EUR / USD always has the smallest spread, no more than 2 pips. And the spread for low-liquid, exotic pairs can reach tens and hundreds of points.
The Forex market works around the clock, but liquidity changes during trading sessions, and therefore volatility also changes. The main financial centers are located in different time zones and cannot all work at the same time. During the Asian session, only the stock exchanges of Japan, Australia, and China operate, providing mainly the liquidity of Asian currencies.
Peak activity can be observed during the opening of the London Stock Exchange and the simultaneous operation of the American and European markets. With the end of the European session, liquidity falls sharply. Liquidity can also decline during the holiday and vacation seasons. Such situations are called “thin market”. In a thin market, the price usually moves in a narrow corridor, but there are price outliers in case of unexpected economic news. During periods of low liquidity, it is very difficult to predict price movements and it is undesirable to trade at this time.