Understanding liquidity of Forex Market

Forex traders often come across the concept of liquidity. Currency rates may change under the influence of increased or decreased liquidity. To understand the impact of this factor, you need to know its features as applied to Forex trading. But first, let's figure out what this term means.

Concept of liquidity


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 value of goods. The property of a commodity that determines the possibility of its sale or exchange is called liquidity. If goods are sold quickly at market prices – they are characterized by high liquidity, if there is no demand for the goods — their liquidity is low. The possibility of buying and selling directly depends on the number of market participants. In general, all products are divided into four classes of liquidity: top sellers, fast-sold, slowly moving and hard-to-sell goods. In financial markets, the role of a commodity is performed by various assets, primarily currency, and this is the most liquid product. In the foreign exchange market there is a huge number of sellers and buyers. And the liquidity of the foreign exchange market is estimated by the trading volume and the difference between the purchase and sales prices. The more transactions are made per unit of time and the smaller the difference in prices, the higher the liquidity.

Suppliers of liquidity on the currency market


In the Forex market, daily trading volumes constitute billions of dollars – the liquidity is enormous. The process of trading, however, consists of a huge number of transactions in various currencies. To ensure each specific transaction there need to be a counterparty, ready to buy or sell the right amount of currency. Therefore, a significant part of the participants of the foreign exchange market are large financial organizations, which are called suppliers or liquidity providers. 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 at any time fulfill an application for the required amount. These are intermediaries through which many brokerage companies and private traders trade. Spread and volatility, which are very important for ordinary traders, depend on the level of liquidity that providers can provide.

Liquidity through brokers


Liquidity providers are approached by financial, investment and brokerage companies that serve institutional and private clients. Each of such companies has its own capital, but these funds may be insufficient to fulfill the client's requests. If, for example, there are more applications 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 applications for a wide variety of currencies.

Liquidity in the Forex market can be represented as a multi-level system. At the lowest rung are retail buyers – ordinary traders. Their orders are executed only by intermediaries, companies with various volumes of equity and methods of execution of transactions. These companies can independently execute customer requests or transfer them to a prime broker. Prime broker is the next link in the liquidity system. These are usually larger banks and financial companies. They process orders of their private clients and brokerage companies.

But these financial institutions do not always have the opportunity to enter the interbank market, since the minimum amount of exchange operations on it is $ 5 million. Therefore, there are companies that aggregate liquidity. They play the role of intermediaries between the largest banks and other financial institutions. The largest global liquidity aggregators are Currenex, Integral, CFH Clearing, KCG Hotspot. They unite numerous clients to enter the interbank market. At the top of the hierarchy of suppliers of liquidity in the Forex market are the global giants of the banking industry. The most famous are the American Bank of America, JPMorgani Citigroup, the British Barclays and the Royal Bank of Scotland, the Swiss bank UBS and the German Deutsche Bank. The largest Russian Forex brokers, such as Finam Forex, are consumers of liquidity of the above mentioned institutions.

Effect of liquidity on currency course movements


For an ordinary trader, the amount of liquidity is expressed in the spreads and volatility of currency pairs. In the highly liquid market there are many changes in quotations per unit of time and the price moves slowly, with constant kickbacks. In a low-liquidity market, sharp price emissions occur, 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 the US dollar. Therefore, the most liquid pairs with the dollar and the major world currencies - EUR / USD, GBP / USD, USD / JPY, USD / CAD, USD / CHF, AUD / USD, NZD / USD. The greater the volume of currencies in the market, the closer the prices of supply and demand. This value, called the spread, is the smallest among the most liquid pairs. For example, EUR / USD always has the smallest spread, no more than 2 points. And the spread of the less liquid, exotic pairs can reach tens and hundreds of points.

The Forex market operates around the clock, but liquidity changes during trading sessions, and therefore volatility changes. The main financial centers are located in different time zones and cannot all work simultaneously. During the Asian session, only the exchanges of Japan, Australia, and China operate, providing mainly liquidity of Asian currencies.

Peak activity can be observed during the opening of the London Stock Exchange and the simultaneous operation of American and European markets. With the end of the European session, liquidity drops sharply. Liquidity may also decline during holiday periods and holiday seasons. Such situations are called “thin market”. In a thin market, the price usually moves in a narrow corridor, but price emissions occur in case of unexpected economic news. In periods of low liquidity, it is very difficult to predict price movements and it is undesirable to trade at this time.

Author: Kate Solano, Forex-Ratings.com
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