Forex traders often come across the concept of liquidity. Exchange rates may change due to increased or decreased liquidity. To understand the influence of this factor, you need to know its features in relation to Forex trading. 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 value of goods. The property of a product, which determines the possibility of its sale or exchange, is called liquidity. Quickly selling goods at market prices – high liquidity, no demand for goods – low liquidity. The possibility of buying and selling directly depends on the number of market participants. In general, all products are divided into four liquidity classes.
There are the most tradable assets and difficult to sell. The rest is conditionally divided into slowly implemented and quickly implemented. In the financial markets, the role of goods is played by various assets, primarily currency. And this is the most liquid product. In the foreign exchange market, a huge number of sellers and buyers. And the liquidity of the foreign exchange market is estimated by the volume of trades and the difference between purchase prices and sale prices. The more transactions are made per unit of time and the smaller the difference in prices, the higher the liquidity.
FOREIGN EXCHANGE LIQUIDITY PROVIDERS
In the Forex market, daily trading volumes amount to trillions of dollars. This means maximum liquidity. But the trading process consists of a huge number of transactions with various currencies. To ensure each specific transaction, a counterparty is required, ready to buy or sell the right amount of currency. Therefore, a significant part of the participants in the foreign exchange market is large financial organizations, which are called suppliers or liquidity providers. They provide high Forex market liquidity.
Liquidity providers can be Forex banks or ordinary banks, as well as large brokerage companies. They accumulate such volumes of financial resources in different currencies that they can fulfill the application for the required amount at any time. These are intermediaries through which many brokerage companies and private traders trade. Spread and volatility, indicators that are very important for ordinary traders, depending on the level of liquidity that providers can provide.
LIQUIDITY AT BROKERS
Liquidity providers are contacted by financial, investment and brokerage companies that serve institutional and private clients. Each such company has its own capital, but cannot always fulfill the client’s application. If, for example, there are more applications for the purchase of a certain currency than for the sale, 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 applications are executed only by reliable Russian intermediaries, which must be included in a reliable rating of Forex brokers and other Brokers.ru lists. These are companies with various amounts of equity and ways of executing transactions. These companies can independently execute customer applications or transfer them to a prime broker. A prime broker is a next link in the liquidity system. Usually, these are larger banks and financial companies. They process orders from 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 transactions on it is $ 5 million. Therefore, there are companies – liquidity aggregators. They act as intermediaries between the largest banks and other financial institutions. The largest global liquidity aggregators are Currenex, Integral, CFH Clearing, KCG Hotspot. They unite numerous customers 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 the American Bank of America, JP Morgan and Citigroup, the British Barclays and Royal Bank of Scotland, the Swiss bank UBS and the German Deutsche Bank. The largest Russian Forex brokers, for example, Finam Forex – are consumers of the liquidity of the mentioned structures.
THE EFFECT OF LIQUIDITY ON THE MOVEMENT OF EXCHANGE RATES
For an ordinary trader, the liquidity value is expressed in the spreads and volatility of currency pairs. In a highly liquid market, there are many changes in quotations per unit time and the price moves slowly, with constant pullbacks. In the low-liquid market, there are sharp price emissions, and there is a significant change in quotes for 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 American dollar. Therefore, the most liquid pairs with the dollar and major world currencies are EUR / USD , GBP / USD , USD / JPY , USD / CAD , USD / CHF , AUD / USD , NZD / USD . The larger volumes 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, not more than 2 points. And the spread for low-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 work all at the same time. During the Asian session, only the exchanges of Japan, Australia, and China operate, mainly providing liquidity to 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 drops sharply. Liquidity may also decline during holidays and vacation seasons. Such situations are called the “thin market.” In a thin market, usually the price moves in a narrow corridor, but there are price spikes in case of unexpected economic news. In periods of low liquidity, it is very difficult to predict the price movement and it is undesirable to trade at this time.