Liquidity is an essential concept in finance. Liquidity is the ability of assets to be converted into cash. In the forex market, liquidity directly determines risk and return for investors. So what is forex liquidity? What are the characteristics of liquidity in the forex market? Also, what does it mean for investors?
What is forex liquidity?
Forex liquidity is the ability to trade, buy and sell currency pairs on the market without significantly changing the exchange rate.
Compared to other financial markets, forex is the most liquid market, with a daily trading volume of over $5 trillion, 24/5 trading time, and the number of participating investors entering the market is the highest.
Investors participate in the forex market through brokers. Therefore, although the forex market is highly liquid, each broker offers different liquidity to traders.
Liquidity of forex brokers
A broker with good liquidity is reflected in 2 aspects: large trading volume and low spread between bid and ask prices.
The liquidity of a forex broker depends to a large extent on the liquidity provider. Liquidity providers are institutions that trade with large market volumes. Such institutions can be banks, investment funds, credit unions, hedge funds, forex brokers. Retail traders also provide a small part of the liquidity to the broker.
The role of the liquidity provider is to ensure price stability. A liquidity provider holds positions in large volumes and is available for trading with investors’ positions in the market.
The main provider of liquidity in the foreign exchange market is called Tier 1. Tier 1 in the market includes Deutsche Bank, HSBC, Citibank, Bank of America, JPMorgan Chase, UBS…
A forex broker has high liquidity when connecting with many large liquidity providers, allowing investors to trade quickly at the best prices in the market.
Liquidity of currency pairs
Not all currency pairs are highly liquid. The majors are the most fluid, followed by crosses and then exotic.
Major currency pairs have the most liquidity because they are popular and are therefore the most traded. Therefore, the spread of these pairs is the lowest. For example, EUR/USD, USD/CAD, GBP/USD, USD/JPY…. These pairs can be bought and sold in large volumes without a significant difference in the exchange rate.
In contrast, exotic pairs have the lowest liquidity due to the interest of a few people, low trading volume. Therefore, the spread of exotic currency pairs is the highest. Some exotic pairs have low liquidity, such as PLN/JPY, NOK/SEK…
The importance of liquidity in the forex market
A highly liquid market is better than a low-liquidity market. Investors will get more benefits:
Save on transaction costs
A highly liquid market has many buyers and sellers, sellers will have to offer the most competitive prices, and buyers will be able to buy at the prices they expect. Investors to trade with low spreads. In addition, it also shows fairness and transparency for the market.
The market has high liquidity has a huge trading volume. It is difficult for an organization or individual to place orders with a large volume to manipulate the price.
Fast command execution
In a highly liquid market, positions are executed more quickly due to a more significant number of buyers, sellers, and excitement.
What is liquidity risk in the forex market?
When the forex market is illiquid, trading currency pairs is difficult. If the forex market suddenly loses liquidity, traders’ investment accounts are at risk.
Example of the Swiss franc (CHF) crisis of 2015. This statement made it impossible for the interbank market to value the franc. As a result, forex brokers cannot provide liquidity for CHF. When the interbank market started pricing again, the EUR/CHF rate went too far. This liquidity risk causes excellent damage to traders trading CHF. EUR/CHF fell from 1.20090 to 0.97401 in a single day. At one point, the EUR/CHF rate fell to 0.84999. With this drop, many accounts were burned or were unable to recover. Because after the crisis, the EUR/CHF rate never rose to 1.20,000.
Liquidity risk in the forex market is dangerous. Investors should only use low leverage and set stop loss to protect their accounts and manage liquidity risk.
The above article explained liquidity, its liquidity characteristics and its risks in the forex.
A forex trader should choose to trade on highly liquid assets. This helps reduce risk and save on transaction costs. Liquidity is significant for financial markets. When deciding to invest, liquidity is the first factor considered.