What is forex liquidity? What is liquidity risk in the forex market?
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Liquidity is an essential concept in finance. Liquidity is the ability of assets to be converted to 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? Moreover, 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 more than 5 trillion USD, trading time 24/5, and the number of participating investors’ market entry 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 the 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 volumes of the market. Such institutions can be banks, investment funds, credit unions, hedge funds, forex brokers. Retail traders also provide a small portion 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 to trade with investors’ positions in the market.
The leading liquidity provider 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 it links with many large liquidity providers, enabling investors to trade quickly at the best prices in the market.
Liquidity of currency pairs
Not all currency pairs are highly liquid. Majors are the most fluid, followed by crosses and then exotics.
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 few people’s interest, 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…
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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 transaction costs
A highly liquid market has a lot of 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. Besides, it also shows fairness and transparency for the market.
Anti-price manipulation
The market has high liquidity has an enormous 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 2015 Swiss Franc (CHF) crisis. 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 who are trading CHF. EUR/CHF dropped from 1,20090 to 0.97401 in just one day. At one point, the EUR/CHF rate fell to 0.84999. With this drop, many accounts were burned or were not able to recover. Because after the crisis, the EUR/CHF rate never rose back to 1,20000.
Conclusion
Liquidity risk in the forex market is hazardous. Investors should only use low leverage and set stop loss to protect their accounts to manage liquidity risk.
The above article has explained liquidity, its characteristics of liquidity, and its risks in the forex market.
A forex trader should choose to trade on highly liquid assets. That helps to reduce risk and save on transaction costs. Liquidity is significant for financial markets. When deciding to invest, liquidity is the first considered factor.
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