Market liquidity is an essential prerequisite for successful trading. High liquidity allows easy flow of transactions and makes pricing more competitive. This holds true for the foreign exchange market as well, which determines the relative values of currencies and other related assets. The FX market is one of the most liquid markets in the world, with a daily average turnover of $5.3 trillion. Liquidity in this space is essential to ensure efficiency and conditions favourable for arbitrage in many other markets, such as derivatives and bonds.
This is why understanding the FX liquidity structure is important, not only for trading purposes, but also for risk management. Lack of liquidity leads to erosion of asset returns and high liquidity premium. Several studies have shown financial crises to be closely linked with liquidity drops. For instance, after the collapse of Lehman Brothers in 2008, even the nine most frequently traded currency pairs suffered low liquidity. Specific currency pairs can also face liquidity issues, due to the release of unexpected news or economic indicators, causing spreads to widen.
So, what drives FX liquidity and why is it important to keep track of? Here’s more.
For traders, the number of buyers and sellers present in the market at any particular time is important for fast order execution. The larger the number of participants, the smoother the executions tend to become, at the desired prices. Of course, forex market liquidity varies throughout each trading day, with the opening and closing of global financial centres in their respective time zones. Peak liquidity conditions are usually seen when the European and London markets are open and overlap with timings of the Asian markets, in their morning session. In their afternoon session, they overlap with the New York market session. Liquidity declines drastically following the closing of the European trading sessions, also commonly referred to as the “New York afternoon market.”
During such low liquidity periods, the currency markets are subjected to large and abrupt price movements. Reduced liquidity makes prices react aggressively to market news and rumours. For traders, maintaining positions during times of such low liquidity means greater exposure to volatility risks.
Market holidays, such as Easter and Christmas, also coincide with periods of low liquidity. Typically, the FX market sees low volatility during such times, with rising instances of ranging conditions. Sudden breakouts and trend reversals tend to occur during this time, leveraged by aggressive speculators, such as hedge funds.
So, forex liquidity is a result of a high rate of transactions between many different participants. Apart from the usual market makers, other significant liquidity providers are central banks, major investment and commercial banks, hedge funds, retail forex brokers, retail traders, asset management firms and high net worth individuals. High frequency traders, speculators and currency futures market makers are also providers of liquidity.
Commercial and investment banks come under the Tier-1 liquidity providers. These companies have extensive forex departments, providing bid-ask quotes for all currency pairs they make market in. They usually offer the tightest spreads for these currency pairs, and often resort to trading the pairs on behalf of their clients, rather than depending on just the bid-ask spreads to make profits.
Market makers in prominent commercial and investment banks are primary liquidity providers for the global OTC interbank forex market. They offer bid-ask quotes to both professional and retail client counterparties. The latter sources this quote through their broker’s dealing desk or platform.
Most of this liquidity flows through major financial institutions, such as Citibank, Deutsche Bank, Société Générale, Union Bank of Switzerland and HSBC. They have extensive operations to support their foreign interbank dealers. Due to their involvement in servicing large companies that require foreign exchange transactions, such large commercial banks remain key liquidity providers in the forex market.
Central Banks usually avoid intervening in the forex markets, unless there is a dire need. They provide liquidity to their respective nations through money market operations. They are approached, typically, as a last resort, by commercial banks for loans, which are then passed on to the primary dealers. Sometimes, they interact with several such dealers, to maximise the effect of their trading operations.
For each currency pair, there usually exists one or two primary dealers in the inter-bank market. They are spread across certain global regions. For example, a commercial bank will have a dealer for the GBP/USD pair in London, New York and Tokyo. These dealers pass books from region to region, depending on declining liquidity levels.
Since the trading volumes of tier-1 liquidity providers are always on the higher side, their transactions can affect market supply and demand forces in the short term. This means that the banks and large enterprises can cause changes in market prices.
Unless traders have access to high capital reserves, they cannot reach the Tier-1 liquidity providers. Retail traders seldom have the need to trade in such large volumes, unlike institutional traders. Their access to the forex market is usually via regulated online forex brokers, who are the secondary liquidity providers in the market.
These brokers have access to some of the Tier-1 liquidity providers, such that the higher the number of such providers, the greater are the pricing benefits passed on to the clients. Electronic bridges are established to connect their own or third-party trading platforms with another platform that serves as the ECN. ECN or Electronic Communications Network is a terminal that allows clients direct access to market prices.
Traders usually avoid the usual market maker model, where brokers can have a conflict of interest, trading on the other side of the client. This is one of the many reasons why traders prefer the ECN or STP (Straight Through Processing) model. In such cases, a trader remains assured that the broker will not trade against them and orders will get filled by tier-1 liquidity providers.
Liquidity affects market volatility and, although, a certain level of volatility is necessary for trading opportunities, illiquidity can lead to unmanageable fluctuations. Traders, therefore, need to be mindful of current developments and news events that could result in drastic movements in forex prices.