Liquidity’s Role in Smooth Forex Transactions

The technical definition of ‘liquid’ is something that flows freely, with the consistency of water and oil. In a metaphorical sense, the forex market should always operate this way. After all, it’s the largest financial market globally.

One attribute that offers FX this prestige is its liquidity, with trillions of dollars traded daily.

Learn how it contributes to an overall smooth-running market here.

What is Liquidity?

Liquidity in forex trading is the quality that describes the ease at which a currency pair can be traded without drastic price changes. It also refers to the ability to have that particular market converted into cash (or, in the case of an online trader, a profit).

An actively traded pair has a high number of participants, resulting in a liquid market where even the largest transactions can happen without interruption. Meanwhile, an inactively traded pair has a lower number of traders, resulting in a less liquid pair where a large order may bring glitches.

The first contributor to forex’s incredible liquidity is its around-the-clock support, which operates 24/5. Forex is a decentralized or over-the-counter market with four distinct sessions globally. When one session closes, there is always overlap; another session begins to carry on the trading until the next day.

This means that even close to midnight, traders can execute a large order of several lots (or sell a large position) with barely any issues. However, this is the least active time, meaning lower liquidity. 

So, trades of various quantities may occur but would lead to higher spreads because there is lower demand for the period. Meanwhile, a more active session results in tighter or cheaper spreads where supply and demand are balanced.

Liquidity also plays a huge role in volatility, describing the magnitude of price changes. A highly liquid market results in lower volatility, where prices are less erratic. Meanwhile, an illiquid asset can bring about higher volatility, where prices can fluctuate more frequently. 

The Different Types of Liquidity

Let’s now look at the different types of liquidity in forex.

Interbank Liquidity

The highest body in the hierarchy is the interbank market. This is a global network that consists of massive banks, including names like JP Morgan, HSBC, Citibank, and Barclays, along with other large specialist trading firms.

Historically, forex has always been traded through these institutions. They are the original source of currencies, which they trade among themselves and for their clients. The interbank market is the largest liquidity provider (also called a market maker), which then feeds the liquidity to other parties through ECNs (electronic communication networks).

Retail Liquidity

The retail market refers to the segment of forex that involves the average trader and is facilitated by online brokers. When considering retail forex, liquidity is spread in two ways. The first method is through an ECN linked to the interbank using straight-through processing. This means that orders are sent directly to the interbank without intervention.

The second method is through a ‘dealing desk.’ Here, the retail broker is essentially the prime liquidity provider or market maker for traders, and all orders are processed internally with them. They provide prices that very closely align with those of the interbank.

How Liquidity Providers and Brokers Contribute to a Liquid Trading Environment

A key factor in ensuring a liquid forex market is that providers and brokers have the necessary financial resources to meet the demands of even the largest orders. 

Retail brokers that source directly from the interbank need a robust aggregation method to fill every order from their clients with millisecond precision and a competitive price. 

Unfortunately, glitches like slippage in forex can put a spanner in the works. A common solution is to impose a maximum size limit for every trader.

Order books are also essential in maintaining a smoothly operating trading environment. Liquidity providers and brokers rely on algorithms and matching engines to match buyers and sellers. They help those facilitating the traders ensure equilibrium and that a certain forex market has enough depth or volume.

Speculative traders who are keen on order flow strategies will be well-versed in the dynamics of the order book. The purpose is to see the size and number of orders at different prices to gauge sentiment. However, these order books are broker-specific and would only provide a microscopic view of the entire forex market.

The general will want to grasp the concept of liquidity and engage in the most traded pairs to receive the best spreads and entries with predictable movements.

The Benefits of Liquidity in Forex

Liquidity is the glue that keeps the enormous forex market steady. It provides stability, competitive pricing, and the ability to execute even the largest orders at any time of the day.

Although the interbank is the true source of forex, retail brokers exist to lower the barrier to entry, allowing the average Joe to participate. Traders who understand liquidity can decide the level of volatility they prefer based on a particular market and benefit from order flow strategies.