What is Liquidity in Forex?

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If a trader gets into Forex trading, one of the first advantages they will notice is how much liquidity is available in the Forex market compared to other markets. So, African traders must know, “what is liquidity in Forex?”

As per the triennial report of the Bank of International Settlements, the latest figures are around $5.1 trillion per day in daily trading volumes. Since Forex Liquidity enables easy trading, traders are attracted to the market.

However, specific FX market variances are taken into consideration. Ultimately, this article will comprehensively cover liquidity and liquidity risk within Forex trading.

What is liquidity?

Businessman hand touching LIQUIDITY  button on virtual screen

Assets, securities, and other currencies are liquid if they can be converted into cash and retained as such without adversely affecting their market value. However, cash itself is the most liquid of all assets.

Understanding liquidity

Liquidity, however, refers to a property’s ability to be purchased or sold quickly in the market at a price that is indicative of its intrinsic value. A liquid asset allows for rapid and straightforward switching between assets.

Cash tends to be the most liquid asset. Assets that are tangible, such as real estate, fine art, and collectables, are relatively illiquid. Various financial assets, ranging from equities to partnership units, fall along the Liquidity spectrum.

For example, if someone wants a $1,000 refrigerator, cash is the asset that will allow them to acquire it most efficiently. If the individual has no cash but a $1,000 rare book collection, they are unlikely to find someone who will trade their collection for a refrigerator. When they sell the collection, they will receive cash for the refrigerator.

It may not be a problem if the person has months or years to make the purchase, but it could be a problem if they only have a few days to make it. Then, they may have to sell the books at a discount instead of waiting for a buyer who wants to pay the total price to make a profit. The rarest of books are illiquid assets.

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Types of liquidity

Liquidity can be measured in two ways: by market and by accounting liquidity.

1. Market liquidity

A market’s liquidity is the extent to which assets can be bought and sold safely and transparently, such as the stock market or the real estate market. As you can see from the example above, there is a market for refrigerators in exchange for rare books that, in all seriousness, do not exist.

In contrast, the stock market is known for its high liquidity. Therefore, a high volume of trade on an exchange that does not rely heavily on selling will result in a close match between the bid and the asking price.

By doing this, investors can quickly sell their investments without losing their unrealised gains. The market becomes more liquid when the spread between the bid and ask prices narrows but becomes illiquid when it widens.

The real estate market is typically much less liquid than the stock market. Liquidity on markets for other assets, such as derivatives, contracts, currencies, or commodities, is often determined by how many exchanges are available and their size.

2. Accounting liquidity

Essentially, accounting Liquidity measures a person’s ability to meet their financial obligations based on the number of liquid assets they have available to them – their ability to repay debts when they become due.

Although the collector’s rare book collection is relatively illiquid, his assets aren’t worth their total value of $1,000 in an emergency. Investing liquidity is determined by comparing liquid assets with current liabilities or obligations due within a year.

Several ratios measure accounting Liquidity, each defining “liquid assets” differently. Analysts and investors use these ratios to determine whether a company is liquid. In addition, they serve as a measure of a company’s depth.

Who provides liquidity to the forex market?

What are Liquidity providers in FX? In the currency market, a Liquidity provider is a market maker who works at both ends of the transaction as a professional market maker. For example, liquidity is provided by several different market participants in the Forex market, resulting in more Forex Liquidity.

Examples are central banks, large commercial and investment banks, hedge funds, foreign investment managers, Forex brokers, retail traders, and high net worth individuals. Tier 1 Liquidity providers in the foreign exchange market are considered the best in the business.

Typically, these financial institutions have large Forex departments that provide buy-sell quotes for the Forex pairs that they trade. These banks also provide a range of other services to their clients.

Liquid and Illiquid assets

It is a liquid asset if it can be bought or sold quickly within the market’s trading hours with a minimal loss in value. To identify a liquid asset, one must make sure that buyers and sellers are always available.

Liquidity is similar to market depth but differs from it in that depth refers to the trade-off between assets bought and their prices, while liquidity refers to how fast one will sell an asset versus its price.

Liquidity refers to a readily exchangeable asset without a drastic price reduction; ilLiquidity refers to the opposite. This is because traders are often uncertain about its actual value, or there is no market interest to trade it regularly due to lack of market interest.

A currency is generally considered the most liquid asset on the global financial market, while collectables, real estate, and fine art are considered relatively illiquid.

Majors, Minors and Exotics

Liquidity is one of the factors that help categorise the currencies involved in the global economy based on their relative values. A currency pair can fall into three categories depending on its liquidity: majors, minors, and exotics.

1. Major currencies

The currency pairs listed above are the most popular globally. Due to their massive liquidity, trading is almost always possible at the lowest spreads. US dollars, British pounds, euros, Japanese yen, Australian dollars, Canadian dollars, and Swiss francs are significant currencies.

2. Minor currencies

In the absence of the US dollar, a currency pair is a minor currency pair, also called a cross-currency pair.

3. Exotics

There is a lack of depth in exotic currency pairs, ilLiquidity, and low volumes for exotic currency pairs. South African Rands and Thai Bahts are examples of exotic currencies.

How does liquidity affect forex trading strategy?

It is easier to trade major and minor pairings because they have lower spreads and are easier to understand. In addition, exotic pairs pose a more significant challenge because of their lower liquidity, which attracts higher spreads.

However, if you have a good strategy and are an experienced South African trader, it is still possible to make money trading exotic pairs. Understanding how to trade different assets and benefit from them is essential.

Measuring liquidity

Financial analysts evaluate a company’s ability to meet its short-term obligations via liquid assets. Therefore, the ratio should be greater than one when using these formulas.

1. Current Ratio

Simple and least strict is the current ratio. A current asset is an asset that can reasonably turn into cash in one year against a current liability. Calculations:

Current Ratio = Current Assets / Current Liabilities

2. Quick Ratio (Acid-test ratio)

Quick ratios, or acid-test ratios, are slightly stricter. This excludes inventories, accounts receivable, and short-term investments, which aren’t as liquid as cash and cash equivalents. To calculate:

Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities

3. Acid-Test Ratio (Variation)

Another way to manipulate the quick/acidic test ratio is by subtracting current assets from inventory:

Acid-Test Ratio (Variation) = (Current Assets – Inventories – Prepaid Costs) / Current Liabilities

4. Cash Ratio

One of the most exacting Liquidity ratios is the cash ratio. Liquid assets are defined strictly as cash or cash equivalents, excluding accounts receivable, inventories, and current assets.

An entity’s cash ratio assesses its ability to survive a major emergency, the worst-case scenario. Even highly profitable companies can face financial difficulties if they lack the liquidity to deal with unforeseen events. A cash ratio works as follows:

Cash Ratio = Cash and Cash Equivalents / Current Liabilities

The importance of liquidity in the forex

Business Concept: Close-up the Liquidity button on the keyboard and have Lime, Green color button isolate black keyboard

Liquidity is of vital importance in the Forex market. An important factor that facilitates the creation of attractive rewards for trading is the presence of a liquid market. Forex Liquidity services play an essential role here.

To ensure price stability, Liquidity providers will take positions in foreign currency pairs that can be offset with those of another market maker or added to the market maker’s book to liquidate later.

Some Forex market makers can execute market orders on behalf of their clients and monitor orders and call levels. Tier 1 Liquidity providers will never provide direct access to individual traders. An online broker will be the only way South African traders can access the foreign exchange market.

Most online brokers utilise at least a few Tier 1 Liquidity providers to fill orders and use ECN/STP networks to execute trades. The other brokers operate on a No Dealing Desk (NDD) basis, which means all their trades are transmitted directly to Tier 1 or secondary Liquidity providers.

Dealing desks allow brokers to serve as Liquidity providers by allowing clients to buy and sell on their systems. The broker then takes the opposite side of the transaction, offloading any risk onto professional counterparties. In other words, these companies act as market makers and profit from the fact that most traders lose money when they trade.

The best Forex trading rates and spreads are usually obtained by connecting with several Liquidity providers. In this way, they can offer their customers the most competitive pricing available from multiple Liquidity providers.

What to consider when choosing a liquidity provider?

A broker must assess their own needs and consider several factors to source the best Liquidity provider. Brokers should look primarily at the overall package available regarding what assets and what kind of liquidity are available. The Liquidity provider should offer multi-asset Liquidity and access to the FIX protocol and historical data.

Additionally, it should be possible to open accounts in different currencies. A key consideration is the depth of the market. The depth of the market determines depth and liquidity. More buy orders and more sell orders at each price indicate greater market depth.

Liquidity providers must offer fast executions without requotes or slippage in times of high impact market news. Spreads and commissions a Liquidity provider offers must be competitive, and swaps and commissions should be below without compromising. Liquidity providers must be regulated in the same way as brokers to operate according to the industry’s best practices and that a prime broker backs them.

Lastly, reputable Liquidity providers should be able to provide robust reporting systems that allow them to meet regulatory requirements. These reports often include trade reports, FIX bridges, swaps and rollovers, and order book access. Last but not least, a Liquidity provider should be able to implement FIX protocol and other APIs, MT4 and MT5 bridge connections, and FIX bridges.

FAQs

  1. How does liquidity affect capital markets?

The term liquid refers to an asset that trades frequently. Having many buyers willing to pay the market price for the asset makes it relatively easy to sell. It also means that the price of an asset remains relatively unchanged when selling a large amount of it.

  1. How is market Liquidity measured?

It is the bid-ask spread that is the simplest way to measure liquidity. A small spread indicates adequate liquidity. However, a widespread may indicate insufficient liquidity, especially if an investor needs to unload a large portion of the asset.

  1. What is Liquidity risk?

Liquidity risks fall into two main categories. Firstly, there is the cash flow risk, which relates to whether or not a corporation can fund its liabilities. Liquidity risk is the second.

Bottom line

The liquidity of an asset, or security, is determined by its ease into ready cash without affecting its price. Cash is the most liquid among assets, whereas tangibles are less liquid. There are several types of liquidity, including market liquidity and accounting liquidity. The most common ratios are current, quick, and cash to measure liquidity.

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