Liquidity on the currency market: what is it

One of the advantages of the currency market that attracts many traders is its high liquidity. A proper understanding of liquidity helps traders to choose an appropriate trading strategy, the most profitable asset and to make a profit. 

 

What is the liquidity on the currency market? Why it is important? How do liquid currencies differ from illiquid currencies? Also, what affects the liquidity of the currency market? Read on to learn the answers to these questions.

What is liquidity in the foreign exchange market

The definition of liquidity refers to the ability to liquidate (sell, exchange) an asset for another in a short period of time and without a strong impact on the price. That is, there is a high supply and demand for the commodity/asset. 

 

For example, imagine that you have a modern and powerful computer that is popular in the market. At any time, you can sell it without a strong decrease in price, because there is a demand for it. Thus, we can conclude that a modern and powerful computer is a liquid commodity that you can buy and sell at any time, because there are enough buyers and sellers in the market. 

 

Now let's go from the other side. Imagine that you have an old granny's desk, with scratches and peeling paint. Sell it quickly and at the desired price will not work. Most likely, you will have to lower the price several times to sell it. Thus, we can conclude that grandma's old table is an illiquid product, because there is no demand. There are more sellers than buyers in the market. 

 

Let's return to the foreign exchange market.

 

Liquidity in the currency market means the ability of a currency pair to be traded (bought/sold) without significantly affecting the exchange rate. Liquidity determines how many traders are actively trading and how many currencies are traded. One of the reasons why the currency market is considered the most active is that you can trade 24/5. In addition, the currency market has a daily turnover of nearly $6 trillion. 

 

The liquidity of the currency market changes as traders move from the most liquid currency pairs to secondary or exotic ones. 

 

Highly liquid currency pairs can be defined as currency pairs that can be bought/sold in significant volumes without greatly affecting their exchange rate. 

 

 

Low liquidity currency pairs are those that cannot be bought/sold in significant volumes without a significant influence on the exchange rate. This may be an exotic currency pair as PLN/JPY, NZD/SGD or AUD/MXN. 

How do high liquid currency pairs differ from low liquid ones?

There are four factors that distinguish a highly liquid currency from a low liquid one.

 

1. Small Spread. The spread is the difference between the purchase price of the asset and the sale price. If the currency is not of interest to buyers, the seller will be forced to lower the price until it is bought. 

2. A lot of information about an asset. Analysts often write about liquid currencies, publish statistics on their prices and the factors that have influenced them.

3. Quotes are formed by the market. Quotes for highly liquid currencies are determined by the supply and demand ratio. Illiquid or illiquid currencies are regulated by central banks of countries. 

4. Economic development. Low liquid currencies are usually the currencies of underdeveloped countries. Unlike the highly liquid currencies of the dollar, euro, and others. 

What does the liquidity of the foreign exchange market depend on?

 

Liquidity in the currency market depends on a large number of different factors. For example, interest rates, central bank news, introduction of new regulations, and the economic situation in the world. Let us take a closer look at the most important factors which influence the liquidity of the currency market. 

 

1. The volume of demand and supply. Increase in demand and supply of the currency depends on the activity and volume of trading on the market. When few buyers are involved in trading, the seller is forced to reduce the price of the asset and wait a long time. The fewer participants are involved in transactions, the less liquid the currency is. 

 

2. Trading session. To some extent, the activity and liquidity of the currency market is determined by the trading session. For example, trading in Japanese yen is most active during the Asian session, when it is daylight saving time in the region. In the whole currency market, the most active liquidity is observed during the European trading session.

 

3. Force majeure (economic crisis, global upheavals, news, changes in the central banks). All these factors have an effect on trading activity, volumes of transactions and, consequently, currency market liquidity.

 

4. Holidays, seasons of the year. Trade days affect the volume of transactions and trading activity. For example, trading volumes decrease before holidays or during vacations, and with them comes liquidity. 

The importance of liquidity on the currency market

The importance of liquidity in the currency market is that investors get the opportunity to trade (buy, exchange, sell) currency quickly. The main advantage an investor gets when trading on the highly liquid market is that no major player on the market is able to significantly affect the exchange rate. Therefore, the high liquid currency market carries fewer risks for investors due to higher predictability.

 

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