Liquidity is an economic indicator that shows how quickly you can sell the asset at the closest prices to the market. High liquidity shows that the product is in high demand and is easy to exchange for other assets (often for money). Liquidity of the market is characterized by an ability to absorb price fluctuations during changes in demand and supply. This ability depends on the number of market participants willing to carry out operations of purchase and sale.
Factors that affect liquidity of the foreign exchange market
The foreign exchange market is the most liquid on the planet, and this is justified by several reasons:
- presence of many various market participants, including large banks, government agencies and intercontinental corporations;
- round-the-clock functioning of the market;
- huge turnover, several times surpassing the volume of trade on stock exchanges;
- exceptionally high liquidity of the currency.
Supply and demand in the foreign exchange market are huge. Each participant, seller or buyer, can meet their currency requirements in just a few minutes. Because of this, there is a minimal difference in prices for the buying and selling money in the financial market.
On the other side, liquidity of the currency market is unstable. It changes depending on trading activity at certain times of the day. Maximum amount if the financial instruments' sales usually occurs during the London session in Forex. At this time, all players conducting operations with the most popular currency pair EUR/USD start trading. Low liquidity falls in the Asian session due to weak market activity during this period. A similar situation also exists during the holidays or weekends.
Currency with the highest liquidity
In highly liquid markets price moves smoothly, without abrupt jumps. The presence of a large number of buyers and sellers prevent spread increase. Therefore, dramatic changes in the quotes flow do not occur. This situation is typical for the most popular currency pairs:
- EUR/USD consists of the two most prominent world currencies, which are the most commonly used in international transactions and are the tools of foreign exchange reserves formation of many countries.
- USD/JPY – this pair covers almost 10-15% of all of transactions in the foreign exchange market. It’s popular due to active international trade related to the high competitiveness of goods from Japan at a relatively low value of the Japanese Yen.
- GBR/USD – this pair consists of national currency of the countries, which are the largest financial centers in the world.
It is no surprise that the U.S. dollar is included with each of the most liquid currency pairs. It accounts for about 75% of all global trade transactions. Supply and demand for the U.S. dollar is constantly on the highest level because the international trade needs the exchange of huge amounts of money everyday.
Liquidity and volatility
Liquidity of the market does not always mean its high volatility, but rather the opposite. The latter phenomenon is suppressed if there is a huge supply and demand of a particular currency in the market. This situation is typical for a highly liquid market.
Low liquidity in the market involves more chaotic movements. Any important news can cause a surge of volatility leading to a big gap between prices of sale and purchase of currency (spread). In such conditions, it is very difficult to predict the price movement. Therefore, traders have some difficulties making decisions about commercial transactions. Besides, the price jumps have a negative impact on the speed of execution of large positions — in low liquidity it is not always possible to find a sufficient amount of the declared value.
High liquidity of the market shows that players may not be afraid of sharp jumps of the prices. This market is more suited for technical analysis than illiquid market. Besides, even a major player can’t significantly affect the price movement due to a great number of buyers and sellers. Thus, advantages of the highly liquid market are obvious.