Role And Principles of Liquidity Distribution in Forex

Pavel Satsuk -

Introduction

Liquidity is the most important aspect of the forex market. It is even called the lifeblood of the FX market because it ensures smooth operations in the market. In the forex market, liquidity distribution is king, and without it, forex trading cannot run smoothly and efficiently.

Liquidity distribution is essentially the ease and efficiency with which currency pairs can be bought and sold in the FX market. The FX market can either be highly liquid or low in liquidity. In a highly liquid market, transactions occur quickly without really affecting the exchange rate. This is a result of sufficient demand and supply for different currencies. Therefore, traders can enter and exit various trade positions with minimal price fluctuations. In low-liquidity markets, however, the market has limited supply and demand. This results in a wider bid-ask spread and then slows down trade execution.

Some of the most visible effects of liquidity in a market are:

Lower transaction costs: A bid-ask spread is the difference between the buying and selling price of a currency. A tight bid-ask spread results in lower transaction costs for traders. Therefore, it helps them retain more of their profits.

Effective Risk Management:  In highly liquid markers, traders can easily adjust their positions or exit the marker as soon as possible. This helps them minimize their potential losses and protect their capital.
Enhanced Order Execution: Traders can react quickly to market movements and take advantage of market opportunities. This means they can enter and exit trade positions more accurately and maximize their returns.

Identifying Forex Liquidity Zones

The level of liquidity distribution is not the same across the forex market at all times. The difference in liquidity distribution can be observed in different currency pairs and trading hours. These pairs and times of higher trading liquidity and activities are known as liquidity zones. Traders can leverage their knowledge of liquidity zones to make better decisions on the best entry and exit positions for their trades.

Several factors lead to the existence of liquidity zones, some of them are:

Currency Pair: Ideally, some currency pairs are more popular among traders than others, examples are EUR/USD. These popular pairs are more liquid compared to other currency pairs that are less frequently traded in the market.

Economic Events: Some events and news can significantly impact the liquidity in the market. The public anticipation might lead to increased volatility in the market. Examples of such events are central bank interest rate announcements, announcements of new policies, and so on.
Trading Session Overlap: There has been observed higher market liquidity at the hours when major financial centers like Tokyo, New York, and London have overlapping trading hours.

Types of Liquidity

The importance of liquidity cannot be overemphasized. In the forex market, all the participants contribute to and are affected by the liquidity situation. However, there are three major types of liquidity to be discussed in this article.

Interbank Liquidity: This is derived from transactions directly made by major financial institutions like banks.  This source of liquidity is the principal contributor to the forex market liquidity.

Retail Liquidity: Brokers contribute to the market liquidity by aggregating orders from individual traders and matching them with those of other market participants. This helps retail traders with small order sizes trade in the market.
Market Liquidity: This is the total level of liquidity of a particular currency pair at a given time. It is influenced by interbank and retail liquidity, and sometimes, factors like upcoming events and market sentiments.

Role of Liquidity Providers

Liquidity providers (LPs)  play a significant role in maintaining an efficient forex market. They are intermediates that quote prices for currency pairs and help traders enter and exit trade positions easily. Some of their primary functions are:

Efficient Order Execution: LPs help facilitate efficient order execution by matching traders’ buy and sell orders.

Market Depth: LPs contribute to the volume of outstanding orders at different price levels by actively quoting the bid and ask prices. This volume of orders is known as the market depth and this pool assists traders by providing flexibility for entering and exiting positions.
Price Discovery: The price quoting function of liquidity providers also helps to facilitate price discovery by determining the fair market value of a currency pair.

Types of liquidity providers

Several institutions facilitate seamless order execution and contribute to market liquidity. Some of these providers are:

Tier 1 Banks: This term refers to the most established and reputable global banks. These banks have huge financial resources and therefore contribute significantly to liquidity through interbank liquidity. These banks usually offer tight bid-ask spreads and efficient trade execution. They are the most trusted financial institutions by the general public.

Non-Bank Market Makers: These are other financial institutions that provide liquidity for specific currency pairs and cater primarily to retail traders. They offer competitive spreads and deep-order books. They leverage the use of technology via algorithms to quote prices and manage risks.

Electronic Communication Networks (ECNs): Platforms such as this aggregate buy and sell orders from various participants anonymously and then match the orders electronically. They ensure transparency and promote price discovery.

Retail Forex Brokers: These are intermediaries between individual traders and the market. They aggregate orders from their clients and transfer them to liquidity providers for execution.

Algorithmic and High-Frequency Trading Firms: Some firms use algorithms and High-Frequency Trading (HFT) strategies to take advantage of the market. They contribute to liquidity by continuously quoting prices and executing trades at high speeds.

Factors to Consider When Choosing a Liquidity Supplier

Partnering with a good liquidity supplier is a very important decision for forex traders. Important things to look out for when choosing a liquidity supplier are:

Technology: Find a reliable trading platform with technology like an advanced order execution capability. Check out factors such as routing speed, uptime guarantees, and fill rates.

Regulatory Compliance: Ensure your preferred liquidity provider has an updated license and complies with the provisions of an appropriate regulatory authority.

Trading Instrument: Check if the LP offers your preferred currency pairs and financial instruments.

Reputation: Conduct extensive research on the reputation of the LP.  Check out online reviews, testimonials, industry reports, and so on.

Pricing: It is important to conduct extensive research to compare bid-ask spreads, commission structures, and all other fees across different LPs before arriving at a decision.

Customer Support: No one loves dealing with a terrible customer support system. Confirm that your preferred LP has a reliable and responsive customer support system.

Practical Applications

Strategies for Identifying and Utilizing Liquidity Zones

  1. Identify peak liquidity hours (e.g. when major trading sessions overlap) and conduct most tracers on those hours.
  2. Use technical indicators on the trading platform like volume bars and order book depth to identify areas of high liquidity
  3. Take advantage of the limit order tool to choose your preferred entry and exit prices when trading during periods of low liquidity to minimize the risk of slippage.
  4. Remember to stay up to date with news of upcoming events that can impact market liquidity.

FAQs

Q1: Who are Tier 1 liquidity providers and what distinguishes them?

Tier 1 LPs is the general name given to all large and reputable financial institutions in the world. They are known for offering tight bid-ask spreads and exceptional trade execution.

Q2: What are forex Liquidity Providers (LPs) and how do they function?

Forex LPs are financial institutions that continuously quote bids and ask prices for currency pairs. They help to facilitate seamless order execution and contribute to the market liquidity.

Q3: How do liquidity providers generate revenue in the forex market?

LPs generate revenue through various means such as bid-ask spreads, order flow management, rebates, revenue sharing with brokers, and other optional fees like commitment fees.