Liquidity providers in the financial markets usually function as “market makers” who hold a substantial amount of a financial asset. Liquidity providers aim to bring price stability to the markets by ensuring proper distribution of these assets to brokerages and other institutional investors.
The foreign exchange or forex market sees daily transaction volumes of over £5.5 trillion. Its liquidity is unmatched by other capital markets around the world. So, what is liquidity in forex?
Forex Liquidity
Liquidity in the forex market is defined as the ability of a valued financial instrument to be converted into currencies within a specific period of time. The availability of liquidity providers makes the market deep and smooth. Traders are able to get in and out of positions quickly because there is a high availability of currency reserves. This is desirable for every player in the market, since greater liquidity means lower spreads and trading costs. As a result, this facilitates price stability. The forex market can absorb large orders without affecting the price of any currency.
A non-liquid market would be volatile and have price gaps. Various events, such as unexpected news releases, economic reports, wars and political instability, can lead to liquidity issues in the forex markets too. This further highlights the necessity of liquidity providers in forex, since they provide liquidity under all market conditions. They undertake a substantial amount of risk and use the information available to them to offer competitive spreads.
How do Liquidity Providers Make Money?
Forex liquidity providers make the market smoother and more robust to handle high trade volumes. What do they get in return?
Liquidity providers are compensated in the form of a differential between the bid and ask price of a currency pair. This is known as the dealing spread, and a liquidity provider charges it as compensation for providing access to liquidity as a service. Individual traders, unless extremely wealthy, will mostly likely use services from Tier-2 liquidity providers. The STP/ECN (straight-through processing/electronic communications network) DMA (direct market access) provider will create the lowest possible spread, on the basis of quotations from Tier-1 providers, and add their own commission to the inter-bank spread data. These commissions are reflected on trading platforms.
Why is it Important to Choose the Right Liquidity Provider?
Market depth describes the amount of trade volumes that can be executed at a given price level. Lower volumes are associated with prices closer to those of the current rates, while the farther we move from these rates, the greater is the volume increase. Brokerages connected to a large number of liquidity providers will have a suitable “market depth”. This translates to less slippage for traders. Slippage is a measure of the difference in price of trade execution compared to that of entering a transaction. The amount of slippage ultimately adds to the cost of trade. The speed of a trading platform is also a factor in avoiding slippage.
Thus, brokers who have partnered with high quality liquidity providers and robust trading terminals are usually preferred by traders in general.
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