Foreign currency and exchange are combined to form the term “forex” (FX). The process of changing one currency into another is known as foreign exchange, and it typically occurs for business, trade, or travel. In this article, we will learn more about Forex Trading and the importance that liquidity has over it.
Because of the large trade flows in the market, Forex Trading makes it possible for the market to be transparent for all the investors that are allowed interbank deals.
What is Forex Trading and The Forex Market?
Forex Trading is the process of exchanging foreign currencies with one another in the Forex Market. This means that dealers who are allowed to deal with foreign currencies can trade in the forex market.
The easiest way to understand this is if we use an example; Let us say that you are from the UK and want to order a certain product or service from another country, like Germany, where the euro is used instead of pounds.
(Forex trading chart. Source: Forex4you)
In this case, you will have to pay for that service or product in euros. Because your main currency is pounds, that means you or the importer of the product will have to exchange your payment for euros and pay in euros.
Is the Forex Market Centralized?
To answer briefly, no, it is not centralized. The Forex market does not have a central location and, as such, is not centralized, meaning that all trades that happen, happen digitally through traders around the world.
Since it is not centralized, it allows the market to be open for 24 hours for almost five and a half days. When the market is not open in the US, that’s when the market opens in eastern countries like Japan, making it possible to be open for 24 hours.
What is The Forex Market?
The Forex market is where all these currencies are traded. As we said, it is not centralized, so this market is open digitally almost every day. Exchanging foreign currencies is incredibly useful for individuals and businesses.
For individuals, it allows you to buy goods, products, and services across the border in different countries. For example, if you were to visit a landmark or a museum somewhere in Italy and you come from the US, you will not be able to pay for the entry with dollars. Instead, you will have to exchange them for euros.
What is Liquidity in Trading and Finance?
Liquidity shows how active a market really is. The number of traders that are actively trading and the amount they trade at shows the liquidity of a market. Another explanation is that liquidity is how quickly the price or cost of an asset is sold.
This easily allows an understanding of how liquid the Forex market really is. Since the market stays open 24 hours a day, it generates nearly $6 trillion in turnover almost every day. We understand now how deep the Forex market is.
The speed at which a buyer of a physical asset can exchange cash for that asset is a measure of liquidity as well.
Therefore, in a market with perfect liquidity, a buyer wishing to acquire an item with a fundamental value of $500 will be able to do so quickly for exactly $500.
Liquidity in Forex Trading
Forex liquidity is the ability of a currency pair to be bought and sold, and traded, without really impacting the exchange rate to a noticeable level. A currency pair can be presented as liquid enough or that their liquidity is high when they can be traded easily with a lot of activity.
Liquidity is very important in Forex Trading because it allows trading to run more smoothly and also makes the currency prices way more competitive. All around, it creates an environment where trading can go on for 24 hours without problems or issues.
How is The Forex Markets Liquidity so High?
Liquidity providers are those that make sure the liquidity of a market runs smoothly. Liquidity providers are usually brokers or institutions whose job is to make markets, or otherwise known as market makers.
These brokers and institutions work on both ends of the market, in this case, the Forex market, in order to make sure the liquidity volume of the market increases. Some of these participants include banks like those of commercial banks, central banks, retail traders, hedge funds, and more.
Some of the largest investment banks or departmends large enough are usually referred to as Tier 1 liquidity providers.
How Important is Liquidity in Forex Trading?
We went through many reasons why the Forex market’s liquidity is high. We also mentioned that the market is open 24 hours and makes it possible for businesses to work with each other world wide.
At the same time, it helps individuals have it easier in foreign countries. All that said, we have to understand that the Forex market and the volume of its liquidity are incredibly important and cannot be stressed enough.
A liquidity provider needs to make sure that prices are stable and that the market is running smoothly. Usually, liquidity providers make sure that pairs of currencies have stable prices. This is where the need for more liquid providers comes into the Forex market.
Individual traders cannot get direct link to a Tier 1 liquidity provider. Instead, through online brokers, they are able to access the market. Online brokers usually have an NDD basis (No Dealing Desk), which all in all means that all their transactions will first be sent to a Tier 1 liquidity provider before being sent through.
Tier 1 liquidity providers usually have ECN/STP network order access, which allows them to execute trades. This is the reason why online brokers have to send their transactions through Tier 1 providers in order to be executed.
Because of this, we understand that liquidity providers are very important in the Forex market because of its high demand, making the liquidity constantly be in high volume. This makes it possible for the market to be open for 24 hours a day and easily accessible worldwide.
Takeaways
- Foreign currency and exchange are combined to form the term “forex” (FX).
- Forex trading is the process of exchanging foreign currencies with one another in the Forex market.
- The Forex market does not have a central location and, as such is not centralized.
- The number of traders that are actively trading and the amount they trade at shows the liquidity of a market.
- Liquidity providers are those that make sure the liquidity of a market runs smoothly.
