If you’ve been searching for the best forex broker to trade with, you’ve probably noticed that most claim to have the deepest liquidity, tightest spreads, or best execution. But what exactly does liquidity mean for you? How can currencies not be liquid when the very definition of liquidity is how easily an asset can be converted into cash, and cash is the most liquid asset? This article explores the concept of liquidity, explains where forex liquidity comes from, and describes how brokers vary in terms of liquidity and execution. Be careful of Forex scams, and be careful investing more than you are willing to lose. Forex is hard; be vigilant.
What is liquidity?
Liquidity is the ease with which an asset can be sold for cash. For example, real estate is not a liquid asset because it can take several months to complete a property sale. Whereas Apple (AAPL) shares traded on the NASDAQ exchange are considered highly liquid, with over 65 million shares traded on Friday, the 5th of November 2021, executing a transaction to sell 10 AAPL shares would take less than a second.
Market liquidity is the ease with which an asset can be sold for cash at a reasonable price without impacting the underlying market. For example, selling one property will not collapse the housing market, nor will selling ten shares of AAPL collapse the stock market. However, selling a property quickly might require selling at a below-market price, whereas selling AAPL shares can be quickly sold at the market price.
Another factor impacting liquidity is the asset volume you intend to sell. Suppose you owned 50 apartments in a complex of 100 units or 30 million AAPL shares and wanted to liquidate the assets as soon as possible; in both examples, you’d have more supply than there is demand at any given time. You would drive down the price to quickly liquidate either of the assets. Therefore, volume impacts liquidity.
For an asset to be considered liquid, it must have the following characteristics:
- It can be easily converted into cash within a couple of days
- You do not need to sell the asset at a below-market price or pay a premium to sell it quickly
- There is a high level of demand, meaning if you sell the asset, it will not impact the market
What is liquidity in Forex?
In the forex market, liquidity refers to the ability to liquidate a position and return the used margin and any unrealized profit or loss to your trading account, which you can then withdraw from your trading account.
Suppose you open a long (buy) position for 5,000 EUR/USD. You will not have any issues opening (buying) or closing (selling) 5,000 euro with any forex broker. Even if you’re trading a South African rand against the Japanese yen, small order sizes are unlikely to get rejected or move the market, even slightly.
The situation looks very different when you start thinking about larger orders, such as tickets for 3,000,000 (30 lots).
When you see bid (sell) and ask (buy) prices in a trading platform, you’re looking at the top of the book prices, which means the best bid and best ask prices at any given moment. Behind the top-of-the-book price is an entire order book of different bids and offers. The contents of the order book are known as the depth-of-market.
See below an example of an order book for EUR/USD.
| Bid | Ask |
| 100,000 @1.15890 | 100,000 @1.15892 |
| 300,000 @1.15888 | 200,000 @1.15894 |
| 500,000 @1.15886 | 500,000 @1.15895 |
| 800,000 @1.15883 | 1,000,000 @1.15897 |
| 1,000,000 @1.15880 | 1,500,000 @1.15899 |
| 1,500,000 @1.15878 | 2,000,000 @1.15903 |
As you can see in the example above, the asking price to buy 100,000 (1-lot) EUR/USD is 1.15892. Suppose you wanted to buy more than 1-lot. In that case, your order will sweep multiple tiers from the order book and be executed with a volume-weighted average price.
An order to buy 30 lots of EUR/USD would sweep five levels from the order book.
- 100,000 @1.15892
- 200,000 @1.15894
- 500,000 @1.15895
- 1,000,000 @1.15897
- 1,200,000 @1.15899
This 30-lot transaction would result in a volume-weighted average price of 1.15897, five points worse than the top of the book price of 1.15892. Another way of looking at it is an increased purchase price of $150.
Where does forex liquidity come from?
Liquidity is an abstract concept in the forex market. Every forex broker essentially has its own broker, or brokers, to execute some, or all, of its clients’ orders. A brokers’ broker is called a liquidity provider.
Many forex brokers claim that their liquidity providers are tier-one market-making banks such as Citibank, Barclays, Deutsche Bank, BNP Paribas, HSBC, UBS, Commerzbank, etc. In reality, forex brokers don’t have the balance sheet to trade directly with tier-one banks. Therefore, retail forex brokers use prime brokers or prime-of-prime brokers.
For example, let’s consider that the minimum order size Barclays would accept is 1,000,000, and the minimum deposit is $100,000,000. Most forex brokers can’t meet those requirements. So, a prime broker steps in to meet those requirements and tells its customers the minimum order size they accept is 100,000, and the minimum deposit is $1,000,000. Some brokers can meet those requirements, but not all.
Therefore, a prime-of-prime broker steps in to meet those requirements and tells its customer the minimum order size they accept is 1,000, and the minimum deposit is $50,000; all brokers can meet that requirement.
Besides tier-one market-making banks, there are other venues where liquidity is created. There are several forex exchanges, which are multilateral trading facilities known as forex ECNs. Organizations participating on a forex ECN can be retail forex brokers, hedge funds, prime brokers and even tier-one market-making banks.
Final thoughts on forex liquidity
As you can see, forex liquidity is indeed an abstract concept with many parties involved. If your broker is using A-book execution and you place a small order for 5,000 units of currency, there is a long journey for that transaction to go on before it gets anywhere near the tier-one banks that many brokers flaunt on their websites. If you want to trade with the big banks, you’ll need hundreds of millions of dollars just to open one account.
Before investing in Forex, learn as much as you can and be careful investing in Forex. How Forex Brokers Execute Your Orders. This post was written with Fiverr by Winston Thesis. I hire Fiverr writers to write posts on areas they are proficient in so that we can all learn more. Subscribe for more investing posts. Have a lovely day.
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