High liquidity is important to all the financial markets and their participants, as it minimizes transaction costs and risks. Some studies associate the lack of liquidity in a market with financial crisis.
The Chase for Liquidity in the Decentralized Forex Market
The Foreign Exchange is an OTC financial market (Over-The-Counter) that operates as a vast decentralized network. In this market, there are many different providers for the same exchange rate, and there is no single quote at any time. Consequently, the quoting for the same pair can vary. That makes the chase for high liquidity even more important.
Liquidity Aggregation
Liquidity aggregation refers to gathering orders from multiple sources and directing them to a large executing entity.
A retail aggregator combines small retail trades into larger orders that can be filled by a large market participant. These larger participants have direct access to the vast liquidity of the ECN network. Retail aggregation offers advantages to every market participant:
- Having access to the best possible spreads at any time
- Trading with a minimal slippage on order execution, especially during news releases
- Easily executing large order sizes
- Continuously diversifying order execution risks via the use of several liquidity sources
Forex brokers can act as retail aggregators to fill their clients’ orders at the best bid-ask at the top of the book. Brokers are using electronic aggregation services to access sufficient liquidity. The software that aggregates all the liquidity from different providers in a single venue is called a Foreign Exchange Aggregator or else an FX Aggregator.
Market Depth
Market liquidity is associated with market depth. The depth of the market calculates how much liquidity is available at various prices and shows the aggregate volume at each price level.
Generally, the depth of the market is based on:
- The number of buyers and sellers
- The size of buyers and sellers
- The existence of market makers
- The participation of institutional traders
The Foreign Exchange Liquidity Providers (LPs)
A Forex liquidity provider (LP) is a participant buying and selling currencies on behalf of others. A liquidity provider facilitates Forex brokers in filling their clients’ orders, but at the same time, this provider can trade its account. Liquidity Providers are usually very large entities such as investment banks, large brokers, and investment firms.
Tier-1 and Tier-2 Liquidity Providers and ECN/STP Forex Brokers
These are the two main types of liquidity providers in the Foreign Exchange market:
(1) Tier-1 Liquidity Providers
Tier-1 liquidity providers include very large banks and organized exchanges such as:
- UBS, Barclays, and Deutsche Bank
- CME Group, CBOE, and ICE exchanges
Moreover, some very large brokers and investment firms that can directly trade on the ECN network can be categorized as Tier-1 providers:
- Forex brokers that can directly trade Tier-1 liquidity are called ECN
- Forex brokers that can directly connect to a large Tier-1 liquidity provider are called DMA
- Only 10% of all financial brokers can directly access Tier-1 liquidity
(2) Tier-2 Liquidity Providers
Tier-2 liquidity providers act as middlemen between Tier-1 entities and brokers. For example, these are Tier-2 liquidity providers in the Forex market:
- LMAX, FXCM Pro, Swissquote, and Currenex
- Forex brokers that access Tier-2 liquidity are called STP
Largest Liquidity Providers in the World
These are some of the largest liquidity providers worldwide.
Table: Largest Liquidity Providers in the World
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Key Takeaways
These are some key takeaways regarding Forex Market liquidity:
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The Foreign Exchange is an OTC financial market (Over-The-Counter) that operates as a vast decentralized network. In this market, there are many different providers for the same exchange rate.
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Liquidity aggregation refers to gathering orders from multiple sources and directing them to a large executing entity.
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A retail aggregator combines small retail trades into larger orders that can be filled by a large institution with direct access to the ECN network.
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Liquidity aggregation offers advantages to traders such as trading in narrow spreads and minimal slippages.
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There are two levels of Forex liquidity providers, Tier-1 and Tier-2. According to the access that they have to these providers, Forex brokers are classified as ECN, DMA, and STP.
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The key liquidity figure is trading volume. High trading volumes indicate an active market with high liquidity.
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Market liquidity is associated with market depth. The depth of the market calculates how much liquidity is available at various prices and shows the aggregate volume at each price level.
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The higher the liquidity in a market the lower the risks. There are studies associating the lack of liquidity with a financial crisis.
■ Foreign Exchange Liquidity and Providers
G.P. for OnlineForex.biz (c) -May 2024