Liquidity is Key to Understanding the Forex Market

 
Losses can exceed your deposits. Issued by IG markets limited
Liquidity
Liquidity

The Forex Market is probably one of the most misunderstood markets among any asset classes. Without an exchange or any centralized clearing house, Forex invites many misunderstandings.

One of the greatest misconceptions is the liquidity relationship between the Forex Broker and the Bank or Liquidity Provider. You can find many Forex Brokers that are out there promoting a multibank STP setup with over 10 banks and sometimes listing as many as 15 banks. Immediately the trader assumes that the more banks the better the liquidity. In reality, this is not the case. When a Forex Broker establishes a liquidity relationship there are expectations for order flow to that liquidity.

Banks do not like it when lines of liquidity are opened and up and not used. There are also minimum thresholds that need to be met in order to maintain the liquidity relationship. Even large established Forex Brokers would be challenged to do this with over 10 banks in the mix. On average most brokers use no more than 5 to 6 banks. This amount is usually sufficient to cover all of the major pairs and any exotics that the Forex Broker might offer.

The Forex Broker / Bank relationship also involves what are known as liquidity bands. These are the spreads in a particular pair that will widen with an increased demand for liquidity. A bank might offer 0.5 spread on EUR/USD for $5 million a click. If the liquidity demand increases, then the spread would increase as well. The EUR/USD spread might move to 1.5 for $20 million a click. The spread becomes a means to manage and mitigate risk on the part of the bank or LP.

Communication is a key component to the liquidity relationship. The Forex Broker needs to keep the Bank or Liquidity Provider informed of any changes that might impact on how they manage risk. They usually want to know and understand the type of client and if the order flow represents professional traders.

 

Trading Forex and Derivatives carries a high level of risk, including the risk of losing substantially more than your initial investment. Also, you do not own or have any rights to the underlying assets. The effect of leverage is that both gains and losses are magnified. You should only trade if you can afford to carry these risks. Trading Derivatives may not be suitable for all investors, so please ensure that you fully understand the risks involved, and seek independent advice if necessary

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