i. Liquidity is the ease by which a currency pair can be bought or sold without affecting its price much.
ii. Major currency pairs have the most liquidity followed by the minor currency pairs. The exotic currency pair has the least liquidity.
iii. Liquidity is mostly generated by the buy or sell orders placed by the institutional market participants.
What is liquidity?
Liquidity is the ease by which a currency pair can be bought or sold without altering its price majorly. If a currency pair can be traded without shaking its price and keeping it stable, the currency pair is said to be liquid enough to trade.
While those currency pairs, that experience sharp price spikes when bought or sold are said to be illiquid.
For instance, a trader wants to trade in the US Dollar, so he will either buy or sell a currency pair that has the USD in it.
The trader wants to buy a particular currency pair at the market price and places a buy order on the broker terminal for the same.
USD currency pairs are said to be immensely liquid due to a large number of active participants present in the market trading such currency pairs as it is a major country in the global scenario with an immensely strong currency.
Hence, the trader will get his buy order filled at a price just a few pips away from his intended price.
Whereas, if a trader wants to trade the Mexican currency, Peso, he may not be able to get his buy or sell order filled at his desired price unless there is a sell order in the market at that price.
The reason being for this is that the market for Mexican currency Peso is not liquid enough, not many traders trade the Peso as Mexico is not a major country with a strong currency.
Hence, it is highly possible that once a trade is placed, it will be filled at a price quite far from what was intended.
Why is liquidity important?
As we already know that liquidity is the ease by which a currency pair can be either bought or sold without disturbing the stability of the price at that moment in the forex market. But why is it that liquidity is so important?
The most important aspect of high liquidity in the market for a currency pair is that there will be minimum spread.
This simply means that it is a difference between the price of buyers and the price of sellers of the currency.
Higher liquidity means that at any given time there are a large number of participants in the market looking to either sell or buy the currency.
This high number of participants results in lots of buy or sell orders placed in the forex market hence reducing the difference between the price at which buyers want to buy and the price at which sellers want to sell.
In cases of lower liquidity, comparatively, there are not many buy or sell orders present in the market for the currency pair at that given time.
This happens when there are not many participants present in the market to trade that particular currency pair.
Hence in situations of low liquidity, the spread is high, which means that there is a big difference between the price at which buyers want to buy and at which sellers want to sell.
Higher liquidity results in trades being filled with minimum spreads and execution are quick. Lower liquidity results in trades being filled with wide spreads and execution can take some time.
The importance of liquidity for retail participants is for lower spread. For the institutional participants, liquidity is of grave importance when they have to buy in bulk or offload in bulk.
Categories of currency pairs
Since liquidity is an important factor in the facilitation of forex trading, currency pairs have been classified into categories on the basis of the liquidity present in the market for those currency pairs:
1. Major currency pairs
The currency pairs that have high liquidity in the market for their pairs are known as major currency pairs. Hence, these pairs can be traded at any given time with ease and without any significant spread.
Major currency pairs are those pairs that consist of currency of the major countries like the US Dollar (USD), the Australian Dollar (AUD), the New Zealand Dollar (NZD), the Canadian Dollar (CAD), the Euro (EUR), the British Pound (GBP), the Swiss Franc (CHF) and the Japanese Yen (JPY).
2. Minor currency pairs
The minor currency pairs are those pairs that do not consist of the US Dollar (USD) but are made up of any other two major currencies.
Since the USD is widely traded, currency pairs with the USD have the highest liquidity in the market. Currency pairs that do not have the USD have relatively lesser liquidity.
Minor currency pairs are the EUR/GBP, CAD/NZD, CAD/JPY, and all the combinations of the major currencies excluding the USD.
3. Exotic currency pairs
Exotic currencies are those currencies that are not mentioned in the list of major currencies. Exotic currency pairs are made up of one major currency pair and one of the exotic currencies.
The exotic currency pairs are illiquid and thinly traded. These currencies are currencies of the developing countries.
There are over 100 developing countries in the world but not all country’s currency is available for trading.
Availability of certain exotic currency pairs depends on the demand for the same, hence brokers would consider trades on such pairs only if clients demand it.
Exotic currency pairs include the Indian Rupee, the Turkish Lira, the Hong Kong Dollar, the Mexican Peso, the Thai Baht, and the Russian Ruble.
This is not an exhaustive list, there are some more currencies that are included in the exotic currency list.
How is liquidity generated?
Liquidity is basically the amount of buy or sell orders present at a given time. When a currency pair has lots of market participants trading the pair, it leads to high liquidity, while low liquidity is the result of not many market participants trading the currency hence less number of buy or sell orders at the time.
This is basically demand and supply. The forex market is dependent on many factors for it to function and demand and supply is one the most major factors.
A currency is said to be a strong currency when it is monitored by a majority of the traders. Currencies that show strength mostly belong to the major developed nations.
The actions of these countries have an effect on the global scenario and have a trickle-down effect on the other countries.
Traders often have the currencies of such countries on their watch as there is so much happening every day, there are reports and data released from time to time.
Traders often look out for such information in order to trade in these currency pairs.
This mass psychology around the currencies of these major countries leads to more participation in the trading of these currencies. Hence, demand and supply are what drive liquidity.