Forex liquidity normally refers to a couple of things. One is a company that makes a market in currency pairs – they provide liquidity to the market by buying and selling currencies. This could be an investment bank, like Morgan Stanley, or some random bureau de change by the side of the road.
The other thing that forex liquidity typically refers to is how liquid a particular currency pair or market is. The more liquid a currency pair is, the easier and cheaper it will be to exchange them. Like any other liquid market, a more liquid currency pair is likely to have tighter spreads and more transparent pricing.
So that’s what forex liquidity normally refers to. In what many people like to call the ‘forex’ industry, the term ‘liquidity’ is used to refer to something slightly different.
Rolling spot forex liquidity and contracts for difference
When you trade forex with a FX/CFD broker, you are actually trading a rolling spot forex contract.
A rolling spot forex contract is a derivative product. It allows a trader to speculate on fluctuations in the prices of currency pairs using leverage. Importantly, that trader never owns the actual currency – they are just speculating on whether a price will go up or down.
A rolling spot forex contract is a contract for difference (CFD) and is defined as such by several regulators, including the UK’s Financial Conduct Authority (FCA) and the pan-EU regulator, the European Securities and Markets Authority (ESMA).
So when you hear people talking about ‘forex liquidity’ in the context of the FX/CFD industry, what they are usually talking about is the provision of pricing and trading in CFDs on currency pairs.
To fully understand forex liquidity, it’s worth looking at these two things – pricing and trading – in more detail.
How is forex liquidity created?
Remember that when you trade a forex CFD, you never own either of the underlying currency pairs you are trading in. You are effectively betting that the price of one currency will rise or fall relative to another.
For example, you could ‘buy’ USD and ‘sell’ GBP if you thought the US dollar was going to increase in value relative to the British pound. But you will never actually take possession of either currency.
Just like betting on a football match, for that trade to take place, you need another company that is willing to take the other side of it. And for the company to actually facilitate that trading, they need to provide you with pricing you can trade against.
This pricing is the first component of forex liquidity. It should be axiomatic that without pricing, you cannot trade. Although they may not get it from them directly, FX/CFD brokers that offer forex trading ultimately derive their pricing from market makers.
These are companies whose job is to buy and sell currencies. They will do this on a huge scale and try to capture profits by buying low and selling high. This price difference is known as the spread.
Historically, most market makers were investment banks and the majority of the large forex market makers today still are. For example, JP Morgan and Goldman Sachs both have huge market making divisions in forex.
However, in the last couple of decades, other companies have emerged that specialise in market making and have ultimately taken a huge share of the forex market. XTX Markets and Jump Trading, for example, are both big forex market makers.
Forex liquidity, market makers and FX/CFD brokers
The pricing that large forex market makers generate is used to price their own forex CFDs.
Some large FX/CFD brokers have direct relationships with investment banks or non-bank market makers to get this pricing. Many do not and get their pricing via intermediaries. These intermediaries are sometimes called prime of primes or liquidity providers.
A FX/CFD broker that gets that price feed will then use it to take trades from clients. Again, remember that when you trade forex with a FX/CFD broker, you never own the currencies you are ‘trading’ in. You are just speculating on the price movements in those currencies.
The FX/CFD broker is taking the other side of those trades, regardless of what they may otherwise claim. This is in effect the provision of forex liquidity. By providing pricing to clients and taking trades on that pricing, the FX/CFD broker is creating a market for forex CFDs and facilitating their trading.
Forex liquidity providers to FX/CFD brokers
This process does create a huge risk. If a FX/CFD broker takes the other side of a lot of forex trades, they can end up being exposed to huge losses. As an example, imagine an FX/CFD broker that has clients who believe the US dollar is going to rise against the pound. They place trades with a notional value of $100m.
Let’s say that is the right trade and the dollar does rise against the pound. A 1% movement upwards would mean that the FX/CFD broker, who has taken the other side of that trade, is now sitting on a $1m loss.
To lower the risk of this happening, FX/CFD brokers will – though not always – place trades to offset the risk posed by the trades their clients have placed with them.
The companies that FX/CFD brokers use to hedge their forex exposure are typically called prime of primes or liquidity providers. As noted, some of these companies have direct relationships with investment banks but others do not.
The simplest way to think about these companies is that they act as brokers to FX/CFD brokers themselves. The FX/CFD broker takes its pricing for its forex contracts from these providers and places trades to hedge their risk with them too.
FX/CFD brokers vary in how much risk they take on and some of them place no hedging trades at all. This is typically known as the b-book model. Those that do place trades to hedge their exposure typically operate in one of two ways.
The pure a-book model
Some FX/CFD brokers place offsetting trades for all of the flow they get. So if you trade GBP/USD with this kind of broker, they take the other side of that trade but then place an identical, close to instantaneous trade to offset this.
An important caveat to this is that almost all FX/CFD brokers that run this model take rebates with the broker that they trade with to hedge their trades. In other words, they still share in the profit and loss of the trades they have made to mimic their clients’.
The hybrid FX/CFD broker model
The other main risk model that FX/CFD brokers use to manage their forex liquidity is to take on risk up to a certain level.
For example, a FX/CFD broker may be willing to take the other side of trades with a notional value of $100m. But if the value goes beyond that amount, they will go to their liquidity provider and hedge their exposure.
Forex liquidity
As the above should make clear, in the context of the FX/CFD industry, the simplest way to think about forex liquidity is that it is what is created by a company that provides prices for currency pairs and is willing to take the other side of trades based on that pricing.
The provision of pricing and trading services is what enables the end retail trader client of an FX/CFD broker to trade forex. It is also what enables the FX/CFD broker to hedge the exposure that is created by their clients’ trades.