Liquidity is crucial when trading any financial instrument. In simple terms, liquidity refers to the ease with which an asset can be bought or sold without affecting its price. In the context of bonds and forex, liquidity refers to the number of buyers and sellers in the market and the size of the typically executed trades.
What is a liquid market?
A market is considered liquid when there are numerous willing buyers and sellers, and the associated transaction costs are cheap. Several tools — such as TradingView and other indicators — help traders determine the liquidity status of a market. As long as there are many willing buyers and sellers and the commodity traded is uniform, and in great demand, the market is considered liquid.
Bond trading is the act of purchasing and selling debt securities. An investor in a bond is effectively making a loan to the issuing corporation or government. The loan is secured by a pledge to repay the principal plus interest at a predetermined rate and time. Bonds have a lower perceived risk than other investments due to their fixed income stream and the creditworthiness of the issuing entity.
The bond market is a significant part of the global financial system. According to the Securities Industry and Financial Markets Association (SIFMA), the bond market (total debt outstanding) in 2021 is projected to be $119 trillion globally and $46 trillion for the US market. A wide variety of bonds are on the market, making it difficult to generalize about the bond market. A few examples are high-yield bonds, municipal bonds, corporate bonds, and federal bonds.
Liquidity considerations when trading bonds
Individual bonds may be acquired for the income they produce, but investors who intend to retain the bonds until maturity may not give much attention to the possibility of selling the bonds or the cost of doing so while constructing a portfolio.
The bond market isn’t always quickly liquid; certain bonds are more easily traded than others.
Although bond liquidity varies, investors who sell their bonds before maturity during market stress risk reduced liquidity and investment losses. Bond prices tend to decline when interest rates rise, and a sell-off in the bond market may exacerbate this trend. It may be more difficult to sell bonds, especially longer-duration bonds, at an attractive price if interest rates rise. Similar to how a sector-wide or issue-specific credit crisis might significantly affect liquidity.
Bonds are often bought and sold by dealers who trade in them for their accounts. The efficiency of bond trading has been aided by the emergence of electronic bond trading platforms; nevertheless, these platforms are not exchanges. Bondholders receive interest payments over the bond’s term and their initial investment back when it matures.
There are a lot of issues that might reduce the availability of bond funds. Among these include limited dealer inventory (supply) of bonds and selling pressure (owners rushing to sell). Liquidity can also be constrained by the Federal Reserve, the country’s central bank, through measures such as quantitative tightening, in which it stops buying new Treasury securities to replace matured bonds. Assigning value and promptly matching buyers and sellers in a market with numerous bonds and no regularity can cause liquidity pressure, further complicated by the sheer amount and variety of bonds.
Currency exchange is the buying and selling of currencies, commonly referred to as forex trading or foreign exchange trade. Currency trading occurs on the forex market around the clock, five days a week, adding to the market’s liquidity.
Because there is no centralized exchange where all trading occurs, the foreign exchange market is one of a kind. Instead, transactions in foreign exchange take place over-the-counter (OTC) through a complex interconnected system of banks and brokers. This results in low transaction costs and tight spreads in the foreign exchange market. The 2022 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity shows that trade in foreign exchange markets averaged US$7.5 trillion per day in April 2022, according to the preliminary worldwide figures from the Bank for International Settlements. It is estimated that the total value of the forex trading market in the world is over $2.4 quadrillion.
Liquidity considerations when trading forex
Three broad categories of currency pairs are traded on the Foreign Exchange market: majors, minors, and exotics. The majors often exhibit the highest levels of liquidity, followed by the minors, and finally, the exotics. For example, the US Dollar accounts for over 80% of all Forex deals, whereas an exotic currency like the naira accounts for less than 1%. These differences influence trading techniques, risk management, and transaction costs. Currency pairs with the highest trading volume are a good place to practice trading strategies for beginners.
Forex liquidity is influenced by two major factors: supply and demand and the opening and closing of global financial centers. As traders engage in buying and selling activities, financial institutions such as banks and brokers are better positioned to compete for and match orders, increasing liquidity and reducing spreads.
Similarly, the Forex market operates 24 hours a day, five days a week, with a significant portion of order flow being executed through algorithmic trading solutions that automate trade placement and portfolio management. However, global financial centers’ official opening and closing times, which are typically aligned with stock market operating hours, impact Forex liquidity. The most notable surge usually occurs during the London-New York overlap session, given that London accounts for most Forex trading volumes, followed by New York.
Forex liquidity plays a vital role in trading costs and significantly influences the performance of trading strategies. When liquidity levels drop, trading costs rise, substantially impacting the outcome of trading strategies. Traders can use TradingView to gauge the liquidity of a market by examining various factors, such as order book depth, trading volume, and bid-ask spreads.
It is essential to note that trading low liquidity currency pairs with certain Forex brokers may lead to requotes, particularly during fast-moving markets. This underscores the importance of adopting suitable trading strategies, such as scalping, that are best suited for high-liquidity assets.
Traders should consider the liquidity of a market when trading any financial instrument. Bonds and forex markets are both liquid markets, but they have different levels of liquidity determined by supply and demand, as well as inherent factors specific to each market.
The liquidity of a market can affect the cost of trading and the risk of trading. More liquid markets tend to have lower trading costs and are less risky. When choosing between any market, it is essential to consider your liquidity needs and risk tolerance. If you need to be able to trade large amounts of assets quickly and easily, then you will need to choose a liquid market.
This article is for information and educational purposes only and does not form a recommendation to invest or otherwise. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.