For an asset, its liquidity is how fast it can be bought or sold without any discount or premium. Liquidity thus reflects the amount and frequency the asset is traded. The more something is bought and sold, an individual's ability to charge premium or look for discounts is lowered. However the less liquid something is, the harder it will be for it to be bought or sold.
A market that is liquid means it has many trades and is composed of many traders. The Forex market is extremely liquid because hundreds of banks and millions of individuals trade currencies everyday. Nearly $4 trillion is exchanged daily and this number is increasing as interest by retail traders are expanding. Consequently, traders can trade quickly with a click or two.
On the other end of the spectrum, real estate development is an extremely illiquid market because it requires a lot of capital and investments are made into physical form such as buildings.
As a result you will find a bigger range of price offered for illiquid assets while a highly liquid asset will have a very specific price.
A liquidity provider is an individual or institution which acts as a market maker in a given asset class. This means that the liquidity provider will act as the both the buyer and seller of a particular asset, thus making a market. For instance many stock exchanges have liquidity providers who make the commitment to provide liquidity in a given equity. These liquidity providers make the commitment to providing liquidity in the hopes that they will be able to make a profit on the bid-ask spread.
Liquidity providers theoretically ensure greater price stability and also improve liquidity by making it easier for traders to buy and sell at any price level. By making a market liquidity providers an important service and take on a significant amount of risk, but are still able to profit from the spread or by positioning themselves on the basis of the valuable information available to them.
In the world of Forex the majority of global liquidity is provided by big name investment banks (referred to as Tier 1 liquidity providers) that make markets in all the available in currency pairings. These investment banks all have currency trading desks where traders quote both Buy and Sell prices in the currency pairings they offer. It is thought that these major liquidity providers in fact lose money on the majority of the trades placed with them, due to the very tight spreads on offer. However Tier 1 liquidity providers are then able to use this order book info to their own advantage ultimately allowing them to turn significant profits.
Only a massive a retail trader will deal directly with a Tier 1 liquidity provider. Instead, most retail traders will instead deal with a brokerage or prime brokerage that has an established relationship with one or more Tier 1 liquidity providers. Tier 1 Liquidity providers will only enter to relationships with institutions and individuals they know to be financially sound, in order to reduce their counterparty risk. This means some STP retail brokerages have an even looser connection with Tier 1 liquidity providers passing their trades through a company which has established relationships with various prime brokerages and tier 1 liquidity providers. This is partly why the spreads on offer for retail traders tend to be significantly wider than those available to institutional traders.
Trading foreign exchange carries a high level of risk, and may not be suitable for all investors. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. A possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial adviser if you have any doubts. Any opinions, news, research, analyses, prices, or other information contained on this websites is provided as general market commentary, and does not constitute investment advice. AlgoHybrid will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.