An overview of liquidity in the financial markets today and how increased regulation and technological developments have changed the industry landscape.
In the last few years, we have seen several developments in the area of liquidity which have resulted in a shift in regulation and technology. This article examines each of these areas, starting with a brief overview of the concept of liquidity.
The Importance of Liquid Markets.
In Forex, liquidity can be described as the market’s ability to absorb a large number of trades without creating big price movements. Liquid markets are characterised by narrow bid and ask spreads, meaning that transactions are carried out cost-effectively. Liquidity reduces the cost and risk for underwriters and market makers and the cost for investors by ensuring lower volatility and transaction costs.
The traditional measure of market liquidity is based on trade volume i.e. the number of trades, bid-ask spreads, market turnover, and trading volume. Liquidity also depends on macroeconomic and market fundamentals including a nation’s fiscal and exchange rate policies and the overall regulatory environment. Market sentiment together with investor confidence is also important factors influencing liquidity. On a micro level, the type of instruments traded, the nature of participants involved, and the structure of the market will have a significant impact on market liquidity.
The more liquid a market, the wider the set of potential counter-offers for any outstanding transaction, and hence the higher the probability of a favourable match. Thus, investors are generally attracted to markets with higher levels of liquidity.
The Forex market thus depends on liquidity, as it makes the market highly efficient, makes for an easier and cheaper flow of transactions, and more competitive pricing for currency pairs. Given its importance, it is clear why regulators place such a strong emphasis on improving overall market liquidity to establish deep liquid markets. Liquid markets ensure a higher degree of investor confidence and market efficiency and render the market more resilient.
Changes in the Forex Market
Structural changes in the Forex market over the last few years have reduced the depth of available liquidity and buy-side firms need to adapt their trading strategies to achieve the best execution. Liquidity is the lifeblood of foreign exchange but in the last few years, there have been major concerns that liquidity has dwindled and buy-side firms are no longer always access firm and tight pricing in the way they used to. Such factors include the increase in regulation constraining market making, the increase in the agency model of execution, and non-bank liquidity provision.
In addition to these broader regulations which have impacted on the various asset classes, the tighter scrutiny of conduct among Forex market makers and changes to some of the market practices have also had an indirect impact on liquidity. The higher standards now evident effectively reduce liquidity, making liquidity provision more challenging.
In terms of crypto liquidity, only a few companies are offering marginal liquidity for cryptocurrencies, which coupled with increased regulation has created imbalances in the market. Practically all those who offer cryptocurrency liquidity for brokers are offshore regulations who are not allowed to work with European regulated brokers.
Forex turnover data also gives the impression that the depth of the market has changed. While trading volume alone cannot be used as a barometer of liquidity, it is a fair indicator with trading in the Forex markets now reaching$6.6 trillion per day (BIS FX turnover April 2019), up from $5.1 trillion three years earlier. This may in part be due to an increase in crypto trading which has driven volumes and revenues recently but is also down to other factors like regulation.
The Forex industry just 10 years ago was perceived by many as a gambling/casino industry. As increasing regulation came along, this caused the numbers of unregulated brokers to decrease due to the complexity of the operation, especially in terms of banking and PSPs, and EMIs policies. Banks then proceeded to close all bank accounts in the EU for offshore brokers, making it very difficult to operate. Even regulated PSPs and EMIs found themselves not wanting to risk serving offshore brokers.
While not all businesses ceased operations, the differences in operations and complexities of banking and transfers today compared with just six years ago in 2013 are huge.
This situation has impacted in creating higher volumes as to the now strictly the regulated industry attracts more professional players who execute huge volumes because the Forex market is so liquid they can hedge their positions, participate in high-frequency trading, short any instrument, and use large leverage (1:30 is high leverage when compared with the stock market). This also explains why volumes are increasing while the numbers of brokers are going down.
Factors Affecting Liquidity in the Forex Markets
Many factors have influenced the structure and liquidity of global Forex markets in recent years, including changes in technology and post-crisis financial reforms. Technology has had a large impact on the structure of the Forex market, but there are differences in opinion on whether it has increased or reduced Forex liquidity overall.
On the one hand, technology has lowered the cost of transactions in the Forex market. By enabling wider use of algorithmic and high-frequency trading strategies, as well as improving connectivity, it has helped pair up a broader range of liquidity providers with those seeking liquidity. It has also helped in the search for liquidity or relevant counter-parties and bridged multiple platforms more cost-effectively than in the past enabling a larger variety of financial institutions to participate more directly in Forex markets.
Finally, technology has helped reduce the costs of executing big trades by facilitating a series of smaller transactions. On the other hand, technology has contributed to market fragmentation by giving rise to new Forex trading venues that have emerged as alternatives to traditional multilateral electronic trading platforms, enabling more non-banks to participate in the Forex markets. Market fragmentation has, according to some market participants, increased the cost of accessing Forex liquidity.
Furthermore, some participants suggest that technology may also have contributed to making the Forex markets prone to order flow imbalances, which are not always easily foreseen but can result in large movements in prices when they do occur.
And as for the impact of regulation, some market participants perceive that regulatory reforms designed to reduce risk-taking have lessened the incentive for dealers to warehouse risk, helping to reduce their participation in Forex markets and to lower their provision of Forex liquidity. However, despite tighter regulation, the costs of warehousing Forex risk is not generally perceived to be a significant issue, particularly in the spot markets.
In conclusion, the Forex market has grown and the requirement for liquidity services continues to soar. Technological innovation has reduced the cost of transactions, facilitating the participation of a broader spectrum of players by increasing the modes available for market access and enabling a wider range of financial institutions to participate in the Forex markets. Technology has also made possible the use of algorithmic and high-frequency trading strategies that are viewed by many market participants as having changed the dynamics of liquidity by enhancing liquidity in normal conditions while countering the impact of market fragmentation.
The future impact of regulatory change on Forex market liquidity remains to be seen as we look ahead towards further developments such as additional fines and stricter requirements for participants to closely monitor trader behaviour. The legal part of the operation is presently far more costly than technology requirements but regardless of technological advancements, legal costs will almost certainly continue to outweigh these costs. However, that is not to the detriment of the industry and is, on the contrary, as all participants want to deal with regulated institutions.
One thing for certain, the Forex market continues to hold a large grip against other asset classes, despite changes in financial regulation, technology and the other factors that have been discussed so we can be certain that liquidity will remain all-important and well-supported for the foreseeable future.
Author: Arthur Azizov, CEO and Founder of B2Broker