A lot of people wonder what makes a currency pair liquid? How do you define it? How can you determine how liquid it is? What variables can you consider?
Let me explain how how you can determine how liquid a currency pair is and why it is so.
This is a pretty simple one. The bigger the trade value between countries the more liquid the currency pair between those two countries is. Why? Because the more trade done between nations means that both sides are constantly making payments to each other for various goods and services. Those payments need to be converted to each countries respective currency.
So if Toyota needs to pay its workers in Japan, it can take the profits it makes from its sales in the United States, sell dollars and buy the Japanese yen in order to pay their workers. That generates order flow in the markets. The banks are glad to accept these orders as they can usually make a tidy profit on them.
But this is not the sole determinant of liquidity. This is just one potential source.
There are certain situations this can be misleading. For example, Canada is the United State’s largest trading partner with total trade totaling over $500 billion per year. The United States does have a good amount of trade with the European Union, but still not as big as the Canada – U.S. relationship. If you just looked at the trade between nations, then you may assume that USD/CAD would have more liquidity than the EUR/USD. This is absolutely not the case. In fact, EUR/USD has a ton more liquidity than USD/CAD.
Which means that there is another missing link.
What is the missing link in this case?
GDP Of The Nations
How big the economy is of the countries is a much better determinant of how liquid a currency pair is. The bigger the GDP of the countries, the more liquid the exchange rate. This answers the question why the EUR/USD is more liquid than the USD/CAD. If you combine the GDP of the eurozone countries, which is around $12 trillion, with the GDP of the United States, which is $15 trillion, you get $27 trillion dollars.
If you combine the GDP of the United States ($15 trillion) with Canada’s ($1.6 trillion) you only get $ 16.6 trillion dollars.
Therefore, even though the trade between the United States and Canada is the largest, the EUR/USD exchange rate is far more liquid than USD/CAD, because the economies of the EUR/USD currency pair are much larger.
What this means is that there is a lot more potential for financial capital to flow into and out of the Eurozone and the United States. Money can flow into and out of the debt markets, equity markets, real estate markets, etc of the United States and Eurozone, far more easily than between the United States and Canada.
Typically, the most liquid currency pairs will have the lowest spreads in normal market conditions. This is why you will almost always see the EUR/USD have a lower spread than the GBP/USD or the GBP/CHF. There is just a lot more financial flows occurring in EUR/USD than between GBP/USD or GBP/CHF.
Looking at spreads are a quick way to determining whether a currency is liquid or not. For example the USD/JPY spread can be 1 or 2 pips, while the spread in EUR/NZD can be 5-10 pips. Whats much more liquid USD/JPY or EUR/NZD?
Don’t always rely on the spread though, as it can deceive you at times. It is possible for the spread in GBP/USD to be temporarily lower than the EUR/USD. There could be market participants temporarily battling each other to provide the best bid/offer, thus reducing the spread in GBP/USD temporarily until those orders are filled. Or it is possible that a news release in the eurozone has temporarily increased the spread in EUR/USD. And it is possible at that moment in time that GBP/USD can be more liquid than EUR/USD. But overall EUR/USD is still more liquid than GBP/USD.
It should also be noted that just because a spread is temporarily low, that doesn’t mean the market is liquid. The spread may be 1 pip in EUR/USD on multiple occasions during the Sydney session, but the market may still be thin. Chewing through the orders at the 1 pip spread can be extremely easy exposing the illiquidity of the currency during such a session.
So a currency pair can absolutely have a tight spread, but have low liquidity as the market is thin.
So many different possibilities.
More Liquidity Means…
If a currency pair starts to be liquid, this will attract more speculators thus adding more liquidity. If there are more speculators and more liquidity, there will probably be more exotic and vanilla options executed. That means there will be more option hunts and barrier defences. All this action can mean more volatility depending on the global macro outlook. Volatility and liquidity can entice the macro traders to enter the market and offer liquidity. Of course the high frequency traders, algos, quants want to get in on the action as well.
All a harmonious cycle of liquidity.
Which is why there tends to be a lot more market participants, speculators, commercial interests, option players, macro traders, quant traders in the EUR/USD as opposed to the GBP/CAD.
That doesn’t mean there can’t be huge moves in some of the less liquid currencies. There absolutely can be. If there is order flow and global macro forces at play, a less liquid currency pair can easily move hundreds, if not thousands of pips. EUR/NZD has posted a few monster moves over the past year.
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