Understanding Forex Market Size and Liquidity

Introduction 

Forex is a combination of two words – foreign and exchange. Therefore, the forex market is a decentralised market where traders and investors exchange one currency for another. It is decentralised meaning there is no specific location for the forex market. Traders can participate in the forex market online from any part of the world.

The forex market is open 24 hours a day every day of the week all year round. However, retail forex traders can only access the forex market 24 hours a day during the five weekdays.

What is Forex Trading?

Forex trading entails the exchange of a currency from one country to a currency from another country. Say you have USD and want to convert them to CAD. In this case, you will sell your USD and in return, get an equivalent value in CAD as per the prevailing exchange rate. For example, let’s say that 1 USD is worth 1.31 CAD. In this case, if you sell your 1 USD, you will receive 1.31 CAD.

Therefore, for a single trade to be complete in the forex market, you have to sell one currency and buy a different one. That is why currencies are always in pairs; for example, USD/CAD. The exchange rate between the two currencies is the price for that currency pair.

Composition of the Forex Market

The forex market is made up of five distinct categories – the spot market, forwards market, forex swaps market, currency swaps market, and forex options market.

In terms of liquidity and volume traded, the forex swaps market is the largest. Here’s a breakdown of their daily turnover.

  • Forex swaps – $3.2 trillion
  • Forex spot market – $2 trillion
  • Forex forwards market – $0.9 trillion
  • Forex options market – $0.3 trillion
  • Forex currency swaps market – $0.1 trillion

Forex Market Liquidity

Liquidity is best described as how active a market is. The forex market is the most liquid financial market in the world. The size and liquidity of the forex market are measured using the daily turnover, which, according to the Bank of International Settlement (BIS), is worth about $6.6 trillion. To put this into perspective, it means that approximately $76 million worth of transactions happens in the forex market every second!

However, the liquidity in the forex market is not constant throughout the day. There are specific periods when the forex market is highly liquid, and others when liquidity is low. Furthermore, not all currency pairs have the same liquidity.

What causes liquidity fluctuation in the forex market?

The answer to this is straightforward – forex market hours.

You see, although the forex market is open 24 hours a day, there are different forex market sessions which correspond to regular business hours across different time zones. Note that the majority of trades in the forex markets are conducted via the interbank forex market. Therefore, liquidity is highest when banks and other businesses are open during regular business hours. Conversely, the liquidity will decrease when the business day ends.

In total, there are four forex trading hours – Sydney, Tokyo, European, and the North American forex trading hours. The liquidity in the forex market varies in these trading hours. Let’s break them down.

Liquidity during the Sydney forex trading hours 

The Sydney forex trading hours start at 9.00 PM GMT and end at 5.00 AM GMT. The Sydney session includes forex trading in Australia and New Zealand. Liquidity in the forex market is often the lowest during the Sydney forex market hours averaging about 17% of the daily turnover.

However, minor currency pairs with the AUD and NZD are the most liquid during this session.

Liquidity during the Tokyo forex trading hours

This trading session accounts for about 22% of the daily traded volume in the forex market. The Tokyo forex market hours is also called the Asian trading hours since it occurs when major commercial hubs in continental Asia are open between 11.00 PM GMT to 7.00 AM GMT.

Forex pairs with the JPY are the most traded during this session.

Liquidity during the European forex trading hours

This forex trading session, also known as the London forex trading session, is the largest and accounts for approximately 42% of the daily forex turnover in the forex market. 

This session runs from 6.00 AM GMT to 2.00 PM GMT. Forex pairs with GBP and EUR are the most liquid during this session.

Liquidity during the North American forex trading hours

The North American forex session is the second largest, with about 22% of the daily trades conducted during this session. It is between noon GMT and 8.00 PM GMT; during which forex pairs with the USD and CAD are the most liquid.

Forex market liquidity during the overlap of the trading sessions

Note that there are times when the above forex trading hours overlap. During these overlaps, the liquidity in the forex market significantly increases since there are more active participants in the market. Here are the overlaps.

  • The Sydney-Tokyo forex trading hours overlap between 11.00 PM GMT and 5.00 AM GMT
  • Tokyo-European forex trading hours overlap between 6.00 AM GMT and 7.00 AM GMT
  • European-North American forex trading hours overlap between noon GMT and 3.00 PM GMT. 

Of the three forex market overlaps, the European-North American overlap is the most liquid and accounts for approximately 70% of the daily turnover. The EUR/USD and GBP/USD tend to be most liquid during this overlap.

Forex Pair Liquidity 

In the forex market, the major currency pairs are the most liquid accounting for up to 72% of the daily trades; followed by minor currency pairs while the exotic forex pairs are the least liquid in the forex market. Here’s a breakdown of the most traded currency pairs as a percentage of the daily traded volume. 

More so, the USD is the most liquid currency involved in forex trading. About 88% of all forex trades involved the USD. Here’s a breakdown of the top five liquid currencies in the forex market.

Conclusion

The popularity of the forex market stems from its status as the most liquid financial market in the world. It is therefore difficult for any group of traders to manipulate prices by coordinating large trades. Furthermore, forex traders enjoy instant executions of trades no matter how large their positions are.

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