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Currency Market Liquidity Returning to Pre-COVID Levels

Currency Market Liquidity Returning to Pre-COVID Levels

Published: May 22nd, 2020

After a rout in March which saw most units tumbling against the greenback, investors are gradually coming back to currency markets.

Consolidated numbers from a group of data providers show liquidity in forex markets is returning pre-coronavirus lockdown levels for some major currencies, with many reaching 70 to 80 percent of their previous daily volumes on average.

The collaboration between CLS, MUFG and Mosaic Smart Data also found that trading volumes in emerging market currencies remain at about 45 per cent of pre-COVID 19 levels while trading outside of market hours is still ‘very thin’.

Euro/dollar, the most traded currency pair, has seen liquidity jump back to nearly 80% of its pre-crisis level. Euro/Swiss franc liquidity, which was also traded widely under the recent economic turmoil, was at 85 per cent of pre-crisis levels. The numbers indicate it is currently the most used pair on the G10 list of widely traded currencies.

One pair largely shielded from liquidity disruption throughout the crisis was dollar/yen. Both units have retained their safe-haven appeal during the pandemic, as FX traders shifted from riskier markets to seek stability.

The data also uncovered a ‘sharp and immediate’ spike in liquidity for sterling/dollar after London's 4 pm fixing hour, marking a change in traders’ behaviour as they adjusted to COVID-19 market conditions.

The Hong Kong dollar, Swiss franc, Australian dollar and South African rand have attracted the biggest increases in liquidity. Traders are still avoiding the Canadian and New Zealand dollars, as well as the Mexican peso.

For all currencies, liquidity falls off sharply outside of trading hours where it remains at lows reached during the peak of the crisis.

The three data providers said in a press release that the economic impacts of the pandemic had changed FX markets profoundly, and market participants needed additional visibility and insights into liquidity conditions. The combined data offer includes aggregated FX market data from CLS, aggregated FX order book data from MUFG, and analytics using Mosaic Smart Data software.

Why FX liquidity matters

Liquidity can be a measure of the level of interest present in a particular market at any given time. It captures the number of active traders and the overall volume of trading. Individual traders experience liquidity in the volatility of price movements.

Liquidity in FX is what enables currency pairs to be traded on demand. If a trade involves major currency pairs, then the market your trading is highly liquid. That liquidity is defined, however, by the financial institution that’s facilitating the trade.

Currency pairs tend to have varying levels of liquidity based on whether they are classed as major, minor or exotic. Forex liquidity tends to decrease as you move down the categories from major to exotic.

A pair with High liquidity can be traded in significant sizes without large differences in price. It usually appears in major currency pairs like EUR/USD. In highly liquid markets, prices will move gradually and in smaller increments.

A pair with Low liquidity can’t usually be traded in large sizes without big variances in its price levels. It often appears in more exotic currency pairs, for example, PLN/JPY. A less liquid market will typically see abrupt price moves in larger price increments.

Conditions of peak liquidity usually happen when London and European markets are open, in the hours that overlap with North American markets in the European afternoon and Asian sessions in the morning. Following close in Europe, liquidity drops off sharply in what is commonly called the New York afternoon market.

During the hours of reduced liquidity, currencies tend to see more fluctuation in price movements. The catalyst for a spike or dip could be news-related, and the impact of reduced liquidity – fewer traders and less volume – means prices react more sharply.

Liquidity can also be reduced by bank holidays and during seasonal periods where investor interest tends to sit idle, like Christmas, Easter, Thanksgiving in the US, and late summer.

Holiday sessions often see reduced volatility, where markets are sluggish and stay within more predictable ranges. Trading risks also increase; however, as a sudden breakout or major trend reversal might occur when, in practical terms, fewer eyes are on the ball.

Hedge funds will sometimes try and use reduced liquidity during holidays as a wedge to push markets past key technical points and compel other market participants to respond. Because their response is often delayed, it can propel a reversal or extend a breakout. When this occurs, markets can move by several hundred points and set an entirely new direction by the tie the holiday is over.

Because forex operates 24 hours a day, it is structurally more liquid, with fewer gaps in activity than other financial markets. That means traders can enter and exit whenever they like.

Markets that only trade for part of the day like stock markets and futures exchanges often see significant price moves at market open based on news announcements overnight that go against analyst expectations.

Liquidity risk vs reward

The relationship between risk and reward in any financial transaction is almost always proportionate, so understanding the liquidity risks around any trade is vital in FX markets.

In 2015 during the Swiss Franc crisis, the Swiss central bank (SNB) announced it would cease pegging the franc against the Euro. The move effectively broke the interbank market (the backbone of FX pricing) as traders’ ability to price the market was disrupted.

It meant brokers couldn’t offer liquidity on CHF. When interbank pricing resumed, EUR/CHF prices had jumped well outside the previous range, a black swan event that meant retail client account balances in CHF were suddenly impacted.

Retail FX traders look to manage liquidity risks by lowering their leverage or using risk mitigation tools like guaranteed stops that oblige brokers to meet the stop price level.