What is the liquidity of foreign exchange?

Those who are exposed to foreign exchange will hear the word liquidity, and those who study the financial side also know that there are liquidity providers, namely LPs. How important is liquidity to markets? In the words of famous scholars Amihud and Mendelson: Liquidity is everything in the market!

1. Liquidity

"Liquidity" is a word we hear a lot, but few people understand the exact meaning of liquidity. The central bank releases liquidity, pays attention to liquidity risks, controls liquidity, etc. The liquidity here is actually different. Liquidity has three meanings in total.

The first type of liquidity is an indicator at the macro level. To put it bluntly, it is the amount of money in the entire society. If there are many currencies, we say that the liquidity is high.

Since it is at the macro level, how to observe the level of liquidity is extremely important.

1. M2 broad money increment

This is relatively professional. The National Bureau of Statistics will publish this data every month, and it is currently about 12%. With more broad money, the natural liquidity will increase.

2. Shibor and Libor

The former is the Shanghai Interbank Offered Rate, and the latter is the London Interbank Offered Rate. The former can roughly reflect the domestic market, while the latter can roughly reflect the international market.

3. Seven-day annualized rate of return of Yu'E Bao

Yu'E Bao is essentially a currency fund, and the rate of return of the currency fund reflects the market's demand for currency. The higher the demand, the higher the interest rate, the higher the yield of Yu'e Bao, and the lack of market liquidity. So think about how much liquidity the central bank has released during this period, when the annualized rate of Yu'e Bao was 6% to 2% today.

There are two other kinds of liquidity at the micro level.

The first is trading liquidity.

Imagine that you are a trader with a lot of money in your hand. When you want to sell a large amount of your stocks (of course, it may also be bonds, futures, etc.), because you sell (or close positions) too much, you buy The market is cleared by you, so you have to lower the price to get more counterparties. This is the lower return caused by illiquidity. So remember, as a retail investor, you must beat public funds.

The last type of liquidity is considered from a financial perspective. From a financial perspective, assets have different liquidity.

The liquidity of asset classes on the balance sheet decreases from top to bottom, and the liquidity of a company's overall assets is the company's liquidity. Cash is king is an eternal truth. The company's liquidity is too low, and a small accident will lead to the company's bankruptcy.

​

2. Foreign Exchange Liquidity

1. Definition of foreign exchange liquidity

Foreign exchange liquidity in our usual sense refers to the liquidity of foreign exchange transactions. Whether it is an ordinary trader exposed to foreign exchange or a liquidity provider who studies the financial B-side, that is, LP, the liquidity of foreign exchange transactions is very important to us.

There are still different opinions on the definition of trading liquidity, but in fact, no matter how you define it, we can think that liquidity is actually investors trading a certain amount of assets quickly at a reasonable price according to the basic supply and demand conditions of the market Ability.

Or more simply, liquidity is the cost of executing a certain number of transactions quickly. The more liquid the market, the cheaper it is to conduct instant transactions. Generally speaking, lower transaction costs mean higher liquidity, or correspondingly better prices.

2. The four dimensions of foreign exchange liquidity

As can be seen from the above definition, liquidity actually includes three aspects: speed (transaction time), price (transaction cost) and transaction volume.

【1】Speed ​​mainly refers to the immediacy of transactions. Measured from this level, liquidity means that once investors have a desire to buy or sell, they can always be satisfied immediately.

【2】Breadth However, in any market, if investors are willing to accept extremely unfavorable conditions, transactions can generally be executed quickly. Therefore, liquidity must also have the second condition, that is, transaction immediacy must be obtained with as little cost as possible, or in a specific period of time, if the buyer's premium for an asset transaction is small or the seller's discount Rarely, the asset is liquid. The price dimension of liquidity means that buying and selling must be at or near the prevailing market price.

The price factor of liquidity is usually measured by market width. The most common indicator is the bid-ask spread. That is, when the bid-ask spread is small enough, the market has width. When the bid-ask spread of large orders is large, the market lacks width. Liquidity, measured by breadth, reaches infinity when the spread is zero, at which point traders can buy and sell at the same price. The breadth indicator is mainly used to measure the transaction cost factor in liquidity.

[3] Depth However, speed and low cost are not enough. Liquidity must also have a third condition-quantity limitation, that is, a relatively large number of transactions can be executed quickly at a reasonable price. The quantity factor of liquidity is usually measured in terms of market depth (depth), which is the total number of orders that exist at a particular price (usually the number of orders equal to the best bid or offer). Glen (1994) defines market depth as the ability to trade at current prices. The larger the number of orders, the deeper the market, conversely, if the number of orders is small, the market lacks depth. Depth reflects the quantity that can be traded at a certain price level (such as the best ask or bid). The depth index can be used to measure the price stability of the market, that is, in a deep market, a certain number of transactions will have a relatively small impact on the price, while in a shallow market, the same number of transactions will have a greater impact on the price.

[4] Elasticity Combining the above three indicators, assuming that a large number of transactions are executed in a short period of time, resulting in a large change in price, the fourth component of liquidity can also be deduced—— Resiliency refers to the speed at which the price returns to the equilibrium price after it deviates from the equilibrium level due to a certain number of transactions. In a highly liquid market, as measured by elasticity, prices will immediately return to efficient levels. In other words, when the price changes due to a temporary order imbalance, a large number of new orders immediately enter, the market is elastic; when the order flow adjusts slowly to the price change, the market is inelastic.

The above four elements are commonly referred to as the four dimensions of mobility. It must be pointed out that these four-dimensional indicators may conflict with each other when measuring liquidity. For example, depth and width are usually a pair of contradictions. The greater the depth, the smaller the width (the bid-ask spread), and the larger the width, the smaller the depth; immediacy and price are also a pair of contradictions, and waiting patiently for better prices will undoubtedly sacrifice immediacy.

3. How to measure liquidity

According to the above four dimensions of liquidity, the methods to measure liquidity generally include price method, transaction volume method, price-volume combination method, and time method. Each measurement method has its own purpose. For example, the price method mainly focuses on width, the transaction volume mainly focuses on depth, the combination of price and volume considers both width and depth, and the time method mainly considers speed and flexibility. Among them, the spread index is the most commonly used liquidity measurement method.

Here is an example of measuring liquidity by trading volume method

The common measurement indicators of the transaction volume method are as follows:

【1】Market depth

The depth indicator mainly refers to the quotation depth, that is, the number of orders at a certain price (usually the best buying and selling quotation). The calculation method of depth is:

Depth = (total number of orders at the highest buying price + total number of orders at the lowest selling price) / 2

The depth can also be calculated according to the order amount (that is, the amount depth), and the calculation method is:

Amount depth = (total number of orders at the highest buying price × buying price + total number of orders at the lowest selling price × selling price) / 2

The depth indicator can also calculate its relative value, that is, the ratio of the absolute value of the depth to the issued tradable share capital or market value.

The main shortcoming of depth indicators is that market makers (or liquidity providers in auction markets) are usually unwilling to disclose the full amount they are willing to trade at that price, so the amount at the best bid or offer does not truly represent the depth of the market.

[2] Transaction Depth

Another measure of depth is trade size, which is an after-the-fact measure of how much traded at the sweet spot. Transaction depth overcomes the lack of market depth indicators that cannot reflect the true trading willingness of liquidity providers, but transaction size indicators may also underestimate market depth, because the transaction size is often lower than the quantity that can be traded at a specific price. Also, the number of deals at a particular price does not take into account the execution costs of large trades that exceed the depth of quotes. The transaction depth can be calculated separately according to the transaction quantity or transaction value.

[3] Depth improvement rate and depth improvement ratio

A deep improvement is when the order is filled at a price equal to or better than the quoted price when the quantity of the order exceeds the quantity on the best bid or offer. There are usually two indicators for deep improvement: one is the deep improvement rate, which is measured by the number of orders, that is, the probability that the transaction volume of the order exceeds the number of the best buying and selling quotes; the other is the deep improvement rate, which is measured by the transaction quantity (number of shares) of the order , that is, the quantity traded at or within a quotation minus the quantity quoted.

The number of deep improvements can also take a relative value (that is, the ratio of deep improvements). There are two calculation methods: one is the number of deep improvements divided by the number of quotations, which is used to measure the deep improvement relative to the number of quotations; the other is the number of deep improvements divided by The number of orders used to measure the deep improvement of this order.

The main deficiency of the Depth Improvement Indicator is that it does not take into account the price factor, especially when the price of the limit order deviates from the best bid or ask price.

【4】Transaction rate (fill rate)

The execution rate refers to the ratio of submitted orders that are actually executed in the market. The transaction rate includes three indicators: one is the probability of the market order and the limit order that is better than the best buying and selling price to be executed in real time; the second is the ratio of all orders to be executed at a single price; The ratio. Fill rate is also used to analyze the ratio of the overall execution of larger orders. Fill rate is also a very important indicator for limit orders that are inferior to the best bid or offer.

Comparing turnover rate metrics across markets is difficult because:

First, we usually measure the marginal transaction rate, that is, the possibility of getting a transaction for each newly arrived order, but in fact, we usually only get the average transaction rate data (the ratio of limit orders to be filled);

Second, for limit orders that are worse than the best bid or offer, the fill rate depends on how far the price of the limit order deviates from the bid or offer.

The main disadvantages of the liquidity index based on trading volume are two aspects: first, it ignores the impact of price changes, and price changes are often one of the most important factors to measure liquidity; second, the size of trading volume is related to volatility, The latter, in turn, will hamper the liquidity of the market.

Generally speaking, each method of measuring liquidity starts from four dimensions, but the four dimensions themselves have some conflicts with each other, so each measurement method must have both advantages and disadvantages. Of course, for investors, their understanding of liquidity may be different in different situations. Sex is seen as the low cost of transaction. If a market has no liquidity, then the market is like a pool of stagnant water. For the market, liquidity is everything.