Liquidity in Retail Trading: How New Systems Help Consumers Get a Better Deal

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Image: Pixabay

In order to trade successfully and at the price you want, you need liquidity. Without the necessary resources to execute a trade in real time, investors are left with delays known as slippage. Indeed, for anyone getting into the investment sphere, avoiding slippage is crucial. Whatever market you’re speculating on, slippage can and will occur. Your goal as a trader is to limit its effect as much as possible. One of the best ways to ensure slippage is kept to a minimum is to invest in high liquidity markets.

ECN Brokers Boost Liquidity

Today, retail trading platforms have built a reputation on liquidity. For example, Electronic Communications Networks (ECN) and, therefore ECN brokers, give consumers access to the interbank market. In simple terms, the broker itself acts an intermediary between the consumer and the forex world. From here, traders can transmit buy and sell orders to the market via an ECN broker. At this point, the brokerage facilitates the overlap of these orders so that each one can be completed in real-time. Another way to think of these networks is like a decentralized blockchain. ECNs work in a similar way. By removing market-makers and grouping together separate entities, the network is devoid of a central power source. This increase the network’s flexibility as the whole becomes greater than the sum of its parts.

Essentially, ECN brokers offer is a solution to the liquidity issue between traders and market-makers. Under the market-maker model, brokers act as a single point of contact, offering both the buy and sell price for a commodity. In one respect, this model works well from a pricing perspective. Because market-maker brokers are competing against each other to offer the best buy/sell prices, traders can scour the market to find the best deal on a particular commodity. However, the problem with this model is that liquidity can sometimes be an issue.

Liquidity Improves Transparency

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Image: Pixabay

To counter this, ECNs connect multiple parties to a global liquidity pool – banks, traders and brokers. This allows everyone to work in unison to ensure deals on all sides are completed efficiently. The upshot of this is that trading forex, for example, becomes a lot more cost-effective for low-level investors. Because high liquidity helps to reduce slippage, traders are able to execute buy/sell orders at the price they see in real-time. Moreover, brokers are able to fulfill orders with fewer issues which, in turn, reduces costs and allows them to offer lower spreads.

In addition to reducing slippage, higher liquidity removes the need for a dealing desk. Under this model, brokers don’t have the same power to intervene in trades and manipulate prices or market conditions. This leads to transparent and fairer prices for consumers which, in turn, leads to more competition between brokers to offer a better overall service.

Ensuring Liquidity in Other Ways

The retail trading industry has also spawned other ways of increasing liquidity in recent years. High Frequency Trading (HFT), otherwise known as algorithmic trading, sees advanced pieces of software execute trades at high speed. The process of moving large volumes of a particular asset in split seconds can improve liquidity. As Investopedia puts it, “as a market-maker, HFT traders post limit orders on both sides of the electronic limit order book simultaneously, thus providing liquidity to market participants looking to trade at that time.”

Although HFT isn’t without its issues, it can ensure market liquidity. But yet another way retail trading platforms boost liquidity is timing and availability. By tapping into financial markets around the world, sites are able to offer a 24/7 service. As the markets in Australia close, those in the US are open. This ability to remove time zone restrictions via a single platform has made it easier for traders to invest whenever they like. Moreover, it ensures a constant stream of liquidity for the industry as a whole.

Increased Liquidity isn’t Risk-Free

In practice, this improves liquidity and makes it easier for consumers to trade online. Of course, there are times when increased liquidity isn’t desirable. Although traditional theories suggest that high liquidity is positive, research by professors at Ben-Gurion University (BGU) in Beersheba, Israel, suggests otherwise.

By taking into account “a more realistic treatment of financial markets in which various investors have different investment strategies,” researchers believe liquidity has an impact on risk. By increasing liquidity, volatility also increases. In situations where more traders are active, it increases the disparity between trading strategies. Because those with a greater tolerance for risk have the ability be more active, they can push up the price of an asset for those that have a lower tolerance. In other words, low-level traders can sometimes suffer in high liquidity markets because large investors are making big moves.

Commenting on their findings, those involved in the research were quick to point at that high liquidity isn’t a bad thing. However, what they wanted to make clear was that simply increasing liquidity wasn’t a costless exercise.

“This is not to say that we favor less liquid markets over highly liquid ones, but we find that liquidity comes at a cost. It is not a free attribute of stock markets,” reads the report.

In overall terms, liquidity has become a key area of development for the retail trading sector in recent years. By improving liquidity to offer quicker, cheaper and more transparent transactions, many platforms have opened up the market to more people. Although liquidity doesn’t make trading risk-free, it has made it easier for novices to trade in ways more similar to professionals than before.