Is the Forex Market Dangerous?

A concern was raised in an article in the Financial Times; Fast forex moves raise liquidity worries.

In recent months a series of dramatic and unforeseen intraday fluctuations -even in popular and widely traded currencies -has led forex investors, bank traders and analysts to question the mechanics of the market.

The broader concern is that declining liquidity will fuel more sudden forex moves and destabilize the market. According to Standard Bank’s G10 currency strategist Steven Barrow, “volatility and spikes borne out of aggressive reactions to perhaps not very startling moves can drive currencies away from fundamentals”.

Is the Forex market dangerous? Traditional thinking is that when one trades two major currencies there is so much trading volume and liquidity that there are no unexpected jumps in prices and no risk of getting trapped in a trade with no way out. If the Forex market is becoming illiquid it may become dangerous.

Liquidity

Investopedia defines liquidity.

The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.

The ability to convert an asset to cash quickly – also known as “marketability.”

There is no specific liquidity formula; however, liquidity is often calculated by using liquidity ratios.

The traditional problem in trading minor Forex currencies is that they trade in small volume and are thus illiquid. A trader can get caught in a trade in which he or she purchases a currency and then wants to sell. If the currency is illiquid he or she will find no buyers except by dropping the asking price significantly. Is the Forex market dangerous? It is if you are trading an illiquid currency pair. Until now one would have though illiquid pairs were only the minors!

Swiss Central Bank

Not all problems in Forex trading come from recent market illiquidity. In January of 2015 the Swiss Central Bank took its cap off of the EUR CHF pair. The Swiss had been buying Euros to maintain the exchange rate. The bankers decided that this strategy was too expensive given that the European Central Bank was going to start printing money for a quantitative easing program and drive the value of the Euro downward. Within minutes after the cap was lifted the Swiss franc soared against all currencies. DeutcheWelle reported the story.

In a surprise announcement on Thursday, the Swiss National Bank (SNB) said it was ending its policy of trying to keep the value of the Swiss franc at a minimum exchange rate of 1.20 francs for one euro.

Following the announcement, financial markets were in an uproar. The Swiss franc appreciated immediately by almost 30 percent against the euro, breaking past parity and trading at 0.85 francs per euro before dropping back to about 0.98 in later trading.

Traders were faced with margin calls and many lost all of their trading capital. Is the Forex market dangerous? It certainly can be when central banks play fast and loose with monetary policy.