Skip to main content
Bid-Ask, Spreads, and Slippage

How Liquidity Affects Spreads in Forex Markets

Pomegra Learn

How Liquidity Affects Spreads in Forex Markets?

Liquidity is the lifeblood of efficient forex markets, and its relationship to bid-ask spreads is one of the most direct and measurable forces in currency trading. When liquidity and spreads move together, traders benefit from tighter execution costs; when liquidity evaporates, spreads widen dramatically. Understanding this dynamic is essential for anyone managing real trading expenses in forex. The fundamental principle is simple: more buyers and sellers competing at the same price level means tighter spreads; fewer participants means wider spreads and higher costs.

Quick definition: Liquidity refers to the ease and speed of buying or selling an asset without moving its price significantly. Higher liquidity results in tighter bid-ask spreads because more market participants compete to execute orders.

Key Takeaways​

  • Bid-ask spreads shrink when liquidity increases because more order flow fills the market depth
  • Highly liquid currency pairs (EUR/USD, GBP/USD) typically have spreads of 1–2 pips; illiquid pairs often exceed 5–10 pips
  • Global trading sessions with the largest participant concentration produce the tightest spreads
  • Algorithmic traders and market makers actively widen spreads during liquidity droughts to manage risk
  • Central bank interventions and news events can drain liquidity instantly, causing spread expansion within milliseconds

The Direct Mechanism: Order Book Depth and Spread Width​

Liquidity operates through a straightforward mechanism visible on any depth chart. When the EUR/USD pair attracts millions of euros in buy orders and sell orders stacked at multiple price levels, market makers face minimal risk standing between buyers and sellers. A market maker willing to buy at 1.0850 and sell at 1.0852 can do so repeatedly because the order book absorbs trades instantly. The 2-pip spread compensates only for minimal inventory risk and operating costs.

Now reverse the scenario: imagine a currency pair with thin order books, perhaps an emerging-market pair like the Thai Baht (THB) traded against the dollar. Buyers and sellers are sparse. A market maker might demand a 20-pip spread—buy at 35.10, sell at 35.30—because holding inventory overnight without immediate offsetting trades exposes them to substantial directional risk. They widen the spread to compensate for that risk premium.

Research from the Bank for International Settlements (BIS) quantifies this relationship. Major pairs like EUR/USD maintain average spreads of 1.2–1.5 pips during London and New York hours; the same pair widens to 3–5 pips during Asian session lows when fewer traders are active. Minor pairs (EUR/GBP, USD/CHF) show spreads of 2–4 pips at peak liquidity, versus 8–15 pips during off-peak windows.

Peak Liquidity Windows and Spread Compression​

The forex market never sleeps, but it does doze. Three trading sessions—Tokyo, London, and New York—dominate global FX volume. When two sessions overlap, liquidity spikes and spreads compress.

London–New York overlap (8:00–12:00 GMT): This is the holy grail of liquidity in forex. The overlap brings together approximately 70% of daily global FX volume. EUR/USD spreads often tighten to 0.8–1.2 pips as thousands of banks, hedge funds, and retail brokers flood the market. A trader executing a 5-million-euro position during this window might pay 1.0 pips in spread cost; the same trade outside overlap hours might cost 3–4 pips, adding €15,000–€20,000 in spread cost for identical size.

Tokyo session (21:00–06:00 GMT): Strong for Asian currency pairs. USD/JPY and AUD/USD attract heavy volume. During peak Tokyo hours, USD/JPY spreads compress to 1–1.5 pips; outside those hours, spreads can widen to 3–5 pips.

Off-peak periods: Between 22:00 GMT (post-London close) and 21:00 GMT (pre-Tokyo open), liquidity is minimal. Major pairs widen by 50–150%, and minor pairs can become nearly untradeable. A trader needing to execute during these windows accepts substantially higher costs or waits for the next major session.

Market Maker Behavior and Spread Dynamics​

Market makers adjust spreads in real time based on order book conditions, not just overall liquidity. When a major bank or hedge fund places a large buy order, the spread widens slightly—market makers raise their asking price because they anticipate more buy interest, signaling willingness to sell at higher levels. Conversely, heavy sell orders prompt them to lower their bid, reflecting sell pressure.

Technology amplifies this response. Electronic communication network (ECN) platforms aggregate orders from hundreds of participants, and algorithms automatically adjust prices in microseconds. A liquidity crunch that once took seconds to reflect in spreads now happens in milliseconds. During the March 2020 COVID-19 market shock, some major pairs experienced spread explosions:

  • EUR/USD: Widened from 1.2 pips to 20–40 pips for 10 minutes
  • GBP/USD: Reached 35 pips amid sterling volatility
  • USD/JPY: Hit 25 pips as safe-haven demand overwhelmed supply

These extremes occurred because liquidity evaporated—every bid had no matching seller, every offer had no matching buyer. Spreads exploded as compensation for market makers' inability to exit positions.

Flowchart​

Spread Behavior Across Currency Pair Categories​

Not all currency pairs respond identically to liquidity changes. Majors (EUR/USD, GBP/USD, USD/JPY, USD/CHF) dominate roughly 60% of daily FX volume. Their spreads remain tight even in low-liquidity periods because institutional demand is persistent. EUR/USD rarely exceeds 5 pips except during extreme events.

Minors (EUR/GBP, GBP/JPY, AUD/USD) have thinner order books. They widen proportionally more when liquidity drops. A minor pair might trade at 2 pips during peak hours and 10 pips during Asia off-hours.

Exotics (USD/THB, USD/MXN, USD/ZAR) are highly illiquid. Spreads regularly exceed 10–30 pips because only a handful of market makers supply liquidity. A trader entering an exotic pair accepts substantial spread costs as the price of accessing less-traded currencies.

Real example: On May 10, 2022, amid European central bank uncertainty, EUR/USD spreads remained near 1.5 pips during London hours, but USD/TRY (Turkish lira exotic pair) widened from 8 pips to 25 pips as local and international participants rushed to adjust positions.

Volatility's Hidden Impact on Spreads​

Volatility and liquidity are intertwined but distinct. High volatility—large, rapid price swings—makes market makers nervous about inventory risk. Even if raw order flow volume is high, volatility causes spreads to widen as a risk surcharge.

During earnings announcements or central bank decisions, volatility spikes. The Federal Reserve interest-rate decision on May 1, 2024, triggered a 40-point move in EUR/USD within 4 hours. Spreads widened from 1.2 pips to 8–15 pips not because fewer traders were present, but because the risk of holding positions between bids and asks multiplied. Market makers demanded compensation for that volatility risk.

This explains why spreads widen during news even if raw transaction volume remains high—liquidity quality deteriorates because fear replaces normal trading patterns.

Measuring Liquidity: Microstructure Indicators​

Traders and brokers measure liquidity using several metrics:

  • Bid-ask spread: Direct measure; tight spreads signal liquidity
  • Market depth: Volume available at each price level
  • Impact cost: The true cost of executing large trades without moving the market significantly
  • Resilience: How quickly the order book rebounds after a large trade

The Federal Reserve's Financial Stability Reports and academic research from the BIS show that these metrics correlate strongly. Currency pairs with tight spreads also show high market depth and low impact costs.

Common Mistakes When Managing Liquidity Costs​

Mistake 1: Trading illiquid pairs without research. Exotic pairs often appear to offer favorable price moves, but spread costs erode small profits instantly. A trader betting on a 50-pip move in USD/THB pays 10–15 pips just in spread costs, cutting profit potential in half.

Mistake 2: Executing large orders at peak spread times. Some traders believe off-peak is always bad, but they execute limit orders during peak spreads when they could have waited 2–3 hours for tighter spreads. A 10-million-unit order might cost an extra €50,000 in spread cost by executing during a wider spread window.

Mistake 3: Ignoring session overlap calendars. Casual traders often trade when they wake up, not when liquidity is best. A New York retail trader trading USD/JPY at 22:00 EST (early morning Tokyo) pays 4–5 pips instead of 1–1.5 pips during the London–New York overlap, just hours later.

Mistake 4: Confusing leverage with liquidity. A broker offering 50:1 leverage doesn't guarantee tight spreads. Many retail brokers widen spreads during high leverage periods to manage their own counterparty risk.

Mistake 5: Placing market orders for illiquid pairs. On minor and exotic pairs, slippage (the gap between expected and actual fill price) can exceed spreads during market orders because your order consumes multiple price levels on thin order books.

Real-World Examples​

Case 1: Brexit Referendum (June 23, 2016). The surprise vote to leave the EU triggered a liquidity collapse. GBP/USD spreads exploded from 1–2 pips to 50–100 pips within 10 minutes. Many retail traders couldn't exit positions at reasonable prices for hours. Stops were triggered far from their intended levels.

Case 2: Flash Crash in Swiss Franc (January 15, 2015). The Swiss National Bank unexpectedly removed the EUR/CHF floor at 1.20. Spreads on EUR/CHF widened from 1 pip to 30–50 pips instantly. Professional traders had set tight stops; retail traders faced massive slippage.

Case 3: Emerging Market Crisis (March 2020, COVID-19 Pandemic). Liquidity drained from all asset classes. Even major forex pairs like GBP/USD experienced 20+ pips spreads at times. Traders forced to hold illiquid positions faced 100+ pip spreads on exotic pairs. Central bank interventions (BOE, ECB) eventually stabilized spreads.

FAQ​

What is the relationship between volume and spreads?​

Higher trading volume creates tighter spreads because more bids and asks compete at the same price level, reducing market makers' inventory risk. The correlation is strong for major pairs but weaker for exotics, where volume can be high yet spreads remain wide due to directional risk.

How much do spreads typically widen during central bank announcements?​

Spreads usually widen 2–5x their normal level during high-impact economic announcements. A pair trading at 1.5 pips might widen to 5–8 pips for 15–30 minutes, depending on the surprise magnitude and market reaction speed.

Can I predict spread widening before it happens?​

Partially. News calendars tell you when announcements are scheduled. Pre-announcement volatility (implied volatility in options markets) also signals expected volatility and wider spreads. However, surprise economic data or geopolitical events can cause spreads to widen without warning.

Why are spreads tight during London hours?​

London is the primary forex hub, hosting the largest concentration of banks, hedge funds, and trading firms globally. The London–New York overlap combines London's volume with New York's, creating peak liquidity and minimal spread costs.

Does using an ECN broker guarantee tighter spreads?​

ECN brokers aggregate orders from multiple participants, tightening spreads, but they pass spreads directly to you—there is no markup by the broker itself. During low-liquidity periods, ECN spreads can still widen significantly. The advantage is transparency; the disadvantage is exposure to raw market spreads.

How do algorithmic traders impact spreads?​

Algorithms provide liquidity by placing orders and canceling them quickly, tightening spreads. They also drain liquidity by executing large orders rapidly. During stress periods, algorithms can amplify spread widening by withdrawing liquidity simultaneously.

Summary​

Liquidity and spreads move in opposite directions: higher liquidity compresses spreads, while liquidity droughts widen them dramatically. Market makers adjust spreads in real time based on order book depth and volatility, compensating for inventory risk. Major currency pairs maintain tight spreads during peak session overlaps (London–New York) but widen significantly during off-peak hours and exotic trades. Understanding when and where liquidity is strongest allows traders to minimize spread costs and execute larger positions with lower impact. Ignoring liquidity dynamics leads to expensive mistakes: trading illiquid pairs without research, executing during wide-spread windows, and failing to account for the true microstructure costs of currency trading.

Next​

→ Spreads During News Events