Incredibly, the forex market comprises 170 different currencies, including major entities such as the US Dollar (USD), which is on one side of 88% of all foreign exchange trades.
Foreign exchange trades that don’t use the USD as the contract settlement currency are described as ‘cross currency’, while this term also refers to a minor or major currency pair that doesn’t feature the greenback (such as the Euro and the Japanese Yen).
In this post, we’ll explore the history of cross currency pairs, while asking what separates them from major currency alternatives.
Cross Currency Pairs vs. Major Currency Pairs – What You Need to Know
At the end of the Second World War, most currencies were pegged to and quoted against the USD. This was due to the relative strength of the US economy at this time, while the greenback was also pegged to a stable asset in the form of gold.
As the forex market evolved and cross currency transactions became increasingly commonplace, however, different pairings were created to allow trades to be completed without first converting the deserted sum of money into US dollars.
But how do cross currency pairs differ from major alternatives? The most obvious difference revolves around liquidity, as major currencies include assets such as the greenback, the Euro and pound sterling are far easier to buy, sell and trade on the forex market.
Conversely, cross currency pairs often include minor or exotic assets such as the Thai baht, which is slightly less liquid and therefore not as immediately appealing to investors.
However, there are a growing number of cross currency pairs that enable investors to capitalise on the relative value of one asset against another.
A recent example saw the EUR/GBP pairing fluctuate wildly for four years following the EU referendum result on June 23rd 2016, rising by 13% during one two-week period alone.
The Pros and Cons of Trading Cross Currency Pairs
One of the main advantages of trading cross currency pairs is that this enables investors to access highly correlated pairings that offer increased liquidity in a number of different time zones.
The EUR/GBP is definitely an example of this, with the correlation between these two currencies indicative of the close trade and economic relations that exist between the nations in question.
So, not only can currency traders access a wider and more diverse range of assets by targeting cross pairs, but this also makes it possible to profit from the economic relationships that exist between two regions.
Another benefit of trading forex cross pairs is that this allows investors to buy and sell the stringent and weakest currencies in the market, without being governed solely by the performance of the greenback.
But are there any cons to trading cross currency pairs (aside from the lack of liquidity associated with some assets)? The short answer is yes, particularly as the settlement of cross pair trade isn’t always as easy as the actual transaction.
Since there is ample liquidity on a major cross trade, most brokers will execute such orders using a relatively tight bid offer spread. However, when you exit the position your profits could be in a currency that isn’t your domestic one, forcing you to complete another transaction to convert your gains.
You should also consider the higher levels of volatility associated with cross pair trades, although this can be seen as an advantage amongst investors with a healthy appetite for risk.