A cross currency refers to a currency pair or transaction that does not involve the U.S. dollar. A cross currency transaction, for example, doesn’t use the U.S. dollar as a contract settlement currency. A cross currency pair is one that consists of a pair of currencies traded in forex that does not include the U.S. dollar. Common cross currency pairs involve the euro and the Japanese yen.
Understanding Cross Currency
At the end of the Second World War, most currencies were pegged and quoted against the U.S. dollar. This was because the U.S. economy in general was the strongest post-war and its currency was fixed to gold. This set precedents when converting two currencies that weren’t U.S. dollars.
Historically, an individual who wished to exchange a sum of money into a different currency would be required first to convert that money into U.S dollars and then convert it into the desired currency. Cross currency transactions could be done under this system, but they sometimes still went through a U.S. dollar calculation to ensure a fair settlement. Although the U.S. dollar still acts as the world reserve currency, the rise of the forex market has made cross currency transactions and cross currency pairs common. The GBP/JPY cross, for example, was invented to help individuals in England and Japan who wanted to convert their money directly without having to first convert it into U.S. dollars.
Advantages of Cross Currency Pairs and Transactions
Since the end of the gold standard and the increase of global trading at a wholesale level, cross currency transactions are part of every day financial life. Not only do cross currency transactions make it easier for international payments, but they have also made them markedly cheaper. Because an individual does not have to swap the currency into U.S. dollars first, there is only one transaction, meaning only one spread is crossed. Furthermore, because non-USD pairs are now more commonly traded, the spreads have tightened making it even cheaper to move from one currency to another.
Cross Currency Pairs in Forex Trading
Cross currency pairs can be excellent tools for forex traders. Some cross currency trades can be set up to position traders on particular world events, such as using the EUR/GBP to bet on the ongoing Brexit saga. The same trade would be more complex and capital intensive setting up separate positions with the USD/GBP and USD/EUR, but this method is still used to create exotic cross currency pairs that are not widely traded. Common cross currency rates involve the Japanese yen. Many traders take advantage of the carry trade where they own a high-yielding currency like the Australian dollar or the New Zealand dollar and short the Japanese yen – the low-yielding currency.