What Is Cross Currency?
Cross currency refers to a currency pair that does not include the U.S. dollar as either the base currency or the quote currency. Instead, these pairs involve two non-USD currencies directly exchanged against each other in the foreign exchange market, also known as FX. While the U.S. dollar has historically been the dominant reserve currency and intermediary in global trade, cross currency pairs allow participants to bypass the dollar, simplifying transactions and potentially reducing exchange rate conversion costs. These pairs fall under the broader category of Foreign Exchange.
History and Origin
Before the modern era of floating exchange rates, international monetary systems often involved currencies pegged to a central reserve currency, such as the U.S. dollar under the Bretton Woods system. In this system, exchanging one non-dollar currency for another typically required converting the first currency to U.S. dollars, and then converting those dollars into the second currency. This two-step process was cumbersome and involved multiple transaction costs.
The demise of the Bretton Woods system in the early 1970s marked a significant shift towards more flexible, floating exchange rates, which laid the foundation for the increased prevalence of cross currency transactions. The system, which effectively became operational in 1958, tied major global currencies to the U.S. dollar, which was itself convertible to gold at a fixed rate.4 When this system collapsed, currencies were allowed to float more freely, driven by market forces. This evolution made direct exchange between non-dollar currencies more feasible and efficient, leading to the growth of the cross currency market as financial institutions and global businesses sought to optimize their international transactions.
Key Takeaways
- Cross currency pairs are exchange rates between two non-U.S. dollar currencies.
- They simplify foreign exchange transactions by eliminating the need for an intermediary U.S. dollar conversion.
- The rise of cross currencies is linked to the post-Bretton Woods era of floating exchange rates.
- Trading in cross currency pairs can offer diversification benefits and specific speculative opportunities.
Formula and Calculation
A cross currency rate is typically derived from the individual exchange rates of each currency against a common third currency, most often the U.S. dollar. For instance, to find the cross rate between the Euro (EUR) and the Japanese Yen (JPY), given their rates against the U.S. dollar (USD), the following calculation can be performed:
If EUR/USD is 1.1000 (meaning 1 EUR = 1.1000 USD)
And USD/JPY is 150.00 (meaning 1 USD = 150.00 JPY)
Then, to find EUR/JPY, you would multiply the two rates:
This means that 1 Euro is equivalent to 165.00 Japanese Yen. This method of calculation is fundamental to understanding how various exchange rates are interconnected within the broader foreign exchange market.
Interpreting the Cross Currency
Interpreting cross currency rates involves understanding the relative strength or weakness of two non-U.S. dollar currencies against each other. For example, if the EUR/JPY cross rate is rising, it indicates that the Euro is strengthening relative to the Japanese Yen, or conversely, the Japanese Yen is weakening against the Euro. Factors influencing this movement can include divergent interest rate differential policies between the European Central Bank and the Bank of Japan, varying economic indicators in the Eurozone and Japan, or geopolitical events impacting one region more than the other.
Traders and businesses use these cross rates to assess trade competitiveness, investment opportunities, and the cost of international transactions without the U.S. dollar as a reference. A higher cross rate for a specific pair might signal that it is more expensive to purchase the quote currency with the base currency, or vice versa, depending on the quote convention (direct quote or indirect quote).
Hypothetical Example
Imagine a German company that needs to pay a supplier in Australia for imported goods. The invoice is for 100,000 Australian Dollars (AUD). The German company holds Euros (EUR). Instead of converting EUR to USD and then USD to AUD, they can directly convert EUR to AUD using the cross currency rate.
Let's assume the current rates are:
- EUR/USD = 1.0800
- AUD/USD = 0.6800
To calculate the EUR/AUD cross rate:
- First, determine how many USD 1 EUR buys: 1 EUR = 1.0800 USD.
- Next, determine how many EUR 1 AUD buys. This requires inverting the AUD/USD rate to USD/AUD, then multiplying by EUR/USD:
- USD/AUD = 1 / 0.6800 1.4706 USD per AUD.
- EUR/AUD = EUR/USD / (AUD/USD) = 1.0800 / 0.6800 1.5882
So, 1 EUR buys approximately 1.5882 AUD.
To pay 100,000 AUD, the German company would need:
This direct conversion simplifies the process and allows the company to manage its currency risk more directly without involving the U.S. dollar. This is a common practice in currency trading for international businesses.
Practical Applications
Cross currency pairs are fundamental to global trade, investment, and financial transactions that do not involve the U.S. dollar. Their practical applications are widespread:
- International Trade and Business: Companies conducting business between two non-U.S. dollar countries can use cross currency pairs for direct invoicing and payments, streamlining operations and potentially reducing conversion costs. For example, a Japanese exporter selling goods to the United Kingdom can price and receive payments directly in GBP, converting them to JPY without an intermediate USD step.
- Portfolio Diversification: Investors seeking to diversify their portfolios beyond major USD-centric pairs can explore cross currency pairs, which may offer different volatility and correlation characteristics. This can be particularly appealing for those looking to manage overall currency risk across various regions.
- Arbitrage Opportunities: Discrepancies in cross currency rates across different forex broker platforms or liquidity providers can create arbitrage opportunities, allowing traders to profit from small price differences.
- Central Bank Operations: Even central banks engage in cross currency transactions, sometimes for reserve management or to influence specific bilateral exchange rates to achieve monetary policy goals. For instance, a central bank might buy or sell a non-dollar currency to stabilize its own currency's value against a specific trading partner's currency, as seen with the Bangladesh Bank's recent interventions to stabilize the local currency against the U.S. dollar by buying foreign currency reserves.3
The Bank for International Settlements (BIS) Triennial Central Bank Survey provides comprehensive insights into the global foreign exchange market, including the volume and structure of cross currency trading, highlighting its significant role in global finance.2
Limitations and Criticisms
While cross currency pairs offer efficiency, they come with their own set of considerations. One limitation is generally lower liquidity compared to major currency pairs involving the U.S. dollar. Lower liquidity can lead to wider bid-ask spread and potentially greater price volatility, making it more challenging to execute large trades without impacting the market price. This can increase transaction costs for participants.
Furthermore, the foreign exchange market, including cross currency trading, has faced criticisms related to market manipulation. A prominent example is the "forex scandal" of 2013, where several major banks were found to have colluded to manipulate exchange rates for their own financial gain, resulting in billions of dollars in fines.1 Such incidents highlight the inherent risks and the importance of regulatory oversight in ensuring fair and transparent market practices. While cross currency trading itself is not inherently problematic, it operates within this broader market context where such risks exist.
Cross Currency vs. Currency Pair
The terms "cross currency" and "currency pair" are closely related but not interchangeable. A "currency pair" is a general term referring to any two currencies quoted against each other, such as EUR/USD, GBP/JPY, or AUD/CAD. It simply indicates the relative value of one currency against another.
"Cross currency," specifically, refers to a type of currency pair where neither of the two currencies involved is the U.S. dollar. For example, EUR/JPY, GBP/CHF, and AUD/NZD are all cross currency pairs. Conversely, EUR/USD, GBP/USD, and USD/JPY are currency pairs, but they are not cross currencies because they include the U.S. dollar.
The distinction primarily lies in the presence or absence of the U.S. dollar as one of the constituent currencies in the pair. Understanding the specific nature of a currency pair as a cross currency helps in assessing its market characteristics, such as liquidity and typical trading patterns, which often differ from U.S. dollar-centric pairs.
FAQs
What is the primary difference between a major currency pair and a cross currency pair?
The primary difference is the U.S. dollar. Major currency pairs always involve the U.S. dollar, such as EUR/USD or USD/JPY. Cross currency pairs, on the other hand, do not include the U.S. dollar, for example, EUR/GBP or AUD/NZD.
Why would someone trade a cross currency pair instead of a major pair?
Traders or businesses might choose cross currency pairs to directly hedge or execute transactions between two non-USD currencies, avoiding the need for a two-step conversion through the U.S. dollar. This can sometimes reduce costs and simplify the process. They may also seek diversification or capitalize on specific economic trends or interest rate differential between two non-U.S. dollar economies that are not directly correlated with U.S. economic factors.
Are cross currency pairs less liquid than major currency pairs?
Generally, yes, cross currency pairs tend to be less liquid than major currency pairs because the U.S. dollar is the world's most traded currency. Lower liquidity can result in wider bid-ask spread and potentially greater price movements, making them riskier for large transactions.
How do central banks impact cross currency rates?
Central bank actions, such as setting interest rates or intervening in the foreign exchange market by buying or selling foreign currencies, can significantly impact exchange rates, including cross currency rates. Their policies directly influence the supply and demand dynamics of their respective currencies.
Can individuals trade cross currency pairs?
Yes, individuals can trade cross currency pairs through various online forex broker platforms. However, due to potentially lower liquidity and wider spreads compared to major pairs, careful consideration of the associated risks is advisable.