Cross-currency trading without the use of US dollars

Cross currencies, often referred to as currency pairs excluding the US dollar, play a unique role in the realm of global exchange rate transactions, which predominantly involve the US dollar or ‘greenback.’ Cross currencies allow other currencies to take center stage in transactions. Trading in cross currencies presents an opportunity for more significant currency fluctuations. This is because currency pairs not linked to the US dollar can experience more pronounced price swings. Traders can engage in trading weaker economies against stronger ones, offering the potential for larger profits but also exposing themselves to greater losses. Cross currency trading also serves as a valuable tool for hedging purposes.

Cross currencies involve major currencies paired without reference to the US dollar, such as pound/yen (GBP/JPY) or euro/Swiss franc (EUR/CHF). In these pairs, the first currency on the left is known as the ‘base’ currency, while the second on the right is the ‘quote’ currency. Interest rates hold significant sway over currency movements. Transaction Costs Transaction costs, as reflected in the spread, tend to be wider in cross currencies. The spread cost depends on the level of trading activity for a particular currency pair, driven by basic principles of supply and demand. When trading different currencies, you encounter both the sell price (bid) and the buy price (ask). The difference between these two prices constitutes the spread, representing the cost incurred for executing the trade. Currency movements are typically measured in pips, with most major currencies quoted to the fourth or even fifth (or sixth) decimal place. For instance, if you observe an EUR/GBP spread, you might find a sell/bid price of 0.8486 and a buy/ask price of 0.8487 (late April 2017). This translates to a spread of one pip, indicating that one euro is equivalent to 85 pence. The narrowness of the spread serves as an indicator of the liquidity of a specific currency pair, reflecting how easily it can be bought and sold. In contrast, when examining sterling against the yen, you may notice a GBP/JPY pair with a sell/bid price of 142.73 and a buy/ask price of around 142.76 (late April 2017). In this case, the spread is three pips wider (since the spread for the Japanese yen is typically quoted with only two decimal points). For less ‘liquid’ currencies, the pip spread can extend to as much as 10.

Diversification and Strategy

Similar to investing in a variety of stocks in the stock market, cross currencies offer diversification opportunities. Over the long term, it is advantageous to have exposure to multiple currency pairs, enabling you to comprehend how these currencies react to one another based on economic or political news. When you purchase currencies, you are essentially acquiring one currency while simultaneously selling another. For instance, if you reside in the UK and purchase US dollars, you are both buying the US dollar and selling British pounds. In essence, this involves two transactions, even though the pricing transaction is treated as a single unit. This differs from stock market transactions where you may typically acquire a single stock without an immediate link to other stocks. Bear in mind that all cross currencies still exhibit a relationship with the US dollar, even when you are trading other currencies. Successful cross currency trading often relies on robust fundamental analysis, considering factors such as interest rates, exposure to commodities (such as gold or oil), employment data, and sovereign debt levels in relation to both currencies. It is essential to grasp the economic conditions of both currencies involved and appreciate ‘safe haven’ considerations. This pertains to the resilience of certain currencies during market downturns.

Handling Considerable Risks

While executing a trade involving cross currency pairs is straightforward, the selling aspect can be riskier. This is because when you exit the trade, your profit or loss may be denominated in a currency other than your home currency. For instance, if your home currency is the British pound, and you have a profitable cross EUR/JPY trade, you will need to convert that profit back into pounds. Cross rate trading is inherently linked to speculation and carries multiple risks, including political, economic, and environmental factors. Many investors experienced losses when the Swiss National Bank removed the euro-Swiss franc peg in early 2015. Similarly, the pro-Brexit vote in the UK in June 2016 led to significant currency fluctuations in GBP/EUR and GBP/USD. Further back in history, substantial losses were incurred in 1997 due to the Thai baht crisis. Up until that point, Thailand had pegged its currency to the yen and the dollar. Lacking sufficient currency reserves, Thailand was compelled to abandon the peg, triggering the Asian financial crisis that subsequently affected South Korea and Indonesia. Therefore, risk management should be a top priority when dealing with these risk factors.

In Conclusion

It’s crucial to recognize that, in any cross currency trade, you must assess the economic and political conditions of not just one but two countries, and possibly more if you aim to capitalize on regional disparities. Risk is heightened when dealing with minor and exotic currency pairs, often originating from developing regions such as Africa, the Middle East, and South America. Additionally, be aware that some brokers may charge higher spreads during specific times of the day when liquidity is lower in certain time zones, such as Asia or South America. Major Currency Cross Pairs (High Liquidity):

• EUR/CHF – Euro/Swiss Franc
• EUR/GBP – Euro/British Pound
• EUR/JPY – Euro/Japanese Yen
• GBP/JPY – British Pound/Japanese Yen

Minor Cross Currency Pairs:

• AUD/CHF – Australian Dollar/Swiss Franc
• AUD/JPY – Australian Dollar/Japanese Yen
• CHF/JPY – Swiss Franc/Japanese Yen
• EUR/CAD – Euro/Canadian Dollar
• GBP/AUD – British Pound/Australian Dollar
• NZD/JPY – New Zealand Dollar/Japanese Yen

Exotic Currency Pairs (Handle with Caution):

• IQD/QAR – Iraqi Dinar/Qatari Rial
• LBP/ILS – Lebanese Pound/Israeli Shekel
• PLN/RUB – Polish Zloty/Russian Ruble
• HUF/EEK – Hungarian Forint/Estonian Kroon

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