The currency market is the world’s most liquid capital market, with a daily volume of $6.6 trillion per day. The daily turnover is driven by central banks, commercial banks, trading companies, corporate treasurers, and retail speculators. The currency market is also known as the foreign exchange or forex market.
The security that is used in the currency markets is a currency pair. A currency pair is one currency as a ratio to another, referred to as the exchange rate. The exchange rate is also changed if one currency in a pair is altered. Some of the more liquid currency pairs are referred to as major currency pairs. There is also a group known as minor currency pairs, cross-currency pairs, and emerging currency pairs.
What is a Currency Pair
A currency pair is a quotation of the ratio of two different currencies, with the value of one currency being quoted against the other. The currency pair is a ratio that indicates how much the quoted currency is needed to purchase one unit of the base currency. For example, the currency pair EUR/USD means how many U.S. dollars are required to buy one Euro.
The value of a currency pair is the exchange rate. There is a base currency and a counter currency. In the example of EUR/USD, the base money is the Euro, and the counter currency is the dollar. The security that is traded is a currency pair. If you purchase a base currency pair and are looking for the exchange rate to rise, generate more dollars for every Euro you own.
What are Major Currency Pairs
The major currency pairs most active in forex trading are the currency pairs. Each of the major currency pairs is traded versus the U.S. Dollar. You can not have a major currency pair without the dollar as the base or counter currency. The major currency pairs are EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CAD, and USD/CHF.
Traders will trade the major currency pairs because they attract more volume and allow investors to enter and exit cheaply. Not only is the bid/offer spread, the level between where a market maker will purchase and sell a currency pair, tighter, but the slippage is also more negligible. When volatility arises, the bid-to-offer spread can widen, reflecting less liquidity and higher uncertainty.
The bid side of a currency pair is where a market will purchase the base currency and sell the counter currency. The offer of the currency pair is where the market maker will sell the base currency and purchase the counter currency.
Slippage is the amount an investor might lose by buying or selling a currency position. The larger the volume, the more likely slippage will occur when a transaction is completed. Additionally, when markets are more volatile because of new information or times of insecurity, slippage can be larger on currencies that are not major currency pairs.
What are Minor Currency Pairs, Cross Currency Pairs and Exotic Currencies
Currency pairs that are not associated with the U.S. dollar are often referred to as cross-currency pairs. These are also considered minor currency pairs, but a minor currency pair can also be a forex pair that includes the dollar versus a non-major currency. For example, the Norwegian Krone is Norway’s currency, not part of the E.U. that accepts Euros as their main currency.
The Norwegian Krone versus the U.S. dollar is a minor currency pair. An example of a cross-currency pair with much liquidity would be the GBP/EUR or the EUR/JPY. An exotic or emerging currency pair is a nation that is still emerging, and its currency is referred to as exotic or emerging. For example, a USD/SGD, the U.S. dollar versus the Singapore dollar, would be considered an exotic currency pair.
What are the Top Currency Pairs
The top currency pairs are the major ones that have the most liquidity. These currency pairs have robust levels of trade that require hedging by companies that sell or buy from another country and have speculative liquidity.
The major currency pair with the most liquidity and the most turnover is the EUR/USD. In 2022 the daily average turnover showed that the EUR/USD attracted 22.7% of the total volume of currency traded worldwide.
The currency pair with the next largest volume is the USD/JPY, a major currency pair. The USD/JPY differs from the EUR/USD in that the dollar is the base currency, and the Japanese Yen is the counter currency. The exchange rate will show the amount of Yen needed to purchase one dollar. When you purchase the currency pair, you buy the dollar and sell the Yen.
About 13.5% of the total currency turnover is through the USD/JPY. While there is a large gap in volume between the EUR/USD and the USD/JPY, there is less of a gap between the turnover between the second-largest and the third-largest currency pairs by volume. The GBP/USD has a daily turnover of 9.5% per day. The GBP/USD is quoted where the British Pound is the base currency, and the dollar is the counter currency.
The fourth most active currency is not a major currency pair. In 2022, the USD/CNY, the Chinese Yuan, captured 6.6% of the total daily turnover of currency pair volume. The Chinese Yuan was followed by the USD/CAD, the fifth largest currency pair by volume, capturing about 5.5% of the total turnover. The USD/CAD is a major currency pair; in this pair, the U.S. dollar is the base currency, and the Canadian Dollar is the counter currency.
Forward Trades Versus Spot Trades
The currency trading that generates the most liquidity is spot trading. The spot market is defined as a currency trade where the currency is delivered between each counterpart within two business days. The currency is transferred from one currency bank account to another. For example, you might have a bank account that only accepts dollars and only takes Euros. If you purchase the EUR/USD, you must accept Euros in a Euro account and send dollars from a dollar account.
You can trade a forward transaction if you do not want to change currency within two days. Your obligation in a forward transaction is to exchange each currency at a date longer than two business days. A forward transaction can be any period. Forward rates differ from spot rates in that the difference between each country’s interest rates is incorporated into the forward rate. The difference between each country’s interest rate makes up the forward points added or subtracted from a spot rate to reflect the benefit of holding a higher-rate currency.
How Does Liquidity Help Trading?
By using actively traded currencies, investors can use several different types of trading strategies and not worry whether they will be caught in a trade and unable to exit. Technical trading strategies, such as short-term trend-following and momentum trading strategies, require dexterity when entering and exiting a currency pair. Liquidity helps you plan your risk management, enabling you to determine how much you are willing to risk on trade to generate the desired profit.
Avoiding Political Risk
Currency trading is performed for many reasons. If the goal is speculation, you want to venture into liquid currency pairs and are less likely to experience political risks. Exotic currencies are much more subject to changes in the political landscape than the major currencies. Additionally, the bid/offer spread on an exotic market currency pair will usually be wide, reflecting the concern over the ability of a market maker to enter and exit a position.
The Bottom Line
There are several reasons why specific currency pairs seem to be more common than others. Part of the reason is trade between countries, which generates volume and the willingness of investors to trade these markets. A market provides liquidity with robust trade between countries, the willingness for banks to be intermediaries, treasuries that want to hedge, and large and small speculators.
The most liquid is the Euro versus the U.S. Dollar which drives nearly 23% of the currency market’s daily turnover. For treasuries with operations in these regions and investors wanting to trade these markets, the huge volumes of liquidity that roll through the Eurozone and the United States make this pair popular from the largest to the smallest investors.
The top three currency pairs in terms of liquidity are rounded out, with the Yen and the British Pound being the next most liquid versus the U.S. Dollar. These three currency pairs are part of what is referred to as the major currency pairs, which are the most liquid. A major currency pair has to have the U.S. dollar as part of the pair. The dollar can be the base or counter currency to be considered a major currency pair. These currency pairs will receive the lion’s share of the daily turnover, which is reported to be more than 6 trillion dollars per day.