Synthetic currency pairs and their creation

Synthetic Currency Pairs: A Tool for Institutional Traders

 

Institutional traders often face challenges when trading certain cross-currency pairs due to the large volumes they process. This can result in insufficient liquidity to execute their orders.

 

To overcome this issue, they use a method called synthetic pairs, which allows them to trade currency pairs indirectly through more liquid instruments.

How Are Synthetic Pairs Created?

 

Let’s say an institutional trader wants to buy the GBP/JPY pair but encounters a lack of liquidity. In this case, they execute two separate transactions:

1.Buy GBP/USD

2.Sell USD/JPY

 

By using the US dollar as an intermediary currency, they effectively open a position on GBP/JPY. These pairs — GBP/USD and USD/JPY — are referred to as the “legs” of the synthetic pair.

 

This approach works because major currency pairs involving the US dollar tend to have high liquidity, enabling institutional traders to execute large orders without significantly impacting the market.

What About Retail Traders?

 

If you’re a retail trader and want to try trading synthetic pairs, it’s technically possible, but in most cases, it’s not practical.

 

Why? Modern broker platforms provide access to a wide range of cross-currency pairs, including exotic pairs like GBP/NZD or CHF/JPY, with sufficient liquidity.

 

Advantages of Trading Cross-Currency Pairs Directly:

1.Lower Spreads: Spreads on cross-currency pairs are typically narrower than those resulting from manually creating synthetic pairs through two separate trades.

2.Optimized Margin Usage: Opening a synthetic pair requires margin for both “legs” of the trade. By trading the cross directly, you conserve capital for other opportunities.

3.Ease of Use: There’s no need to calculate correlations or manage two positions simultaneously.

Tips for Retail Traders

 

If you’re not trading volumes in the billions, creating synthetic pairs is rarely the best choice. Focus on trading available cross-currency pairs directly.

 

Here’s Why:

•Technology Simplifies Trading: Modern broker platforms offer seamless access to even exotic currency pairs.

•Saves Time and Effort: You spend less time managing trades and calculating values.

•Better Profitability: Lower transaction costs and simplified management improve your returns.

When Are Synthetic Pairs Useful?

 

Synthetic pairs can be beneficial in specific scenarios:

•If your broker doesn’t offer access to certain cross-currency pairs.

•If the desired cross-currency pair has low liquidity and you want to avoid slippage.

•If you’re employing unique strategies based on the correlation between specific pairs.

Conclusion

 

Creating synthetic pairs is a useful tool, but it is primarily designed for institutional traders dealing with large volumes and unique requirements.

 

For retail traders who aim to manage their capital efficiently and avoid unnecessary complexity, trading cross-currency pairs directly is often a better option.

 

Pro Tip:

Before opening trades, always analyze spreads, margin requirements, and instrument availability. This not only minimizes costs but also enhances your overall trading profitability.