How is base currency vs quote currency defined in forex

Why is the dollar second in most majors pairs on forex, but first with the Japanese yen and Canadian dollar? And why is the euro first in all its pairs and the Japanese yen second in all its pairs? The explanation is very simple.

Trading in the currency market is specific in that by opening a position, you are speculating on the rise of one currency and/or the fall of the other. So in one instrument you have two currencies where the value of one currency is quoted against the value of the other currency. The currencies in a currency pair are also referred to accordingly, i.e. the first currency is referred to as the base currency and the second is referred to as the quoted currency. Thus, in the most traded currency pair, the euro is the base currency, whereas the US dollar is the quoted currency. The EURUSD pair thus represents the value of one euro expressed in a given amount of US dollars.

How are currency pairs quoted?

Forex traders take it for granted that currency pairs are traded in a predetermined format and don't think much about it. But why are individual pairs on forex quoted as we know them from trading platforms? The answer is actually very simple, it is due to conventions and in principle there is no precise rule by which currency quotes in forex are determined.

Only the abbreviations used for the currencies themselves are clearly defined, and these are defined by the International Organization for Standardization (whose abbreviation ISO comes from the Greek word isos) within the ISO 4217 standard.

The USD is the most traded currency on the forex market, and therefore one would expect the US currency to be the top currency in most pairs. However, the position of currencies in a currency pair is not determined by the liquidity of the currency or its strength. The truth is that the USD is often listed as the base currency in pairs involving less-traded or exotic currencies, and its value tends to be higher in these cases.

Clearly defined order

The basic rule that determines the mutual quotation of the ten most important currencies, i.e. the currencies of the G10 countries, is to arrange the currencies in the following order: EUR - GBP - AUD - NZD - USD - CAD - CHF - NOK - SEK - JPY.

In the GBPUSD pair, the order is determined both by the strength of the currency and by historical practice, as the British pound is the oldest currency in common use in the world today. It originated in 760 and was pegged to gold until 1940.

This is similar to the AUDUSD and NZDUSD pairs, for example, as both the Australian and New Zealand dollar have historically had a close link to the British pound. Here, the US dollar is the stronger currency, yet it is listed as the second most valuable currency (however, in the early days of forex in the 1970s, both AUD and NZD were more valuable than the dollar).

In the USDCHF pair it is again the weaker currency, the Swiss franc has been the more valuable currency recently. However, even this is more a matter of recent years, as the CHF is considered the most popular safe haven among traders, and therefore its value has appreciated significantly practically since the start of the new millennium.

An interesting case is the EURGBP pair, which actually makes the euro the only currency that appears as the base currency in all currency pairs, i.e. in first place. This is one of the few cases where, although the base currency has never been stronger than the quoted currency, the traders themselves have decided how this pair will be traded in forex. In fact, when the ECB introduced the euro in 1998, it decided that the euro would always be listed first in currency pairs, but this was not agreed to by London bank officials who were used to the historical rule that the GBP was always first. When euro trading started in early 1999, both EURGBP and GBPEUR were available on Reuters or EBS terminals, but eventually the EURGBP pair used today took over.

Another interesting feature are some of the rules used by some financial institutions in their home market. In the case of the EURGBP pair, some UK institutions use the GBPEUR quote, the British pound being their natural base currency. The reverse is true for companies in Switzerland, who prefer to quote with CHF in second place and therefore their domestic banks provide them with the JPYCHF rate, even though the basic rule is to quote CHFJPY on the forex market.

Rates accurate to the tenth of a pip

Until 2006, the exchange rates of individual currencies in the spot market on Forex were quoted to four decimal places, with the fourth decimal place representing one pip. Another unwritten rule was that rates that were worth more than 20 were quoted to three decimal places and rates that were worth more than 80 (for example, pairs with the Japanese yen) were quoted to two decimal places. However, in 2005, Barclays Capital introduced an innovation in its platform in which it added an additional decimal place for several of the most traded pairs. This allowed prices to be quoted in tenths of a pip and this more accurate pricing was then adopted by other banks and institutions, allowing the quotes from individual institutions to vary and creating a more competitive market. It is now quite common for most pairs to be quoted to five decimal places in the spot market and for pairs with the Japanese yen to be quoted to three decimal places.