We've all traveled and paid for things overseas in other currencies and seen the current exchange rates on the internet and nightly news yet the foreign exchange (FX) market is one of the most widely used yet least understood parts of the global economy.
So here is a short write up about the FX markets, not just for your general knowledge, but to also help you when you're shopping around for the best deal!
An introduction to the FX Market
The first thing to know is that the FX market is a decentralized one (also called “over the counter”). This means that at any given time there are multiple prices for the same thing, depending on who you are talking to and, the trades are done directly between two parties and not through an exchange.
This also means the legal rules for governing disputes vary on who you are dealing with and where they are (e.g. when you have to pay the cash for your trade).
So do your homework and shop around before you make a transaction!
How does the FX Market work?
The FX market works in tiers, with the top tier being the interbank market. This is where large banks buy and sell billions of dollars of currencies a day between each other.
10 banks (all US & European) account for over 2/3rds of the total daily volume. How much volume you may ask? The daily dollar amount transacted is more than 5 times the economic output for the entirety of Australia for one year.
No, you did not read that wrong.
Now, unless you have billions yourself to trade you can't access or participate in this market. However, the prices from this market are often what is quoted on the news, etc. as what the “exchange rate” is and this is known as the interbank rate.
When you trade currency you'll be dealing with a retail market maker (also called a broker), who will buy large volumes of currency from one of the major bank dealers to then on-sell it to you. The difference in price between when the interbank market quote is and what your retail broker gives you is called the “spread”.
Talking about buying and selling money can get confusing, so it can be easier to think in other (smaller) terms.
FX Markets & Apples
The big banks are basically buying and selling apples 10 crates at a time, the retail brokers are buying 1 crate at a time off the big banks and you buy 5 apples from the retail broker.
So whilst it might be a big deal for you transferring over thousands, tens of thousands, or even hundreds of thousands of dollars to pay for, say, a property purchase deposit, it's nothing in the scheme of things for the banks.
This is why most of the time the deal you will get through your bank directly is especially bad.
They have a ‘retail' division that will transact FX for you but it's often more hassle than it's worth for them. Got that all down? It's what you need to know to understand that sometimes a higher transaction fee may not always mean a worse deal for you.
Some examples of how this all plays out
To keep with our apple example, let's run a couple of scenarios where the wholesale price (a.k.a the interbank price) of apples is $2.55 per apple. So each:
Apple Orchard (Broker) A – “We charge no fees!”
Price of apple to you: $2.70
Total cost: $2.70
You pay a “$0.15 spread”
Apple Orchard (Broker) B
Price of apple to you: $2.60
Total cost: $2.65
You pay a “$0.10 spread”
This happens way more than you realize, especially with most credit cards when you transact overseas (especially if you select the option on the card machine terminal for them to do the conversion). To say ‘no fees' is (in most cases) basically just a great marketing ploy and will attract a lot of customers.
The way to do your homework is to compare the total cost of the transaction over the interbank rate (comparing the wholesale apple rate to the “you pay” amount). Sometimes a “no fee” transaction will be the best for you, and sometimes it won't.
Other options when traveling for a short time (instead of transferring money)
Another great option (one that I used for almost 2 years whilst living in London!) is to use your credit card as you go. Note that you really want to check the fees etc. The Capital One Platinum card I've found to be great, no fees, and a small reasonable spread over the interbank rate.
This method is useful for short to medium-term trips (not 2 years like me, but that's another story) where the strategy is that you average out the cost of FX overtime over a bunch of small transactions.
This saves you from buying a bunch of currency at the start of the trip and then ‘losing out' over the ensuing weeks/months when the FX rate moves against you. (I should note that a big rate move could also go in your favor, but this strategy is designed to be ‘price neutral’).
Most importantly though: Don't be a currency trader unless you can devote 100% of your time to it!
Some other fun facts to note
Don't transact on the weekends! From when New York closes on Friday night until Sydney opens on Monday morning there is ‘no one at the desk' so to speak at the major banks so the spread widens. The tightest spreads (and best rates) are usually in the overlapping period when New York and London are both open.
Currencies are traded in ‘pairs': As in, you can't just buy USD, you simultaneously have to sell another currency.
Basically every currency pairs with the USD. This is why, for example, if you're transferring AUD to say Indian Rupee because you're going on a holiday to India, the spread will be larger than a AUDUSD spread.
What is basically happening on the back end is that your AUD gets converted into USD then into Indian Rupee. So you're paying for two separate transactions. There is no way around this, and even if a broker quotes you an Aussie/Indian rate it's a synthetic (combined two-step) rate and not a real one.
What makes currencies move and what dates should I be sensitive to?
Without going into reams of economic theory, a currency's value is a reflection of the world's perception of the strength of that country's economy.
The big news tickets items that you should be aware of are:
- When interest rates change (e.g. the US Fed and the RBA in Australia); and
- When the US jobs report is released.
If the market's expectation of these data points is different from what the actual numbers are or change is, there can be a big move in the currency.
Why are you hearing the Aussie dollar (against the $USD) is rising because Australia is selling more iron ore to China? We're not selling it to the US?
This goes back to the currency pairs issue plus the fact that almost all commodity (metals, oil, agricultural products) transactions are settled in US dollars.
This is largely because the USD market is the most liquid/stable and it kinda creates a self-fulfilling prophecy.
More transactions are settled in USD, so the market grows so more transactions are settled etc. This is, and I cannot stress this enough, one of the MAJOR reasons the US economy underpins so much of the global economy.
Got any FX questions? Leave them below!!
PS – One final note.
Over time it is very possible that you may transact some currency, have the exchange rate move in your favor, and think “I’m rich! I’m a genius! This was free easy money!”
Resist the urge to become an FX trader. Professional traders have spent years of their life studying and trading. They sit at a computer screen watching numbers go up and down all day. It’s a full-time job and even then you can still lose millions.
My guide is this: If there is something I want to buy and need to convert money to do so, I stay focused on that goal. If I can achieve that goal at the rate today, then I make the transaction. I then can buy the thing I want and get my focus back on my usual day-to-day.
This blog post is presented for educational purposes only and is not intended to give financial advice. It does not take into account your specific financial needs and circumstances. Please seek professional advice.
Special rates with America Josh
Josh here again, thanks Michael for this great post!!
With all of this in your wheelhouse now, I wanted to point you to a comparison I did of the rates Michael is talking about above.