There’s a whole host of reasons one might need to exchange currency. If you’re a speculator in financial markets trading foreign exchange then that’s literally the whole gig. Alternatively, one might have a need to exchange currency if planning a trip abroad wherein you have a requirement to physically exchange one currency for another.
Depending on which of these applies, the fees involved can vary staggeringly. Also, within each there are a number of ways that individuals can substantially reduce the costs involved with exchanging currency. In this article we’re going to explore why you lose money when you exchange currency and how, investor or holidaymaker alike, can cut these costs.
How and Why Do You Lose Money When You Exchange Currency?
Whether a speculator in currency markets or a holidaymaker, the general cause of losses when exchanging currency remains the same and in order to understand it we need to take a look at the foreign exchange market hierarchy and how currency markets work as a whole.
At the highest level, big banks and large institutions have access to what is known as the interbank market which, is exactly what it sounds like. The interbank market allows for huge volume trades between large institutions and given the regular flow back and forth, rates are set with a minimal spread allowing banks to trade the interbank rate – also known as the mid-market rate or spot – with lower costs per unit.
Great, but what’s the spread? Every financial market has a spread and forex is no different. The spread is essentially the difference between the buying and selling prices for an exchange rate. When you open your trading terminal, along side the the mid-market exchange rate for a currency pair, you usually see the buying rate (aka bid) and selling rate (aka ask) given these are the price levels you can actually trade at.
Above: Euro to US Dollar Bid Ask Spread
The buying or bid rate can be considered the price at which the MARKET is willing to BUY an asset, be it a currency pair, stock or otherwise. The selling or ask rate is the price at which the MARKET is willing to SELL an asset. The bid is generally always lower than the ask – if it wasn’t you’d have a free money opportunity on your hands. The difference between the highest ‘bid’ and the lowest ‘ask’ is the spread.
In practice, the spread can be considered a cost associated with exchange currency. When you place a trade, you immediately lose the spread. For illustrative purposes, the following figures are grossly inflated but consider what would happen if the Pound to Euro (GBP/EUR) exchange rate was trading with a spread of 1c. You go long GBP/EUR at €1.12 and are immediately out of pocket, given the price must rise to €1.13 before you even break even.
Essentially, the spread is a cost and the minute you place a trade or exchange currency you lose money.
Where Does the Spread Come From?
Given that nothing comes for free, at its most basic level the spread can be though of as the fee applied by brokers to facilitate your engagement with the financial markets. At the interbank level, spreads are virtually non-existent but as liquidity flows down the forex hierarchy, each subsequent specialist, bank or broker tacks on their own spread to ensure they can profit when they in turn pass liquidity on down the line.
Above: Currency Market Hierarchy
Given spreads exists in all-but the rarest of cases (inter-exchange pricing discrepancies can lead to arbitrage opportunities), and the spread is essentially a cost associated with placing an order, what can we do to minimise our losses when exchanging currency? The following are a number of tips to trading the narrowest spreads possible.
Choose Highly Liquid Currency Pairs and Trade Appropriate Hours
When referring to the ‘market’ what we’re actually talking about is all the orders on your brokers book, which are made up from the many thousands of market participants actively engaged in currency markets. By submitting limit orders to the order book, participants are essentially adding liquidity into a market. The more participation, the higher the liquidity, the higher liquidity the lower the spread!
Where this really comes to the fore is if you’re trading out of hours for your respective market or trading an exotic where there are fewer speculators. In terms of timing, 1300 – 1600 BST (0800 – 1100 EST) is the most the most ‘liquid’ time of day, with both European and US markets open.
In terms of the currencies with the highest liquidity, EUR/USD trumps all but all of the common currencies – USD, EUR, JPY, GBP, AUD, CAD, CHF, CNY, SEK and NZD – have high liquidity.
Above: How Are Spreads in Forex Calculated
STP or ECN Entities Leverage Higher Liquidity to Provide Narrower Spreads
Broker-choice can also have a considerable bearing on the spreads (and therefore the costs) involved in exchanging currency. With investors looking to trim costs when trading, there’s been a rise in popularity of straight through processing (STP) broker as well as Electronic Communication Network (ECN) brokers.
These types of brokers operate as ‘no dealing desk’ entities, meaning they forward orders on to liquidity providers. In the case of STP, trades are forwarded directly (straight through) to liquidity providers, allowing speculators to benefit from narrower spreads than typically available at the retail forex level. ECNs draw on liquidity from a number of sources (network), with trades forming inner liquidity between members of the network.
Above: Electronic Communication Network
How to Save Money When Buying Holiday Currency
While the principles driving the cost of exchanging currency are the same whether you’re engaged in the forex markets or looking to buy holiday money, the routes to reducing losses can vary.
If you’re looking to buy holiday money, the first and foremost step should be to compare providers – both relative to each other and to the interbank market rate. While still apparent in currency markets across brokers, discrepancies between prices for holiday money providers can be much higher.
Above: Pound to Euro Travel Money Deals
Economies of scale also come into play when purchasing travel money. Many operators will offer a better rate (closer to the intermarket exchange rate) for higher volume purchases so while there are risks involved in putting all your eggs in one basket, buying all of the holiday cash you need is likely to cost less overall than making multiple smaller purchases.
If you’re abroad and you’ve run out of physical cash, you might be faced with choosing between a debit card and credit card. In this case, the general rule of thumb is to opt for credit given providers tend to offer better exchange rates and lower fees than high street banks.
– Do you lose money when you exchange currency? Yes
– When you exchange currency you immediately lose money because of the spread
– The spread is the difference between the highest ‘bid’ and the lowest ‘ask’
– The ‘bid’ or buying rate is the price at which the market will buy an asset
– The ‘ask’ or selling rate is the rate at which the market will sell an asset
– In order to make a profit, a trade has to overcome the spread…
– Meaning narrower spreads equate to lower costs
– Exchange currency during periods of high liquidity to minimise spreads
– ECN and STP entities connect traders with liquidity, resulting in tighter spreads
– Holidaymakers should always compare travel money deals available