Foreign exchange: rates, spreads and conversion

Most cross border payments involve a foreign exchange conversion, because the sender holds one currency and the beneficiary needs another. A company in India that holds rupees and must pay a supplier in euros needs to sell rupees and buy euros. A worker in the United States who earns dollars and sends money to family in the Philippines needs to sell dollars and buy pesos. The conversion happens at an exchange rate, which is the price of one currency in terms of another, and the rate changes constantly during the day as currencies are traded in the global foreign exchange market. The rate at 9 in the morning can be different from the rate at 3 in the afternoon, and the customer must know which rate applies to their payment. The spread is often the largest cost in a cross border payment, larger than the transfer charges, and it is also the least transparent. A customer who sends USD 10,000 and receives the equivalent in euros may not realise that the bank's rate was one percent worse than the market rate, which means the customer paid USD 100 for the conversion without seeing a separate charge. A business analyst must understand the difference between the mid market rate, which is the rate in the middle of the buy and sell prices and is the rate most often quoted in the news, and the customer rate, which is the mid market rate plus the bank's spread. The spread is the bank's margin, and it is how the bank is paid for providing the conversion service. The mid market rate for USD to EUR is 0.9200, meaning one dollar buys 0.92 euros. The bank's customer rate is 0.9110, which is one percent worse. A customer who sends USD 10,000 receives EUR 9,110 at the customer rate, but would have received EUR 9,200 at the mid market rate. The difference is EUR 90, which is the spread, and it is the bank's revenue from the conversion. The customer sees EUR 9,110 credited to the beneficiary, but does not see the EUR 90 that was kept. Regulators now require banks to disclose the spread, and fintech companies compete by offering a rate close to the mid market rate with a transparent fee instead. The analyst must design the payment screen to show the rate, the spread, and the amount the beneficiary will receive, before the customer confirms. In the simplest case, the sending bank converts the currency and sends the payment in the beneficiary currency, so the beneficiary receives exactly the amount expected. In other cases, the sending bank sends the payment in the sender currency, and the receiving bank converts it on arrival, so the beneficiary receives an amount that depends on the receiving bank's rate and timing. In a third case, an intermediary bank converts the currency in the middle of the chain, which can lead to a double conversion, where the payment is converted twice and the spread is paid twice. A double conversion is expensive and should be avoided, and the analyst must design the payment flow to convert once, at the point where the rate is best and the transparency is highest. The value date of the conversion is another detail that matters. A foreign exchange deal has a value date, usually two business days after the deal date for a spot transaction, and the payment must be funded on that date. If the payment is instructed on Monday and the conversion is booked for value Wednesday, the funds are not available until Wednesday, and the beneficiary will not receive value until Wednesday. If Monday is a holiday in one of the countries, the value date moves. The analyst must ensure that the value date of the conversion and the value date of the payment are aligned, because a mismatch will cause the payment to be held or the conversion to settle without a payment to fund. Foreign exchange risk is the risk that the rate moves between instruction and settlement, and it falls on different parties depending on the product. If the rate is fixed at settlement time, the customer takes the risk, and the amount the beneficiary receives can change. A customer who is promised EUR 10,000 and receives EUR 9,950 because the rate moved is a customer who will complain, and the analyst must make it clear in the product whether the rate is fixed at instruction or at settlement, and must show the customer the rate that will apply. For large payments, the customer may want a forward contract, which locks the rate for a future date, and the analyst should know whether the bank offers that and how it is booked. The system design for foreign exchange includes the rate feed, the spread table, the conversion engine, and the accounting. The rate feed must come from a reliable source and must be updated frequently, at least every few minutes during business hours. The spread table sets the margin by currency pair, by amount, and by customer segment, because a large corporate customer will get a better spread than a small retail customer. The accounting posts the debit and credit in the two currencies, and the nostro accounts are updated in the currency of the payment. The analyst must specify each of these, and must test that the rate shown to the customer is the rate applied, not a rate that changes after confirmation. Finally, the analyst should know that foreign exchange is a regulated activity, and that the bank must hold a licence to deal in foreign exchange, must report large transactions to the regulator, and must comply with anti money laundering rules for currency conversion. In India, the Reserve Bank's Foreign Exchange Management Act sets the rules for who can buy and sell foreign exchange and for what purpose. In the European Union, the Markets in Financial Instruments Directive sets the rules for foreign exchange dealing. The analyst does not need to be a foreign exchange dealer, but must know that the conversion is not just a calculation, it is a regulated transaction with its own compliance requirements, and the payment flow must include the checks that those requirements demand.