Investors often scrutinise a stock broker’s trading commissions very closely, but don’t think hard about other costs. That’s a huge mistake. You can end up paying a great deal more than trading fees when you’re investing in foreign shares.
One of the biggest yet best hidden costs are foreign exchange conversion costs. By that, I mean how much it costs you to buy foreign currency when your stockbroker settles a foreign share trade. Or what your bank charges to convert money and wire it to your overseas brokerage account.
In theory, these costs should be very low. Currency markets are highly liquid. The bid/ask spread in the interbank currency market is almost non-existent for major currencies. But financial institutions often stick a large margin on this when dealing with retail clients, figuring that most people don’t know what’s going on.
So it’s useful to know that FX costs can sometimes be cut dramatically. Doing so requires you to take control of what happens to your money and choose which firm you choose to do the currency conversion.
Let’s take a look at the details of how it works. Afterwards, I’ll run through a real example, and look at three risks to watch out for.
Your broker could be costing you 4% per trade
There are three ways in which you and your stock broker might settle an order for foreign shares. I’ll summarise them quickly, using an example of a British investor buying French shares:
- Your broker deals with a market maker in London who quotes a price in sterling. You then settle the trade in sterling. The currency conversion from sterling to euros is done by the market maker.
- Your broker deals directly in the shares in Paris in euros, but tells you how much you need to pay for them in sterling. You then settle the trade in sterling. The currency conversion from sterling to euros is done by your broker.
- Your broker deals directly in the shares in Paris in euros and tells you how much you need to pay for them in euros. You then settle the trade in euros, either from a euro cash balance in your account or by converting sterling cash in your account into euros.
In the first two examples, you have no control over the exchange rate used. It’s what the market maker quotes or what your broker uses internally. You can’t do anything about that. But when your broker is the kind that uses the third method – and more and more are – you can sometimes get a better deal.
The first thing to do is to check what rate your broker offers on FX conversions within your account. Different brokers will quote you very different exchange rates. Let’s look at two stockbrokers, both with registered offices in the UK:
- Interactive Brokers will exchange currency at close to the interbank rate – the rate at which major institutions transact. There will be a small spread between the buy and sell price for the currency, which depends on how much you’re exchanging, and Interactive Brokers then charges a small commission of its own on top – about 0.01%. You can’t get better than that as a retail client.
- TD Waterhouse will charge you a margin of up to 2% over the interbank rate on each leg of the transaction. If you converted from sterling to euros to sterling, you’d lose a total of 4% in FX costs.
That TD Waterhouse fee is definitely expensive. The firm is advertising low headline trade rates for most markets, but will hope that most investors won’t notice them trying to claw it back on FX. If you want to get the best deal from brokers like this, you need to try to cut those costs.
How to make a foreign currency transfer
One option is to switch to a broker with lower FX charges. But perhaps you don’t want to do that because your current broker offers something that it’s hard to get anywhere else. So how else can you cut costs?
If a stockbroker allows you to hold euros in your account and settle trades in euros, it will usually allow you to transfer in money that’s already in euros, rather than transferring in all money in sterling. That way, you don’t end up paying the broker an excessive fee to convert the currency.
That’s great if you have a euro bank account – you can just transfer it straight from that. But even if you don’t, you should still be able to make a sterling payment from your bank account, have it converted into euros and then paid into your stockbroking account as euros.
You won’t get the conversion done at interbank rates. You will still have to pay a premium. But depending on how much your broker charges, it could still be a significant lower premium than you’d pay if you were converting the money within your brokerage account.
You might think this is most easily done by asking your bank to do the currency conversion and transfer. But it probably won’t be. Yes, your bank will make payments in foreign currency. But it will usually charge a large premium to do so as well.
If you have a foreign brokerage account and you want to make a payment to it, the same usually applies. Say your broker is in Hong Kong and your bank is in London. The obvious way to fund the account is to get your bank to make a Hong Kong dollar transfer to your broker. But your bank probably won’t be offer a terribly competitive rate – and may try to hit you with a high international transfer fee.
Instead of using a bank, you’ll probably get a better deal from a foreign exchange transfer specialist. It won’t get rid of all the margin, but you’ll usually save some money.
So how does it work? You need to open an account with a suitable firm – well-known UK examples include HiFX and CaxtonFX and those are the two I’ve quoted in the example below, although there are plenty of other options and some may be cheaper (there are more suggestions later in this article).
Account opening can usually be done online and completed in an hour or less. There are typically no account fees or maintenance fees. You only pay a commission when you make a transfer. Smaller transfers can be done online, while dealing tens of thousands usually means speaking to a broker by phone.
Then you instruct the firm to purchase however much money you want and transfer to your receiving account (eg your stockbroker). You lock in the quoted exchange rate at that point and the broker takes the equivalent amount of sterling from your bank account or debit card. They purchase the required amount of foreign currency and forward it to the receiving account. Transfers typically take about 2-5 days to clear.
Note that while transferring money IN to your brokerage account through a foreign exchange transfer firm is usually possible, transferring money back OUT via one is more difficult, at least in the UK. Most brokers reportedly say they are unable to send money via a third party due to money laundering regulations. So when you come to withdraw money again, your best options may be to:
- Accept your broker’s FX rate to convert back to your home currency
- Do the transfer in foreign currency and allow your bank to convert it when it reaches your account
- Open a foreign currency bank account to receive the payment and use the most effective solution to convert it back to your home currency (which may be the roundabout route of sending it between your bank accounts via an FX transfer firm)
The third option is certainly more hassle, but may be worth considering if you make large or frequent withdrawals in foreign currency.
How much could you save with a currency specialist?
How much margin you save depends on how much you’re transferring – larger amounts will usually save you more. And it’s important to shop around for a good currency broker and to compare rates. Different forex specialists use different fee structures and the cheapest for one transaction may not be the cheapest for another.
Below, I’ve compared the costs of a bank and two money transfer firms for varying sizes of transfer from sterling to Singapore dollar. The rates are tradable online quotes, taken around 2pm on Tuesday 19th July 2011. The interbank rate at the time was S$1.959.
- A bank, HSBC UK. They quoted me a flat rate of S$1.912 for transactions up to £10,000. There was also a transfer fee of £30, reduced to £17 for transfers done online.
- A currency specialist, CaxtonFX. They quoted me a flat rate of S$1.914 for transactions of up to £20,000.
- Another currency specialist, HiFX. They quoted me varying rates on different transaction sizes, from S$1.879 for a £1,000 transfer to S$1.938 for a £20,000 one.
I put all these numbers together to calculate the margin over the interbank rate that you’d pay through each of these firms on five transactions from £1,000 to £20,000. The results are in the table below. With HSBC, there’s no quote for £20,000 because £10,000 was the maximum online and the quoted exchange rate is adjusted to include the £17 transfer fee.
£1,000 1.879 4.06% 1.887 3.68% 1.914 2.3%
£2,000 1.896 3.23% 1.905 2.76% 1.914 2.3%
£5,000 1.905 2.73% 1.932 1.38% 1.914 2.3%
£10,000 1.909 2.57% 1.935 1.23% 1.914 2.3%
£20,000 N/a N/a 1.938 1.07% 1.914 2.3%
You can see it isn’t a miracle. At best, you’re still being quoted a sizeable margin over the interbank rate (although be aware that rates can often be negotiated down – see the note below for more on this). There’s nothing here as good as the rate you’d get within your brokerage account with a deep-discount firm such as Interactive Brokers.
But you can save. If you want to send £1,000 internationally, then CaxtonFX’s quote saves you getting on for 2% versus what HSBC would charge. As far as I know, HSBC is relatively typical of UK banks on this score and better than some. For frequent small payments, the lower costs will add up over time.
Meanwhile, if you wanted to buy a few thousand dollars worth of Singapore shares in your UK brokerage account, using HiFX to handle the conversion is going to get you a better rate than doing it in-account at one of the more expensive brokers. HiFx would cost 1.4% on £5,000, versus 2% in-house at NatWest, for example.
It’s worth observing that forex firms often have a very sharp step-up in the rate you get once the transfer goes over a certain amount. This doesn’t typically fall on a round number, as you’d expect, and it changes. On this occasion, I found that HiFX began offering a much better rate at some point between £4,700 and £4,800.
For larger amounts, the savings clearly stack up quite quickly. However, rates vary between firms, so shop around. It makes sense to have two or three accounts set up – at most firms, it’s simple to do with no account fees – and choose whichever quotes the best rate for the currency and trade size you need.
I’ve only quoted rates from HiFX and CaxtonFX here, but there are plenty of other firms in the market. Popular choices among the major operators include TorFX, Currencies Direct, Moneycorp and WorldFirst.
TorFX have a reputation for offering slightly better rates than HiFX sometimes, although there probably isn’t a vast amount in it. Moneycorp and WorldFirst have a wider international reach. They may be particularly useful for transferring funds back from abroad to the UK, or for non-UK residents looking for an FX broker (WorldFirst caters to 11 countries, including the US, Australia, Hong Kong and Singapore).
It’s worth being aware that smaller firms may offer better rates, since it’s the main way that they can compete against larger outfits with bigger marketing budgets. One reader has suggested London-based City Forex and Thomas Exchange as significantly cheaper than the big names.
Three questions on FX transfers
Using an FX specialist is pretty straightforward and the savings are not trivial, so it’s well worth doing. But before opening an account, there are three final points you should bear in mind.
1) Is my money safe with a currency transfer specialist?
Whichever currency transfer firm you use, make sure you’re dealing with a reputable business and not just the firm offering the best quote. Remember that this firm has custody of your money at some point between leaving your bank account and reaching your broker. If it suddenly collapses, what will happen to your funds?
In fact, this business is more lightly regulated than you might expect, so it’s important to be careful. Regulations vary in different countries – but even in the UK, where the rules seem to be tougher than most – many firms are effectively unregulated. Small payment institutions are obliged to be registered, but are not closely monitored. In the past, some firms have collapsed and clients have lost the money they had in the firm at that point (Crown Currency Exchange was a high-profile example).
It’s very important that to be aware that funds being held by a currency exchange firm are not covered by the Financial Services Compensation Scheme, unlike the money in your bank account. So there is no compensation available from the regulator if the worst happens.
So what should you do to stay safer? In the UK, any large and reputable transfer firm will be authorised and regulated by the FSA as an Authorised Payments Institution under the Payments Services Regulations 2009. This compels them to hold a certain minimum level of capital and – most importantly – to keep its clients’ money in segregated client accounts at a European Economic Area-regulated bank.
Technically speaking, this does not completely remove all risks to you. First, segregated bank accounts hugely reduce the ability of the firm to steal your money and swan off to the Caribbean. But it’s impossible to defend against all possibility of fraud and no FSCS compensation would apply if that did happen.
Second, at the point of settlement of the FX conversion, your funds are briefly non-segregated. They are handed over to the transfer specialist’s counterparty in exchange for the foreign currency that it’s buying for you. If one of the firms failed at this point, your money could theoretically be entangled with the failed firm.
This is not a problem unique to FX transfer specialists. It’s a risk that often applies with FX conversion and it even has its own name – Herstatt risk, after a German bank that collapsed mid-transfer in 1974. But I suspect that if your funds were lost in this way in a transfer using a major high street bank, the bank would be compelled to make good any losses to account holders. A small FX transfer specialist might not be able to stand the losses, even if it wanted to do so.
The risks of either event hitting your transfer are vanishingly small. But clearly, going with the most reputable and responsible currency specialists can reduce the risk that something bad will happen. Of course, if you’re making a big transfer and you’re still worried, you could consider splitting it into more than one transaction and sending it at different times or via different firms.
You can check whether a firm is authorised and regulated by searching the FSA register online. If it is not on the register, you should not use it.
2) Can I get a better deal on the exchange rate?
Be aware that there is scope for negotiation if you’re transferring large amounts. For example, HiFX will do online transfers of up to £300,000. But if you were transferring that much, you’d be better off ringing up and haggling over rates than taking what you’re offered online. In fact, I’d say that even with a £20,000 transfer you’d have a good chance of negotiating a better margin than the 1% quoted online in the example above.
This isn’t just true of FX specialists. If you’re doing a large currency conversion within your stock brokerage account, you’d have a good chance of arranging a better rate than they’ll offer you at first, especially if you’re a sizeable customer.
These huge margins over the interbank rate are a good source of additional, non-obvious profit for many financial institutions and a broker often has scope to bring them down to keep clients happy when it’s clear they know the score. I have heard of long-standing clients haggling 1%+ margins down to 0.25% for a £50,000 transfer, for example.
3) Will my transfer be accepted?
If you have an account that lets you hold foreign currency, you’d expect that you could transfer in funds in that currency. And certainly I’ve never had any problem with doing this. But I have heard stories of people who have.
The fund manager or broker has refused to accept transfers via a currency specialist. Instead, it’s insisted that it comes from a personal bank account. As result, the client has had the choice of doing the conversion through his bank or through the institution he’s transferring the money to. In both cases, the rate would less competitive than a good FX firm.
Officially, this is usually put down to the need to comply with money laundering regulations. That could be true. But UK FX specialists need to comply with money laundering regulations anyway. And it is curious that some providers are happy to accept transfers from these firms and others aren’t.
If you’re cynical, you might conclude that some firms are putting up plausible-sounding barriers to transfers in an effort to continue pocketing excessive margins on doing the conversions themselves.
So if you run up against a financial firm that won’t let you use a transfer via a reputable, UK-regulated specialist, push for an explanation and check the FX rate they offer on conversions. And if they won’t budge and won’t cut you a better deal on the in-house exchange rate in compensation, you may want to shop around for another firm that will.
Hidden FX costs are one of the easiest ways for banks, brokers and fund managers to rip off unsuspecting clients. It’s in every investor’s advantage to call them on it.