Clarifying "There's only ONE exchange rate"
Today an article about exchange rates cropped up on hacker news, and caused quite a bit of controversy and confusion, so I want to clarify some of the things said, as well as fix some of the incorrect information (including the title, which is factually incorrect).
The original article.
Some formalities first
Firstly, I want to explain why you should listen to me: I work as a developer for an FX brokerage in London, UK. I’ve been working here for under a year, but I’ve been actively applying all of what I’m about to explain.
I don’t represent the company I work for on this blog.
Why the post is wrong
The title of the blog post is “There’s only ONE exchange rate. Any others are just works of fiction.” which is incorrect, no matter what interpretation of it you use. They mention in the post that what they mean by one exchange rate is the mid-market rate, which only exists to make estimations and stuff easier. There are actually 2 exchange rates: the bid, and the offer. The difference is called a spread.
Let’s create a fictional scenario to explain what the spread is:
Say you have 1,000 Euros (EUR), and you’re interested in swapping it for United States Dollars (USD). In this situation you’re putting your money up for bid, wanting an offer from a bank, or a brokerage. Unfortunately for you, there’s been a lot of speculation recently about the Euro collapsing due to an economic crisis in Germany, so people are more interested in keeping their USDs than selling them for Euros. This means that what you might want for your EUR is going to be less than what other people are willing to offer, because they are worried that it will soon be worthless.
Now think of it from the other side. You have 1,000 USD and you’re interested in swapping it for EUR. Because everyone’s so interested in buying USD and selling EUR, it means that you’re able to set your bid at a higher figure, and the market will still take it off your hands.
The mid-market in this case was never on the table, it was simply a figure that’s in the middle of the bid/offer spread for EUR/USD. All currency pairs that aren’t pegged to each other have this spread, with some having a larger spread than others (this depends on how volatile the market is for those pairs).
Remember, there’s no regulative authority dictating what currency is worth what, it’s purely dictated by market demands.
The spread your bank offered you
So the market always has a spread, but that spread is not the same as the one your bank (or brokerage) offered to you. What happens is that they will take that spread, and apply an additional percentage to each side (eg. +5% on the buy, -5% on the sell for EUR/USD), which they pocket. Some places (high street banks usually), will do this and add an additional fee on top of that.
Who should you work with?
That’s entirely up to you, I’m not pushing an agenda. I have no real opinion of the company who wrote the original article, I just wanted to clear up some mistakes.
Written by Matthew Hotchen on