Foreign Exchange | The Complete Guide for Business

The mammoth 6.6 Trillion USD daily volume market is one that you have to delve into when undertaking business abroad.

We break down in this article exactly how it works, why it is so important to have a basic understanding of the market and how it can affect your business:

• Interbank exchange rate

• International Payments

• Receiving International Payments

• How do exchange rates affect businesses

• Foreign exchange fees

• Spot and forward contracts

• Advantages and disadvantages of forward contracts

• Best bank for receiving international payments

• Best Foreign Exchange providers for business

Interbank exchange rate

The interbank exchange rate is the price that the banks exchange currency with each other at. This price denotes the value for exchanging one currency for another.

Normally when looking at a foreign exchange rate feed you are seeing the average between what is called the bid and ask price. The asking price is the price that banks are buying the given currency pair at and the bid price for what banks are selling that currency pair at.

This rate is normally not achievable by businesses since they are not undertaking the volume that the banks are. This is similar to any other wholesale industry, the more you buy the better price you get.

For businesses, this rate acts as a benchmark for where they should be getting close to when placing a currency trade and helps them facilitate their international money transfer.

We take a deep look into how the interbank rate works here.

International Payments

International payments are where you send money to a different country in a different currency. This can be to purchase goods or services, purchase a house abroad and many other reasons.

When undertaking international transactions your transactions are handled by the SWIFT network using a swift code, this is in essence a messaging platform used by banks to convey payment information. Standing for ‘Society of Worldwide Interbank Financial Telecommunications’ it facilitates most global transactions.

Once receiving the swift notification the recipient banks will post the funds to the given account number. When undertaking international payments you have to be wary of the fees associated with doing so. We take a deep look into how to combat those fees in our article here.

Receiving International Payments

Receipt of international payments is mostly for Exporters where they have customers abroad that pay their foreign currency directly into the businesses bank account.

Also handled by the SWIFT network most of the time businesses will have their foreign currency accounts based in the UK to receive these funds. At the point of receiving the foreign currency, they would then convert it back to GBP through their bank or broker or use it to pay suppliers abroad.

Some customers will prefer to pay in their local currency although some might pay in GBP and do the conversion on their end. Ultimately it comes down to which currency you bill the customer in but unless your customer has a GBP surplus there will always be a currency conversion by you or your customer.

One thing that is very important when receiving international payments is to not send foreign currency to a GBP bank account. We’ve seen this happen many a time where for example a customer sends EUR’s to your GBP bank account.

Banks then automatically convert these funds at extremely poor exchange rates, ranging from anything between 3-6% per transaction. Always make sure you are receiving payments into the correct currency account, we look at how to mitigate these costs here.

How do exchange rates affect businesses?

The interbank exchange rate moves by the second and at key times where data within that currency zone are released movements can turbulent. Like any other commodity the price of the underlying asset moves frequently, this can affect your profit margins on the business you conduct internationally.

For importers, if the currency pair you are using goes down in value your imports become more expensive. Likewise, if the rate goes up you are now getting a cheaper price for your product or service.

Exporters on the other hand receive more local currency for their foreign currency earnings if the exchange rate (for example GBP/USD) goes down in value. On the flip side, they will get less local currency for their exchanges back into the country if the pair goes up in value.

Normally you have payment terms with suppliers abroad, you agree to a contract where you might pay an initial deposit on a spot contract (we dive into this shortly) but then you have a further larger payment which you have to pay for the goods or service which can be up to 12 months in the future.

The exchange rate when you agree to purchase the goods will 99% of the time change by the time you come to make that bulk payment. That can be for the better or worse but with large currency movements against you, this can heavily eat into your profit margins.

We look further at ways currency can impact your business and what you can do to ease the risk here.

Foreign exchange fees

Commonly banks will charge clients a wire fee which can be a nominal £5-15, this is the fee for sending the given currency but does not cover the money they make on selling you the currency. The margin charges are where providers make 95% of their money and this is what you as a business need to be most aware of.

Some businesses still do think that the wire fee is all you are charged for transacting currency. This is most certainly not the businesses fault, banks and brokers do a very good job of covering up this fee as it’s embedded into the exchange rate you are offered.

Ultimately banks and brokers job when quoting you an exchange rate is to price as far away from their buy price so that they can create their profit. In the chart below I break down exactly how this works for a scenario where you are buying US Dollars (USD) from British Pounds (GBP).

This is a scenario where a company from the UK will be buying goods or services from abroad, if you were bringing funds back into the country you would invert this chart.

A recent study showed that the industry offers 'total spreads of up to 3.71%, including fixed fees’ but from personal experience, I have seen charges as high at 6% (both banks and brokers).

We have written an interesting article on how banks and brokers differ when they quote their customers which you can read here.

Spot and forward contracts

These are two of the main foreign currency products used by businesses, we break down how they differ and what they are below:

What is a spot contract?

Consider a spot contract as a normal transaction between you and a foreign exchange provider. You want to exchange a currency, the provider fulfils that contract and the funds get sent to their destination.

The most used product conducting 1 trillion USD a day is where the exchange happens as soon as you agree with your provider to do so. Whilst the definition stipulates that a spot contract is normally two days this is commonly a same working day transaction.

When placing a spot transaction the rate you will receive will be your provider’s given price on the trade date.

What is a forward contract?

A forward contract is where a business agrees with a provider to buy or sell a certain amount of currency within a certain timeframe and at the exchange rate on the day of booking.

These forms of contracts can be between one week and two years in length. You would normally purchase a percentage of the amount of currency you expect to use within that period, throughout the contract you can draw down smaller chunks of the contract value.

Depending on your company standing providers can offer these types of contracts with a 0% deposit. Providers will grant you a set amount that you can book with a no deposit facility (normally a percentage of your turnover).

Should the bank or broker deem it too risky to offer you a 0% facility they would request that you deposit 5-10% of the total value of the contract before placing a forward contract.

This is the most accessible and widely used hedging tool on the market for business as it provides certainty in knowing what exchange rate you are going to achieve one week to two years in the future.

For contracts that you are undertaking abroad, this can be useful to limit your currency exposure to market fluctuations as in a sense it locks in your profit on your transaction ahead of time. Whilst the currency exchange rate will move between the time you place a trade and ultimately come to using that reserved currency you will still achieve your forward contract rate.

The way that forward contracts are priced are completely different to spot contracts, we break down how the pricing differs and what to expect here.

Within the market there are more complex products available like options and a futures contract, futures price and options price depend on a wide range of factors so we delve into that fully here.

Advantages and disadvantages of forward contracts

Like any other financial instrument, there are positives and negatives. Below we list a few of both although if you want a more comprehensive view go to our article here.

Positives

• You know in advance what currency exchange rate you will get in the future

• Pricing business abroad is easier when fixing in a forward contract

• Allows you to conduct risk management, not leaving you as exposed to currency movements

Negatives

• You can get margin called if the forward contract moves a percentage out of the money (look into exactly how this works here)

• The spread you pay (costs) can usually be higher than a spot contract

• The currency market can move further into your favour throughout the time of the contract but you still will have to use the forward contract

There are plenty more pros and cons which we look at here.

Best bank for receiving International payments

All high street banks will allow you to open currency accounts that enable you to receive international payments from your suppliers in their currency. As we touched on earlier the fees for receiving funds into a GBP account in a different currency can be astronomical.

For this reason, we would always suggest opening currency accounts with your provider. When it comes to the best bank for receiving international payments this does depend on a range of factors.

With banks whilst it is possible to open currency accounts this can be a tedious process due to internal processes of the banks with accounts taking as long as a few months to be opened. New fintech and non-banking providers have now entered the market and normally provide a quicker route to receiving international payments.

We look further into this question here and go over what you should look out for when searching for the right provider.

Best Foreign Exchange providers for business

The foreign exchange market in the UK is now home to over 250 different currency providers for businesses. Traditionally an industry captured by high street banks and Western Union now a large range of alternative providers have entered the market looking for a piece of the profit.

With so many options, which company do you choose. This will depend on several factors, what your current usage is, what products you will use and what service you ultimately need.

Bear in mind that a lot of these companies offer the same product with slight differences. A lot of your decision on who you ultimately use will come down to price, we show you multiple ways on how to find the best price for your foreign exchange here.

Conclusion

The largest market in the world has a lot of different moving parts, providers, products and intricacies which can affect different parts of your business.

If you would like to know further or check which solution could be right for your business you can contact us here.