Why do financial institutions charge so much to convert currency?

Question

With all the modern technology that we have, I am astonished that financial institutions charge such exorbitant prices for currency conversions. My bank, Fifth Third, charges a 3% conversion fee, while Paypal charges about 4%. I know that currency fluctuates - free-floating and managed - but I can't understand why there is such a high conversion fee, let alone a conversion fee at all.

Is there not some central service that tracks current currency rates that banks can use to get currency data? For example, XE has an API (web service) that for $12,000/year gets you live currency data with unlimited requests. But at 3% they would only need $400,000 to recover such an expense; this is purely speculation, but as a major national bank, I would imagine that they have much much more than $400,000 in international transactions per year. This is even more true for Paypal, yet bizarrely their rate is even higher at 4%!

Why do these fees exist? Are there back-end processes and requirements that require financial institutions to pass off the loss to consumers as a fee? Or, is it just to make money on the convenience of international transactions?

Answer 1

Mainly because they can.

Yes, there is a cost for banks to execute such transactions, and yes, there is a cost to cover the implied risks, but it is far from 3 or 4%.

There are banks that charge a flat rate of less than 30$ (and no percentage), so for larger amounts, it is worth shopping around. Note that for smaller amounts, which are the majority of personal transactions, that is probably about as, if not more expensive, than paying 3% - below 1000$, 3% is less than 30$. So charging a percentage is actually better for people that want to transfer smaller amounts.

Answer 2

All institutions, financial or otherwise, seek to maximize profits. In a free market, each bank would price its services to be competitive with the current state of the market.

Since the currency conversion fee is generally a small part of the decision as to which bank to choose, banks can be non-competitive in this area. If this is an important consideration for you then you would need to find a bank with a lower conversion fee, but be prepared to have higher fees in other areas.

TL;DR: The market bears it.

Answer 3

Why do these fees exist?

From a Banks point of view, they are operating in Currency A; Currency B is a commodity [similar to Oil, Grains, Goods, etc]. So they will only buy if they can sell it at a margin.

Currency Conversion have inherent risks, on small amount, the Bank generally does not hedge these risks as it is expensive; but balances the position end of day or if the exposure becomes large. The rate they may get then may be different and the margin covers it. Hence on highly traded currency pairs; the spread is less.

Are there back-end processes and requirements that require financial institutions to pass off the loss to consumers as a fee?

The processes are to ensure bank does not make loss.

is it just to make money on the convenience of international transactions?

Banks do make money on such transactions; however they also take some risks. The Forex market is not single market, but is a collective hybrid market place. There are costs a bank incurs to carry and square off positions and some of it is reflected in fees.

If you see some of the remittance corridors, banks have optimized a remittance service; say USD to INR, there is a huge flow often in small amounts. The remittance service aggregates such amounts to make it a large amount to get a better deal for themselves and passes on the benefits to individuals. Such volume of scale is not available for other pairs / corridors.

Answer 4

In my experience working at a currency exchange money service business in the US:

Flat fees are the "because we can" fee on average. These can be waived on certain dollar values at some banks or MSBs, and sometimes can even be haggled.

If you Google EURUSD, as an example, you also get something like $1.19 at 4pm, 9/18/2017. If you look at the actual conversion that you got, you may find your bank hit you with $1.30 or something close to convert from USD to Euro (in other words, you payed 10% more USD per Euro). And, if you sell your Euro directly back, you might find you only make $1.07. This spread is the real "fee" and covers a number of things including risk or liquidity. You'll see that currencies with more volatility or less liquidity have a much wider spread. Some businesses even go as far as to artificially widen the spread for speculators (see IQD, VND, INR, etc.).

Typically if you see a 3% surcharge on international ATM or POS transactions, that's the carrier such as Visa or Mastercard taking their cut for processing. Interestingly enough, you also typically get the carrier-set exchange rate overseas when using your card. In other words, your bank has a cash EURUSD of $1.30 but the conversion you get at the ATM is Visa's rate, hence the Visa fee (but it's typically a nicer spread, or it's sometimes the international spot rate depending on the circumstances, due to the overhead of electronic transactions). You also have to consider the ATM charging you a separate fee for it's own operation.

In essence, the fees exist to pad every player involved except you. Some cards do you a solid by advertising $0 foreign exchange fees. Unfortunately these cards only insulate you from the processing/flat fees and you may still fall prey to the fee "hidden" in the spread.

In the grander scheme of things, currency exchange is a retail operation. They try to make money on every step that requires them to expend a resource. If you pay 10% on a money transaction, this differs actually very little from the mark-up you pay on your groceries, which varies from 3-5% on dry food, to 20% on alcohol such as wine.

Answer 5

Banks do of course incur costs on currency transactions. But they're not as high as the fee charged to the customer. Most banks in most places lose a lot of money on operating bank accounts for customers, and make the money back by charging more than their costs for services like currency exchange. If you don't choose to pay those fees, use an online service instead. But bear in mind that if everyone does so then banks will be forced to charge higher fees for current accounts.

Answer 6

Is there not some central service that tracks current currency rates that banks can use to get currency data?

Sure. But this doesn't matter. All the central service can tell you is how much the rate was historically. But the banks/PayPal don't care about the historical value. They want to know the price that they'll pay when they get around to switching, not the last price before the switch. Beyond that, there is a transaction cost to switching. They have to pay the clearinghouse for managing the transaction.

The banks can choose to act as a clearinghouse, but that increases their risk. If the bank has a large balance of US dollars but dollars are falling, then they end up eating that cost. They'll only take that risk if they think that they'll make more money that way. And in the end, they may have to go on the currency market anyway. If a European bank runs out of US dollars, they have to buy them on the open market. Or a US bank might run out of Euros. Or Yen. Etc.

Another problem is that many of the currency transactions are small, but the overhead is fixed. If the bank has to pay $5 for every currency transaction, they won't even break even charging 3% on a $100 transaction. So they delay the actual transaction so that they can make more than one at a time. But then they have the risk that the currency value might change in the meantime. If they credit you with $97 in your account ($100 minus the 3% fee) but the price actually drops from $100 to $99, they're out the $1.

They could do it the other way as well. You ask for a $100 transaction. They perform a $1000 transaction, of which they give you $97. Now they have $898 ($1000 minus the $5 they paid for the transaction plus the $3 they charged you for the transaction). If there's a 1% drop, they're out $10.98 ($8.98 in currency loss plus a net $2 in fees).

This is why banks have money market accounts. So they have someone to manage these problems working twenty-four hours a day. But then they have to pay interest on those accounts, further eating into their profits. Along with paying a staff to monitor the currency markets and things that may affect them.

Answer 7

Perhaps it's the terminology "fee" that makes it a little confusing. I'm not sure whether it's due legislation or if it's tradition but banks and money changers in my country don't charge "fees". Instead they advertise separate prices for buying and selling money.

For example they'd normally advertise: USD, we buy: 4.50, we sell: 4.65.

It's a business. Just like selling cars or lemonade selling money only makes sense if you sell it at a higher price than what you bought it for.

Regardless of what you call it it's the profit margin for the seller.

Answer 8

Echoing that bank fees are mostly "because they can", although partly this is because simply holding onto the money doesn't really pay enough for the physical infrastructure of branches, ATMs and staff. So like a budget airline they make it up on additional fees.

But that document doesn't actually say they charge 3% for currency conversion! It's "0.20% of transaction amount" for currency conversion, which is not bad (although watch out for the "spread" between buying and selling rates).

I see "International POS/ATM Transaction Fee 3% of transaction amount", which is very different. That's a card fee. The big issue with these is fraud - your card number suddenly being used in a different country will nearly always trigger extra fraud checks. It also involves a much more complicated settlement process.

I'm more unimpressed with the monthly service charges and the huge $85 fee for international wire transfers.

Answer 9

As mentioned in several other answers, the main reason for high rates is to maximize profit. However, here is another, smaller effect:

Additional answer: It prevents abuse

The typical flow of getting money from an ATM:

1. You mention that you want 10 Euro
2. The bank offers to give you 10 Euro at a cost of 11 Dollars
3. You evaluate the offer for a period of time and accept or decline

Suppose you have a minute to consider the offer, then in that time the currency may drop or rise (which you can see from an external source of information). Therefore this opens a window for abuse.

For real major currencies these huge switches are rare, but they do happen. And when 1 or 2 minor currencies are involved these switches are more common.

Just looking at a random pair for today (Botswana Pula to Haitian Gourde) I immediately spotted a moment where the exchange rate jumped by more than 2 %. This may not be the best example, but it shows why a large margin is desirable.

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Note that this argument only holds for when the customer knows in advance what the exchange rate would be, for cases where it is calculated afterwards I have not found any valid excuse for such large margins (except that it allows them to offer other services at a lower price because these transaction).