How do foreign exchange companies turn profit / make money

The foreign exchange market. So large that banks aren’t even interested in providing a decent solution for private individuals and SMEs.

In fact, the FX market is the largest financial market in the world. According to data from the World Bank the global remittance market, money defined as being sent home by overseas workers to low and middle income countries, was $529 billion in the year of 2018. Being such a large market in itself why wouldn’t the banks be interested in this? Well, it’s easier to understand when it gets put into perspective to the wider FX market where $6.6 trillion is traded each day. These 2019 figures indicate a 29% jump from the 2016 daily volumes of $5.1 trillion.

For the ‘lower’ end of the FX market? Step up international money transfer companies

 

💵 The Interbank Rate

As you may already know banks trade with each other at the interbank exchange rate (more on that on our best foreign exchange rate guide). The going FX rate that is based on a country’s currency exchange rate which can be relative to a number of factors such as economic performance and political stability. On the demand for that country’s products, services, shares, bonds – resulting in the demand for the purchase of their currency.

A common question asked is why can banks trade at the the interbank exchange rate with each other but I can’t achieve that rate? Well it’s a bit like everything, there is a huge cost to providing FX as a service – the IT infrastructure, compliance procedures, property and staff costs to name just a few. As all banks incur these costs to provide foreign exchange they’re happy to wave these costs when trading with each other (often having to trade currencies from a treasury perspective at the end of day depending on what deposits they are long and short in). But it makes sense they need to charge businesses and individuals for the service. What doesn’t make sense is the extortionate spreads they apply to the interbank exchange rate, meaning bad exchange rates are offered to their private and SME customers.

💼 The Standard Foreign Exchange Brokerage Business Model

Most foreign exchange brokers work on quite a simple business model to generate turnover. As FX brokers work with a number of clients they’re able to buy large amounts of currencies from the bank and achieve ‘wholesale’ rates. A very tight margin which is almost equal to the interbank exchange rate. Just like a wholesaler of coca cola would receive a preferential price the more bottles of coke they buy at once. The foreign exchange broker then adds their own margin to achieve the customer rate that is available to you or I.

The broker incurs their own costs – investment into their FX trading platform, compliance, onboarding and staff costs but they will have less overheads than a bank. As they specialise only in foreign exchange there should be significantly less unnecessary costs that aren’t related to providing an FX service. With this in mind they can provide better exchange rates to their customers than banks and more often than not, a significantly better service too.

When you book an international payment with a foreign exchange brokerage the broker books the exact matching trade with their banking counterparty. Nullifying market risk and ensuring there is no speculation with their clients funds. Revenue is purely gained from the differences in the spread they were able to achieve from the bank and the spread offered to its clients. Let’s take a look at the examples below:

 

Bank Example

  • Interbank Exchange Rate for £10,000 GBPEUR: 1.20
  • Customer Rate: 1.152
  • Spread Applied: 4%

In this example the bank would have made €480 on the trade, when transferring £10,000 they would have received €12,000 whilst the customer rate would have meant the customer received €11,520 into their account. 

 

International Money Transfer Example

  • Interbank Exchange Rate for £10,000 GBPEUR: 1.20
  • Wholesale Rate for IMT Provider: 1.1995
  • Customer Rate: 1.1815
  • Spread Applied by IMT Provider: 1.5%

In this example the bank makes a very small profit margin –  €5 in this case. The IMT provider receives €11,995 and the customer receives €11,815. The IMT provider makes €180 on the transfer.

 

The TransferWise Business Model

There are a number of IMT providers who are pushing the boundaries in their quest to reduce the unnecessary costs related to international payments and none is at the forefront more than TransferWise. In fact, their mission is to move money without borders – instant, convenient, transparent and eventually free. Now that last part might sound audacious and even a downright lie, but with enough scale they might have their eyes on alternative sources of income. 

How TransferWise Was First Pitched 

When TransferWise first launched they were keen to be perceived as a peer to peer money transfer company. It was this model that the two founders would use between each other when they required more currency prior to launching TransferWise. The principles of a peer to peer exchange are simple, user A needs to send £10,000 to EUR and user B needs to send €12,000 to GBP. As the GBPEUR rate is exactly 1.20 the two trades net each other off, so rather than having to book two separate matching trades with the bank (at an already worse rate than the interbank rate) they can simply release funds to respective clients when they know they have sufficient settlement on the other side of the trade.

In theory it’s the perfect solution but in practice the peer-to-peer model will not run as it does in the ideal scenario occurring in the working example above. Different customers have different payment size requirements and payments to more exotic countries may never have payments coming the other way. TransferWise may not even have the capabilities to register clients in the country you’re looking to send money to. There’s also the question that with the investment into peer-to-peer technology whether it actually allows the company to provide cheaper money transfers than brokerage firms who have very strong relationships with their banking partners. TransferWise will often have to match trades with a bank too. For this reason TransferWise has stepped back from its peer-to-peer message and focuses more on its mission to reduce costs for those who have been getting a bad deal from the banks. Something it is certainly doing very well.

TransferWise Rates

There’s no doubt about it, TransfeWise has some of the cheapest rates going in the industry. Unlike many banks and IMT providers they’re completely transparent with their pricing structure too. TransferWise’s obsessive focus on low rates and new client acquisition meant the firm didn’t actually turn profit until year 8 of existence – founded in 2010 and turning its first profit in 2018. Its ridiculous scale up in clients and investors belief in what it was trying to achieve was however evident from launch. In its most recent release, TransferWise has revealed it now works with over 6 million customers –  almost as many as NatWest bank.

 

TransferWise example 

  • Interbank Exchange Rate for £10,000 GBPEUR: 1.20
  • TransferWise Fee for £10,000 Payment: £37.12
  • Customer Rate same as the Interbank Rate: 1.20

With TransferWise the customer is able to receive the actual interbank exchange rate but TransferWise charges a fixed fee depending on your currency requirements somewhere between 0.3-0.5% of the transfer. So in essence this is the same as an FX broker charging a spread somewhere between 0.3-0.5% between the rate they get from the bank and the rate they offer their clients. In this example TransferWise transfers £9,962.88 @ 1.20 meaning the customer would receive €11,955.45. For more information on TransferWise fees, see our detailed TransferWise review.

 

TransferWise Fees / Exchange Rates

Currency Sent


TransferWise Fee 2020


AUD

0.41% Fee on initial $ 180,000.00 AUD, 0.31% on anything over + $ 1.14 AUD


BRL

2.51% of the amount that’s converted + R$ 2.40 BRL


CAD

0.59% Fee on initial $ 175,000.00 CAD, 0.49% on anything over + $ 0.87 CAD


CHF

0.32% Fee on initial CHF 150,000.00 CHF, 0.22% on anything over + CHF 0.64 CHF


CZK

0.4% Fee on initial Kč 3,000,000.00 CZK, 0.3% on anything over + Kč 11.84 CZK


DKK

0.36% Fee on initial kr 1,000,000.00 DKK, 0.26% on anything over + kr 5.29 DKK


EUR

0.33% Fee on initial € 115,000.00 EUR, 0.23% on anything over + € 0.61 EUR


JPN

0.63% of the amount that’s converted + ¥ 185.00 JPY


NZD

0.37% Fee on initial $ 200,000.00 NZD, 0.27% on anything over + $ 2.12 NZD


TRY

0.4% Fee + ₺ 7.46 TRY


USD

0.37% Fee on initial $ 135,000.00 USD, 0.27% on anything over + $ 1.23 USD

 

Could TransferWise Really Offer Free Transfers? (Eventually)

According to their most recent annual report, TransferWise have saved their customers £1 billion in fees over the last year. Certainly not chump change and a reflection of Transferwise’s commitment to their mission to move money without borders for as cheap as possible. After all TransferWise could have charged more and still offered their clients significant savings. But this would be completely against its values and what its investors believe in, the moment it stops this is the moment it gets found out and loses everything it is based on.

Completely free transfers though? Perhaps this will never be possible but with enough clients adopting more TransferWise products including the borderless account and international currency card there are more revenue streams which can help to drive the costs of its core offering down. If enough clients are registered with TransferWise and processing payments from one TransferWise account to another then this would drastically reduce costs for the firm and based on their track record, savings would be passed on to the customer.