One foot in sea and one on shore

It's been a while since I've posted, in part because work has demanded more of my attention of late, and in part because I've been traveling. As part of traveling internationally, the topic of currency conversion comes up with some regularity. Having dealt with this topic for a number of years, 1 I decided it would be helpful to have a blog post that explains it all rather than repeat everything over and over.

In my examples, I'm going to talk about two currencies - a 'native currency', which is the one you use when you're at home, and a foreign currency. For my examples, I'm going to use the US dollar (USD, $) and the Euro (EUR, €) as my native and foreign currencies, respectively. As usual, you will also find reasoned opinion and, quite possibly, unreasoned (and possibly unreasonable) opinion here as well. I'll try to identify when something is codified by rules and when something is an assumption based on my experience or is pure conjecture (the latter being something of which there should be little).

First, let's identify what it is we're talking about. Currency conversion is simply trading one currency for another, such as trading USD for EUR. Currency conversion comes up nearly any time there is cross-border trade, as is the case when I buy something online from Kennys Bookshop and Art Gallery, or when traveling internationally. Currency conversion may be either dynamic currency conversion or ordinary currency conversion, which is just called 'currency conversion'.

Now that I've opened the dynamic currency conversion versus ordinary currency conversion discussion, let's talk about what those terms mean. Where currency conversion is converting one currency into another, dynamic currency conversion happens as part of another transaction - typically when you're trying to pay for something either online or at a merchant that does use your native currency - that is not a conversion transaction.

There are a host of other transactions that qualify as currency conversion, some of which involve a physical change of currency (though there can be instances that do not). Typically, these happen with a financial institution - usually a bank, but possibly an institution dedicated to such exchanges, called a 'currency exchange' or something similar. Payment gateways that allow their users to hold a balance, such as PayPal, and online banks, may allow their users to convert currencies without involving a physical change, but those instances tend to be rare.

As an example of ordinary currency conversion let's say I'm going on holiday to Ireland. Before I go, I go to my bank and ask to withdrawal money equal to a few hundred euro. (I don't like to carry cash, but taxi cabs and a few other merchants seldom take anything but cash, especially for small transactions, so it's helpful to have some cash on hand.)  The customer representative at my bank checks the exchange rate - that's the amount of my native currency that I must 'spend' to 'buy' one unit of foreign currency. For example, my currency is USD and I'm changing it to EUR - $1 is worth about 0.7€, so I'm going to have to 'spend' about $1.50 for every 1€ I 'buy' - that 1.50 is the 'exchange rate'. If my native currency were the euro instead of the dollar, my 'exchange rate' would be 0.7, so for every 1€ I 'spent', I could buy about $1.5.

Of course that's too simple for people who need to make money, so they made it more complicated. These 'complications' are what enable some banks to make money converting money through the forex market, or currency market.

First, the 'exchange rate' isn't really the 'exchange rate'. If you search online for an exchange rate (using Google, for example), you will see an exchange rate from the forex market, but that exchange rate is the exchange rate financial institutions charge each other...it's not the exchange rate mere mortals, such as we are, get to use. The exchange rate the not-a-bank gets to use is tied to the forex exchange rate and is generally very close, but there's a cushion built into the transaction.

Second, the 'exchange rate' changes frequently, but not always the exchange rate that a specific institution uses. For example, many banks only change their 'exchange rate' (the exchange rate they use for customers, that is) once per week, but that information is not always posted, nor is the date the rate changes. In reality, this means that the exchange rate you believe you're getting may not even be close if one of the currencies is experiencing a period of volatility.

To make matters worse, the exchange rates are not direct inverses, they're the relative value of currencies. To illustrate this, let's consider an example using the USD and EUR. Let's say I'm planning to go on holiday to Ireland, so I go into my bank in the US to get a little cash for incidentals, like taxi cabs, and withdrawal $150 and 'buy' 100€ (at an exchange rate of 1.50). Unfortunately for me, something comes up and my holiday is canceled and so I go into my bank to 'sell' my 100€. Instead of getting back the $150 I 'spent', I only get $125 because the 'buy' exchange rate is 1.25 while the 'sell' exchange rate is 1.50. The difference in dollars 'spent' and 'received' is not some hidden $25 fee or a change in the exchange rate, it's simply a difference in the relative value of the currencies, hence the 'buy' and 'sell' rate. As a point of interest for US and EU readers, I should point out that the difference between the relative values of USD and EUR is not the 16 percent demonstrated here, it is typically 8 percent or more - which is significant.

So far I've explained the very basic ideas behind currency conversion that apply to both dynamic and ordinary currency conversion. There are special considerations, however, that apply solely to dynamic currency conversion 2. You will typically see, especially on travel-oriented sources, warnings intended to dissuade you from using dynamic currency conversion. These warnings are typically hyperbolic, using phrases such as "never pay in <your native currency>" and "paying in <your native currency> always benefits the merchant". For travelers from the US to the EU, these warnings are given to those who are given the option to pay in USD at hotels, car rental counters, and a few merchants, so the warnings are frequently "never pay in USD" or "always pay in EUR". Before going into the specifics about dynamic currency conversion, let me just point out that such generalizations are seldom accurate, and you should, instead of following some adviser's rule, determine what is best for you after educating yourself.

Now that you understand the basics about general currency conversion, let's talk about dynamic currency conversion for a moment.

Let's suppose for a moment that instead of my Ireland holiday being canceled, I've gone. As I'm visiting the Jameson Experience on Bow Street in Dublin, I decide I'll pick up a souvenir - a nice bottle of whiskey - to bring home, and it's priced at 100€. I recall from my visit to my bank to get cash for incidentals, that 100€ cost me $150 - a little pricey for a bottle of whiskey, but how often are you in Dublin able to treat yourself? When I bring the bottle to the counter and offer my card, the sales clerk asks "would you like to pay in dollars or euro", and with that simple question I recognize that they're offering dynamic currency conversion. Since I've read this blog post in addition to the (poor) overly-generalized advice to "never pay in dollars" and "always pay in euro" I wonder about the exchange rate. Luckily for me, I'm using a Visa card, which means the exchange rate has to be listed in the documentation and that I can decline the conversion if I don't like it. Let's say that as it turns out, the exchange rate offered is 1.45 - not much of a difference, but $5 in my pocket is better than nothing - so I accept the conversion. What happens after that acceptance is that the merchant sends through a transaction for $145, which my bank sees as a domestic (not a foreign currency) transaction and it goes through without event.

A personal note here: I've heard anecdotes that describe a difference of 10 percent or more difference - using our example that would make the exchange rate 1.65 instead of 1.50 - and while I'm certain that can happen, that has not been my experience, ever. On a recent trip, the exchange rate through my bank was 1.47, the exchange rate at currency exchanges in Dublin two, or maybe three, weeks later was 1.44, and the exchange rate at merchants was 1.43 - which is a difference of around 2 percent, not 10.

Let's get back to my holiday and think about that 100€ bottle of Jameson, only this time instead of the exchange rate being 1.45 it's 1.65 - 10 percent more than when I was in my bank. As good as the $5 in my pocket looked, the extra $15 out of my pocket looks considerably worse, so I decline the conversion. Let's take a look at what happens in this case.

The first thing that happens is a 100€ transaction goes through the Visa card network for authorization. I'm not anywhere near my limit, so Visa authorizes the transaction and I leave with my bottle of uisce beatha. Behind the scenes, the merchant sends the actual charge through the card network (they only received an authorization before, and that didn't move the money) - this will often happen a day or more later, especially if the day the authorization is issued is not a business day for my bank. Let's assume this is the case - I was visiting the shop on a Saturday afternoon and the transaction will actually be processed at my bank on Monday (which is a short time in international transactions). 

The next thing that happens is that my bank sees a 100€ charge, on Monday, and they recognize it as a 'foreign transaction', which means first, they're likely to charge me a foreign transaction fee 3 and second, they'll convert it to my native currency at that point. Why is that important? If my bank changes their rate on Monday morning, they may have a different rate than I received the week before when I changed my $150, and I may not know what that new rate is. In contrast to this procedure, if I accept the conversion, it is done immediately at the rate the merchant gives and it is received by my bank as a 'domestic transaction'. Let's say that my bank charges the typical 1 percent for foreign transactions and, without me knowing it, they changed their rate from 1.50 to 1.70, I'm now short the $5 (between a 1.70 bank exchange rate and 1.65 merchant exchange rate) and a $17 foreign transaction fee. That lovely bottle of Jameson, that could have cost me $165 (using dynamic conversion) instead cost me $187, all while I thought it was going to cost $150 (based on what I thought the conversion rate was).

Granted, our example of a swing from 1.50 to 1.70 is extreme, but so is the difference between the 1.50 bank rate and the 1.65 merchant rate. I was using round numbers because the calculations are easier - actual numbers are closer to what I experienced between 1.47 and 1.43, and an exchange rate fluctuating several points, e.g., 1.43 to 1.47 in less than 2 weeks is not out of the range of possibility - in fact, nearly that exact difference happened in a span of 10 days in March of 2014. 4

This post is not intended to persuade you to never pay in a foreign currency or always pay in a foreign currency - those rules are so overly-generalized as to be worthless. This post is intended to remove some of the mystery around the very complex topic of currency conversion so that you can make educated choices the next time you have one foot in the sea of foreign currency and one on the shore of your native currency.

Notes and references

Links in the notes and references list open in a new window

1. In addition to covering this topic in depth at university, I have spent a large portion of my career working for financial institutions, including recently working in the team responsible for processing payments to merchants (also known as "checkout") at PayPal.
2. Different payment networks have different rules, however, most are similar to the rules published by the Visa, Inc. network. If the card used is a member of the Visa, Inc. network, the merchant must provide a document that clearly shows: (1) the transaction amount of the goods or services purchased in the merchant's local currency - including currency symbol next to the amount; (2) the exchange rate, including any commission; (3) the total price in the transaction currency, accompanied by the words "Transaction Currency" — including currency symbol next to the amount; (4) a disclaimer that: is easily visible to the cardholder, specifies that the cardholder has been offered a choice of payment in the merchant's local currency, and the cardholder understands the choice of currency is final. The merchant must not (1) use any contractual language or procedures that result in the cardholder choosing DCC transaction by default - The merchant must inform the cardholder that the service is optional; (2) convert a transaction amount in a local currency into an amount in a cardholder's billing currency, after the transaction has been completed, but not yet entered into the Interchange. (Rules for Visa Merchants - Card Acceptance and Chargeback Management Guidelines. Foster City, CA: Author, 2006. 16-18. PDF.)
3. Typically about 3 percent of the converted amount - e.g, if your 100€ charge is converted to $150, then this would be a $4.50 charge. This fee will cover the 2 percent charged by the card network (e.g., Visa or MasterCard) and any additional charge (typically 1 percent) by the issuing bank.
4. Using my real-life data, the differences are not as pronounced as they were in the example using conversion rates of 1.65, and 1.70, and they happen to work in my favor in that instance, but had I done everything exactly as I did and traveled two weeks later, that 100 EUR bottle of uisce beatha would have cost me 143 USD using dynamic currency conversion, and 145 USD (144 USD + 1.44 USD foreign transaction fee) using the card and paying in EUR. Of course, if I'd used the 100 EUR in my pocket that I purchased when the rate was 1.47, it would have cost me 147 USD.