1. Especially heavy exports of merchandise.2. Large purchases of our stocks by the foreigners and the placing abroad of blocks of American bonds.3. Distrust on our part of financial conditions existing at some point abroad where there are carried large deposits of American capital.4. High money rates here.5. Unprofitably low loaning rates at some important foreign centre where American bankers ordinarily carry large balances on deposit.
1. Especially heavy exports of merchandise.
2. Large purchases of our stocks by the foreigners and the placing abroad of blocks of American bonds.
3. Distrust on our part of financial conditions existing at some point abroad where there are carried large deposits of American capital.
4. High money rates here.
5. Unprofitably low loaning rates at some important foreign centre where American bankers ordinarily carry large balances on deposit.
1. Just as unusually large imports of commodities mean a sharp demand for exchange with which to pay for them, unusually large exports mean a big supply of bills. In a previous chapter it has been explained how, when merchandise is shipped out of the country, the shipper draws his draft upon the buyer, in the currency of the country to which the merchandise goes. When exports are heavy, therefore, a great volume of bills of exchange drawn in various kinds of currency comes on the market for sale, naturally depressing rates.
Exports continue on a certain scale all through the year, but, like imports, are heavier at some times than others. In the Fall, for instance, when the year's crops are being exported, shipments out of the country invariably reach their zenith, the export nadir being approached in midsummer, when the crop has been mostly exported and shipments of manufactured goods are running light.
From the middle of August, when the first of the new cotton crop begins to find its way to the seaport, until the middle of December, when the bulk of the corn and wheat crop exports have been completed, exchange in very great volume finds its way into the New York market. Normally this is the season of low rates, for which reason many shippers of cotton and grain, who know months in advance approximately how much they will ship, contract ahead of time with exchange dealers in New York for the sale of the bills they know they will have. By so doing, shippers are often able to obtain very much better rates. They can then protect themselves, at least, from the extremely low rates which they may be forced to take if they wait and accept going rates at a time when shippers all over the country are trying to sell their bills at the same time.
How great is the rush of exchange into market may be seen from the statistics of cotton exports during the period given below. Not all of this cotton goes out during the last four months of the year, but the greater part of it does and, furthermore, cotton, while the most important, is onlyoneof the domestic products exported in the autumn.
During the autumn months, under normal conditions, the advantage is all with the buyer of foreign exchange. By every mail huge packages of bills, drawn against shipments of cotton, wheat and corn, come pouring into the New York market. Bankers' portfolios become crowded with bills; remittances by each steamer, in the case of some of the big bankers, run up, literally, into the millions of dollars. Naturally, any one wanting bankers' exchange is usually able to secure it at a low price.
2. With regard to the second influence making for low exchange, sale of American bonds or stocks abroad, no season can be set when the influence is more likely to be operative than at any other, unless, possibly, it be the Spring, when money rates are more apt to be low and bond issues larger than at any other time of the year. No time, however, can be definitely set—there are years when the bulk of the new issues are brought out in the Spring and other years when the Fall season sees most of the new financing. But whatever the time of the year, one thing is certain—the issue of any amount of American bonds with Europe participating largely means a full supply of foreign exchange not only during the time the issues are actually being brought out, but for long afterward.
There used to be a saying among exchange dealers that cotton exports make exchange faster than anything, but nowadays bond sales abroad have come to take first place. For foreign participation in syndicates formed to underwrite new issues almost invariably means the drawing of bills representing the full amount of the foreign participation. A syndicate is formed, for instance, to take off the hands of the X Y Z railroad $30,000,000 of new bonds, the arrangement being that the railroad is to receive its money at once and that the syndicate is to take its own time about working off the bonds. Half the amount, say, has been allotted to foreign houses. Immediately, the drawing of £3,000,000, or francs 75,000,000, as the case may be, begins. The foreign houses have to raise the money, and in nine cases out of ten, their way of doing it is to arrange with some representative abroad to let them draw long drafts, against the deposit of securities on this side. These drafts, in pounds or francs, at sixty to ninety days' sight, they can sell in the exchange market for dollars, thus securing the money they have agreed to turn over to the railroad. In the meantime, during the life of the drafts they have set afloat and before they come due and have to be paid off, the bankers here can go about selling the bonds and getting back their money. Perhaps before the sixty or ninety days, as the case may be, are over, the syndicate may have sold out all its bonds and its foreign members have been put in a position where they can pay off all the drafts they set afloat originally in order to raise the money.
Very often, however, it will happen that on account of one reason or another, sixty days pass or ninety days pass without the syndicate having been able to dispose of its bonds. In that case the long bills drawn on the foreign bankers have to be "renewed"—that being a process for which ample provision has, of course, been made. In a succeeding chapter, full description of how long bills of exchange coming due are renewed will be made. Just here it is only necessary to say that most or all of the money necessary to pay off the maturing bills is raised by selling another batch of "sixties" or "nineties," an operation which throws the maturity two or three months further ahead.
From this outline of the way foreign participation in American bond issues is financed, it can be seen that every time a big issue of bonds of a railroad or industrial in which European investors are actively interested, is brought out, it means a large supply of foreign exchange created and suddenly thrown on the exchange market for sale. Not any more suddenly or publicly than the bankers concerned can help, but still necessarily so to a great degree, because big bond issues can only be made with the full knowledge and coöperation of a large part of the public. Bankers who know in advance of large issues likely to be made and in which they know they will be asked to participate, often sell "futures" covering the exchange they foresee their participation will bring into existence, but as a general rule it may be set down that heavy issues, involving the sale abroad of large amounts of bonds, are a most depressing factor on the foreign exchange market. Especially so, as the participants who have agreed to turn over the money to the railroad, must sell bills to raise it, even if the horde of speculators and "trailers" who are always on the lookout for such opportunities, make every effort to sell the market out from under their feet.
3. Uneasiness with regard to the stability of the financial situation at some point abroad where American bankers usually carry large balances is another circumstance which often depresses the exchange market sharply. "Trouble in the Balkans" and "trouble over the Moroccan situation" are two bugbears which have for years back furnished the keynote for many swoops downward in the exchange market, and for years after this book is published will probably continue to do so. Money on deposit at a point several thousand miles away is naturally very sensitive, and the least suspicion of financial trouble is sufficient to cause its withdrawal. Withdrawal of bankers' balances from a foreign city means offerings of exchange drawn on that point with resultant decline in rates.
In the everyday life of the exchange market, political developments of an unfavorable character and war rumors are about the most frequent and potent influences toward the condition of uneasiness above referred to. Few war rumors ever come to anything, but there are times when they circulate with astonishing frequency and persistence and cause decided uneasiness concerning financial conditions at important points. At such times bankers having money on deposit at those points are apt to become influenced by the drift of sentiment and to draw down their balances. Here, again, operators in exchange, keenly on the alert for such chances, will very likely begin to sell the exchange market short and often succeed in breaking it to a degree entirely unwarranted by the known facts.
4. But of all the sure depressing influences on exchange, none is more sure than a rise in the money market. More gradual usually than a decline caused by such an influence as the sale of American bonds abroad, the influence of a rising level of money rates is nevertheless far more certain.
The theory of this "counter" movement in money rates and exchange is simply that when money rates rise, say at a point like New York, American bankers find it profitable to draw in their deposits from all over Europe for the purpose of using the money in New York. Such a process means a wholesale drawing of bills of exchange on all the leading European cities, with consequent offering of the bills and price-depression in the leading American exchange markets.
The number of banks scattered all over the United States which keep running deposit accounts in the leading European cities has become surprisingly great during the past ten years, and a movement to bring home this capital has to go only a little way before it reaches very large proportions. That is exactly what happens when money rates at a point like New York become decidedly more attractive than they are over on the other side. Arrangements with foreign correspondents usually call for a minimum balance of considerable size, which must be left intact, but under ordinary circumstances there is considerable leeway, and when the better opportunity for loaning presents itself here, drafts on balances abroad, in large aggregate amount, are apt to be drawn and sold in this market. Especially is this the case when the cause of the higher money level appears to be deep-rooted and the outlook is for a continuance of the condition for some time to come.
5. Lastly, as a depressing factor, there is to be considered the condition which arises when money at some important foreign center, such as London or Paris, begins to ease decidedly. Large receipts of gold from the mines, a bettering political outlook—these or many other causes may bring it about that money in London, for instance, after a period of high rates, may ease off faster than in Berlin or Hamburg. As a result, American bankers having large balances in London and finding it difficult to employ them profitably there, any longer, either withdraw them entirely or have the money transferred to some other point. In either case the operation will result in depressing the rate of exchange on London, for the American banker will either draw on London himself or, if he wants to transfer the money to Berlin or Hamburg, will instruct the German bankers by cable to draw for his account on London. In whatever way it is accomplished, the withdrawal of capital from any banking point tends to lower the rate of foreign exchange on that point.
These are the main influences bearing on the fluctuation of exchange. Needless to say they are not exerted all one way, or one at a time, as set forth. The international money markets are a most decidedly complex proposition, and there is literally never a time when several influences tending to put rates up are not conflicting with several influences tending to put rates down. The actual movement of the rate represents the relative strength of the two sets of influences. To be able to "size up" the influences present and to gauge what movement of rates they will result in, is an operation requiring, first, knowledge, then judgment. The former qualification can perhaps be derived, in small degree, from study of the foregoing pages. The latter is a matter of mental calibre and experience.
CHAPTER IV
THE VARIOUS KINDS OF EXCHANGE
Beforetaking up the question of the activities of the foreign exchange department and the question of how bankers make money dealing in exchange, it may be well to fix in mind clearly what the various forms of foreign exchange are. Following is a description of the most important classes of bills bought and sold in the New York market:
1.Commercial Long Bills
Form of Commercial Long BillForm of Commercial Long Bill
Drafts drawn by shippers of merchandise upon buyers abroad, or upon the banking representatives of the buyers abroad, at thirty days' sight or more. The drafts may be accompanied by shipping documents or may be "clean." The former kind of bill making up the greater part of the whole amount of foreign exchange dealt in in the New York market, will be described first.
Suppose a cotton dealer in Memphis to have sold one hundred bales of cotton to a spinner in Liverpool, the arrangement being that the English buyer is to be drawn on at sixty days' sight. The first thing the Memphis merchant does is to ship the cotton on its way to Liverpool, receiving from the railroad company a receipt known as a "bill of lading." At the same time he arranges for the insurance of the cotton, receiving from the insurance company a little certificate stating that the insurance has been effected.
The next step is for the Memphis shipper to draw the draft on the Liverpool buyer—or upon some bank abroad designated by the buyer. This draft is drawn in pounds sterling for the equivalent of the dollar value of the cotton and made payable sixty days after the party abroad on whom it is drawn has seen it and written "accepted" across its face. This draft, the bill of lading received from the shipping company, and the insurance certificate received from the insurance company are then pinned together and constitute a complete "commercial long bill with documents attached."
Other less important documents go with such a bill. Sometimes invoices showing the weight and price of the cotton go along with it and sometimes there is also attached a "hypothecation slip" which formally turns over the right to the goods to the Memphis or New York banker who buys the draft and accompanying documents from the Memphis cotton shipper. Sometimes, too, insurance is effected by the buyer abroad, in which case there may be no insurance certificate. But in the main, one of these "documentary" commercial bills consists of the draft itself, the bill of lading, and an insurance certificate.
Having pinned the document and the draft together, the Memphis cotton shipper is in possession of an instrument which he can dispose of for dollars. This he does either by selling it to his bank in Memphis or by sending it to New York, in order that it may be sold there in the exchange market at the current rate of exchange. Say, the bill of exchange is drawn on London at sixty days' sight, for £1,000. The buying price for such a draft will be, perhaps, 4.84. The Memphis shipper gets his check for $4,840, and is out of the transaction. The bill has passed into a banker's hands, who will send it abroad—deposit it in some foreign bank where he keeps a balance.
As to the rate of 4.84 received by the shipper, it is to be noted that had the bill been drawn at less than sixty days' sight, he would have received more dollars for it, while if it had been drawn at more than sixty days' sight, he would have received less for it. The longer the banker who takes the draft off the shipper's hands has to wait until he can get his money back on it, the lower, naturally, the rate of exchange he is willing to pay. On the same day that demand drafts are selling at 4.87, sixty-day drafts may be selling at 4.84 and ninety-day drafts at 4.83.
Assume, in this particular case, that the draft has been taken off the shipper's hands by some foreign exchange banker in New York. By the very first steamer the latter will forward it to his banking correspondent abroad, with instructions to present it at once to the parties on whom it is drawn, in order that they may mark it "accepted—payable such-and-such-a-date." After that the bill is a double obligation of the drawer and the drawee, and may be discounted in the open market, for cash.
Just here it is necessary to digress and state that documentary commercial bills are of two kinds—"acceptance" bills and "payment" bills. In the case of the first-named, the documents are delivered to the party on whom the bill is drawn as soon as he "accepts" the bill, which puts him in a position to get possession of the merchandise at once. In the case of a "payment" bill, the credit of the man on whom it is drawn is not good enough to entitle him to such a privilege, and the only way he can get actual possession of the goods is to actually pay the draft under a rebate-of-interest arrangement. All bills drawn on banks are naturally "acceptance" bills; and being discountable and thus immediately convertible into cash abroad, command a better rate of exchange in the New York market than "payment" bills, which may be allowed to run all the way to maturity before a single pound sterling is paid on them.
Except in the case of the shipment of perishable merchandise—grain shipped in bulk, for instance. In that case the buyer on the other side cannot afford to let the draft run, because the merchandise would spoil. He is simply forced to pay it under rebate, in order to get possession of the grain. And the rebate being always less than the discount rate, less pounds sterling come off the face of the bill in the process ofrebatingthan ofdiscounting. For which reason sixty-day bills drawn against shipments of grain—documents deliverable only on payment under rebate—command a better rate of exchange even than the very best of cotton "acceptance" bills drawn on banks.
2.Clean Bills
Form of Clean BillForm of Clean Bill
Where the drafts of the merchants of one country drawn upon the merchants or bankers of another are unaccompanied by shipping documents they are said to be "clean." Bills of this kind may originate from the transfer of capital from one country to another or may represent drawings against shipments of merchandise previously made. It is not unusual, indeed, where the relationship between some foreign merchant and some American merchant is very close, for the one to ship merchandise to the other without drawing drafts against the shipment until some little time afterward. It might happen, for instance, that a cotton manufacturing firm in France wanted to import a lot of raw cotton from the United States, but did not want to be drawn upon at the time. Under such circumstances the American house might ship the goods and send over the documents to the buyer, postponing its drawing for some time. Eventually, of course, the American house would reimburse itself by drawing, but the documents having gone forward long before, the drafts would be what is known as "clean."
Later on, in the chapter on the actual money-making operations of the foreign department, the risk in buying various kinds of bills will be fully explained, but in passing it may be mentioned that "clean" bills are of such a nature that bankers will touch them only when drawn by the very best houses. With a documentary bill, the banker holds the bill of lading, and if there is any trouble about the acceptance or payment of a draft, can simply seize the goods and sell them. But in the case of a "clean" bill, he has absolutely no security. The standing of the maker of the bill and what he knows about the maker's right to draw the bill is all he has to go by in determining whether to buy it or not.
3.Documentary Commercial Bills Drawn at Short Sight
Form of Documentary Commercial Sight BillForm of Documentary Commercial Sight Bill
A comparatively small part of our exports are sold on a basis where the draft drawn is at less than thirty days' sight, but there are a good many small bills of this kind continually coming into the market. Drafts drawn against manufactured articles and against such products as cheese, butter, dried fruits, etc., are apt to be drawn for, with shipping documents attached, at anywhere from three to thirty days' sight, but there is no rule about it. Where the "usance"—the time the bill has to run—is only a few days, documents are apt to be deliverable only on payment of the bills.
4.Drafts Drawn Against Securities
Form of Draft Drawn Against SecuritiesForm of Draft Drawn Against Securities
Exchange of this kind is naturally of the highest class, the stocks or bonds against which it is drawn being almost always attached to the bill of exchange. In the case of syndicate participations by large houses, the bonds may be shipped abroad privately and exchange against them drawn and sold independently, in which case, of course, no security is attached, but as a rule the bonds or stocks go with the draft. A, in New York, executes an order to buy for B in London, one hundred Union Pacific preferred shares on the New York Stock Exchange. The stock comes into A's office, and he pays for it with the proceeds of a sterling draft he draws on B. The stock itself he attaches to this sterling draft. Whoever buys the draft of him gets the stock with it and keeps possession of it till the draft is presented and paid in London.
5.Bankers' Checks or Demand Drafts on Their Correspondents Abroad
Form of Bankers' CheckForm of Bankers' Check
Bankers who do a foreign exchange business, keeping large balances in several European centers, are continually drawing and selling their demand drafts—"checks," they are called, or "demand"—upon these foreign balances. Such checks are always to be had in great volume in the exchange market, the banker's business being to draw and sell exchange, and his degree of willingness being merely a matter of rate. There come times, of course, when bankers have every reason to leave their foreign balances undisturbed, but even at such times the bid of a high enough rate will usually bring about the drawing of bills.
6.Bankers' Long Drafts
Form of Bankers' Long DraftForm of Bankers' Long Draft
In describing the nature of bankers' drawings of long bills, great care must be taken to differentiate between thedifferent kindsof long bills being bought and sold in the exchange market. A finance bill looks exactly the same as a long bill drawn by a banker for a commercial customer who wants to anticipate the payment abroad for an incoming shipment of wool or shellac, but the nature and origin of the two bills are radically different. The three main kinds of bankers' long bills will thus be taken up in the following order:
A.Bills Drawn in the Regular Course of Business
Such is the nature of foreign exchange business that bankers engaged in it are continually drawing their sixty and ninety days' sight bills in response to their own and their customers' needs. One example which might be cited is that of the importer who has a payment to make on the other side, sixty days from now, but who, having the money on hand, wants to make it at once. Under some circumstances such an importer might remit a demand draft on the basis of receiving a rebate of interest for the unexpired sixty days, but more likely he would go to a banker and buy from him a sixty days' sight draft for the exact amount of pounds he owed. The cost of such a draft—which would mature at the time the debt became due—would be less than the cost of a demand draft, the importer getting his rebate of interest out of the cheaper price he pays for the pounds he needs. Prepayments of this sort are responsible every day for very large drawings of bankers' long bills.
B.Long Bills Issued in the Operation of Lending Foreign Money
Bills of this kind represent by far the greater proportion of bankers' long bills sold in the exchange market. European bankers keep an enormous amount of floating capital loaned out in this market, in the making and renewing of which loans long bills are created as follows:
A banker on the other side decides to loan out, say, £100,000 in the New York market. Arrangements having been made, he cables his New York representative to draw ninety days' sight drafts on him for £100,000, the proceeds of which drafts are then loaned out for account of the foreign house. The matter of collateral, risk of exchange and, indeed, all the other detail, will be fully described in the succeeding chapters on how bankers make money out of exchange. For the time being it is merely necessary to note that every time a loan of foreign capital is made here—and there are days when millions of pounds are so loaned out—bankers' long bills for the full amount of the loans are created and find their way into the exchange market.
C.Bankers' Long Bills Drawn for the Purpose of Raising Money
Finance bills constitute the third kind of bankers' long exchange. In this case, again, detailed discussion must be put off until the chapter on foreign-exchange-bankers' operations, but the fact that bills of this kind constitute so important a part of the bankers' long bills to be had in the market, necessitates their classification in this place. Every time a banker here starts to use his credit abroad for the purpose of raising money—and there are times when the privilege is pretty freely availed of—he does it by drawing sixty or ninety days' sight drafts on his correspondents abroad. Finance bills, it may be said without question, are one of the most interesting forms of foreign exchange banking—at the same time one of the most useful and one of the most abused of privileges coming to the domestic banker by reason of his having strong banking connections abroad.
CHAPTER V
THE FOREIGN EXCHANGE MARKET
Theforeign exchange market is in every sense "open"—anyone with bills to buy or sell and whose credit is all right can enter it and do business on a par with anyone else. There is no place where the trading is done, no membership, license or anything of the kind. The "market," in fact, exists in name only; it is really constituted of a number of banks, dealers and brokers, with offices in the same section of the city, and who do business indiscriminately among themselves—sometimes personally, sometimes by telephone, by messenger, or by the aid of the continuously circulating exchange brokers.
The system is about as follows: The larger banks and banking houses have a foreign exchange manager, or partner, taking care of that part of the business, whose office is usually so situated as to make him accessible to the brokers who come in from the outside, and whose telephoning and wiring facilities are very complete. These larger houses have no brokers or "outside" men in their employ. The manager knows very well that plenty of chance to do business, buying or selling, will be brought in to him by the brokers and that his wires keep him constantly in touch with his fellow bankers.
Next come the big dealers in exchange, some of whom do a regular exchange business of their own, the same as the bankers, but who also have men out on the street "trading" between large buyers and sellers of bills. Such houses are necessarily closely in touch with banks, bankers, exporters, and importers all over the country, and have always large orders on hand to buy and sell exchange. Some of the bills they handle they buy and use for the conduct of their own business with banks abroad, but the more important part of what they do is to deal in foreign exchange among the banks. They are known as always having on hand for sale large lines of commercial and bankers' bills, while on the other hand they are always ready to buy, at the right price.
After this class of houses come the regular brokers—the independent and unattached individuals who spend their time trying to bring buyer and seller together, and make a commission out of doing it. In a market like New York the number of exchange brokers is very large. Like bond-brokerage, the business requires little in the way of office facilities or capital, and is attractive to a good many persons who are willing to accept the small income to be made out of it in return for being in a business where they are independent.
Foreign exchange brokerage, like all other employment of the middleman, is not what it used to be. Before the business became overcrowded as it is now, exchange brokers made their quarter-cent in the pound commission, and could depend on a respectable income. But nowadays brokers swarm among the foreign exchange bankers and dealers, doing business on any commission they can get, which is not infrequently as little as 1/128 of one per cent., say, $1.50, for buying or selling francs 100,000. In handling sterling, the broker is lucky if he makes his five points (5/100 of a cent per pound), which means that for turning over £10,000 he would be rewarded with the sum of $5. Under such conditions it is not difficult to see how hard it is to make any money to speak of out of foreign exchange brokerage.
The dealers, of course, fare much better. Handling commercial bills where the question of credit affects the price, they have a chance to make more of a profit, and buying and selling bills for their own account they naturally are entitled to make more than the man without capital, who simply tries to get in between the buyer and the seller. Dealing in exchange, especially for out-of-town clients, is a highly profitable business, but one which takes time, brains, experience and money to build up. Dealers representing large out-of-town sellers of exchange are very much in the position of the New York agents of manufacturing companies who sell goods on commission.
There being no regular market in which foreign exchange rates are made, it follows that the establishment of rates each morning and during the course of each day will be according to the supply and demand for bills. On any given morning by ten o'clock the bankers will all have received their cables quoting money and exchange rates in the foreign centers, and will all have pretty well made up their minds as to what the rate for demand bills on London ought to be. A banker, for instance, has £10,000 he wants to sell as early in the morning as possible, and from his foreign cables figures that 4.86 is about the right price. He offers it at that, but learns that another banker is offering exchange at 4.8595. He offers his own at that price, and somebody comes along, taking both lots and bidding 4.86 for £50,000 more. Somebody else bids 4.86 for other large lots, refusing, however, to pay 4.8605. The market is established at that point.
For the time being. A cable message from abroad may induce some banker to bid 4.8605 or 4.8610, or it may cause him to throw on the market such an amount of exchange as may break the price down to 4.85-3/4. Rates are constantly changing, and changing at times almost from minute to minute. Yet so complete is the system of telephones and brokers that any exchange manager can tell just about what is taking place in any other part of the market. Not infrequently, of course, sales are made simultaneously at slightly different rates, but, as a rule, if a trade is made at 4.86 on Cedar Street, 4.86 will be the rate on Exchange Place. It is remarkable how closely each manager keeps in touch with what is going on in every part of the market. And the great number of brokers continually circulating around and trying to "get in between" for five points is in itself a powerful influence toward keeping rates exactly the same in all parts of the market at once.
"Posted rates" mean little with regard to current conditions, being simply the bankers' public notice of the rate at which he will sell bills for trifling amounts. Exchange bankers dislike to draw small drafts and usually can be induced to do so only by the offer of a much higher rate than that current for a large amount. A banker might offer to sell you £10,000 at 4.87, but if you said you wanted only £10, he would be likely to point to his posted rate and charge you 4.88. Considering that in transactions based on the best bills the banker only figures on making from $10 to $20 profit on each £10,000, it may readily be seen why he is not anxious to sell a £10 draft.
As to the actual fluctuation of exchange, while it is true that rates at times rise and fall with all the violence so often displayed in the security markets, most of the time they move within a comparatively narrow range. On an ordinary business day, for instance, the change is not apt to run over fifteen points (15/100 of a cent per pound). In the morning, demand sterling may be at, say, 4.86; at noon a moderate demand for bills may carry the rate, first, to 4.8605, then to 4.8610; and finally, perhaps, to 4.8615. On fairly large offerings of bills the market might then recede to, say, 4.8605, ending the day five points up. And that would be an ordinary day—by no means the kind of a day the exchange market always sees, but a day corresponding to a stock market session in which the market leaders rise or fall a point or so.
There are times, of course, when very different conditions prevail. An unexpected rise in the bank rate in London, the announcement of a big loan or any one of many different happenings, are apt to cause a reduction in the exchange market and a bewildering movement of rates up and down. At such times a rise or fall of fifty points in sterling within half an hour is not at all out of the ordinary, while in times of panic, or when great crises impend, the fluctuations will be three or four times as great. During the latter part of October, 1907, and in November, the exchange market fluctuated with greater violence than, perhaps, at any other time since the gold standard was firmly established. Thrown completely out of gear by the premium of 3-1/2 per cent. a day for currency during the panic time, the exchange markets for some time would rise and fall several cents in the pound on the same day. Completely baffled by this erratic movement, many bankers temporarily withdrew entirely from the market.
As to the relative importance of the different kinds of exchange, sterling, of course, occupies the most prominent position. What proportion of the total of exchange dealt in in the New York market consists of sterling it is impossible to determine, but that it is as great as the volume of all the other kinds of exchange put together can safely be said. Many big dealers, indeed, make a specialty of sterling, and if they handle any other bills at all, do so only on a very small scale. As to whether francs or marks come next in volume, there is a difference of opinion. With Germany our direct financial transactions are probably considerably larger than with France, but the position of Paris as a banking centre makes the French capital figure prominently in many operations where the French market is not directly concerned. Despite the fact that sterling easily predominates, the volume of franc and mark bills, too, is enormous. Drafts on Paris for from three to five million francs and on Berlin for as many marks are not at all infrequently traded in in the exchange market, and at times bills for very much larger amounts have been drawn and offered for sale.
Bills drawn in other kinds of currency—guilders on Holland, for instance, form an important part of the foreign exchange dealt in in a market like New York, but are subservient in their rate fluctuations to the movement of sterling, marks, and francs. The latter are, indeed, the three great classes of exchange, and are the basis of at least nine-tenths of all foreign exchange operations.
In the following chapter will be taken up the various forms of activity of the foreign exchange department. No attempt is made to state out of which kind of business bankers make most money, but before looking into the more detailed description of how exchange business is conducted, it may be well to fix in mind the fact that it is out of the "straight" forms of foreign exchange business that the most profit is made. Highly complicated operations are indulged in by some managers with more theoretical than practical sense, and money is at times made out of them, but on the whole the real money is made out of the kinds of business about to be described. To the author's certain knowledge, the exchange business of one of the largest houses in New York was for years thus limited to what might be called "straight" operations. While the profits might at times have been materially increased by the introduction of a little more of a speculative element into the business, the house made money on a large scale and avoided the losses inevitable where business is conducted along speculative lines.
CHAPTER VI
HOW MONEY IS MADE IN FOREIGN EXCHANGE. THE OPERATIONS OF THE FOREIGN DEPARTMENT
Completedescription of the various forms of activity of the foreign exchange department of an important firm would fill a large volume, but there are certain stock operations in foreign exchange which are the basis of most of the transactions carried out and the understanding of which ought to go a long way toward making clear what the nature of the foreign exchange department's business really is.
1.Selling "Demand" Against "Demand"
The first and most elementary form of activity is, of course, the buying of demand bills at a certain price and the selling of the banker's own demand drafts against them at a higher price. A banker finds, for instance, that he can buy John Smith & Co.'s sight draft for £1,000, on London, at the rate of 4.86, and that he can sell his own draft for £1,000 on his London banking correspondent at 4.87. All he has to do, therefore, is to buy John Smith's draft for $4,860, send it to London for credit of his account there, and then draw his own draft for £1,000 on the newly created balance, selling it for $4,870. It cost him $4,860 to buy the commercial draft, and he has sold his own draft against it for $4,870. His gross profit on the transaction, therefore, is $10.
As may be imagined, not very much money is made in transactions exactly of this kind—the one cited is taken only because it illustrates the principle. For whether the banker sends over in every mail a bewildering assortment of every conceivable form of foreign exchange to be credited to his account abroad, or whether he confines himself to remittances of the simplest kinds of bills, the idea remains exactly the same—he is depositing money to the credit of his account in order that he may have a balance on which he can draw. That is, indeed, the sum and substance of the exchange business of the foreign department of most banking houses—the maintaining of deposit accounts in banks at foreign centers on which deposit account the bank here is in a position to draw according to the wants and needs of its customers.
To analyze the underlying transaction a little more closely, it is evident that the banker, in order to make a profit, must be able to buy the commercial bill at a lower rate of exchange than he can realize on his own draft. Which suggests at once that the extent of the banker's profit is dependent largely upon the amount of risk he is willing to take. For the rate on commercial bills is purely a matter of the drawer's credit. The best documentary commercial exchange, drawn at sight on banks abroad or houses of the highest standing will command a rate of exchange in the open market only a little less than the banker's own draft. From which point the rate realizable on commercial bills tapers off with the credit of the house in question, some bills regularly selling a cent or a cent and a half per pound sterling below the best bills of their class.
Without the introduction, therefore, of the element of speculation, except as to the soundness of the bills' makers, it is possible for bankers to make widely varying profits out of the same kind of business. Everything depends upon the amount of risk the banker is willing to take. The exchange market is a merciless critic of credit, and if a commercial firm's bills always sell at low rates, the presumption is strongly against its financial strength. Cases very frequently occur, however, where the exchange market misjudges the goodness of a bill, placing too low a valuation upon it. In that case the banker who, individually, knows that the house in question is all right, can make considerable sums of money buying its bills at the low-going rates and selling his own exchange against them. This, evidently, is purely a matter of the exchange manager's judgment. With comparatively little risk there are banking houses which are making a full cent a pound out of a good part of the commercial exchange they handle.
2.Selling Cables Against Demand Exchange
No description of a cable transfer having been given in the preceding description of different kinds of exchange, it may be explained briefly that a "cable," so-called, differs from a sight draft only in that the banker abroad who is to pay out the money is advised to do so by means of a telegraphic message instead of by a bit of paper instructing him to "pay to the order of so and so." A, in New York, wants to transfer money to B, in London. He goes to his banker in New York and deposits the amount, in dollars, with him, requesting that he (the New York banker) instruct his correspondent in London, by cable, to pay to B the equivalent in pounds. The transfer is immediate, the cable being sent as soon as the American banker receives the money on this end.
To be able to instruct its correspondent in London by cable to pay out large sums at any given time, a bank here must necessarily carry a substantial credit balance abroad. It would be possible, of course, for a banker to instruct his London agent by cable to pay out a sum of money, at the same time cabling him the money to pay out, but this operation of selling cables against cables is not much indulged in—there is too little chance of profit in it. Under special circumstances, however, it can be seen that a house anxious to sell a large cable and not having the balance abroad to do it, might easily provide its correspondent abroad with the funds by going out and buying a cable itself.
But under ordinary circumstances foreign exchange dealers who engage in the business of selling cables carry adequate balances on the other side, balances which they keep replenishing by continuous remittances of demand exchange. Which in itself constitutes an important form of foreign exchange activity and an operation out of which many large houses make a good deal of money.
All the parties involved being bankers there is little risk in business of this kind; but, on the other hand, the margin of profit is small, and in order to make any money out of it, it is necessary that very large amounts of money be turned over. The average profit, for instance, realized in the New York exchange market from straight sales of cables against remittances of checks is fifteen points (15/100 of a cent per pound sterling). That means that on every £10,000, the gross profit would be $15.00. A daily turnover of £50,000, therefore, would result in a gross profit of $75 a day.
It may seem strange that bankers should be willing to turn over so large an amount of money for so small a profit, even where the risk has been reduced to a minimum, but that is the case. Very often cables are sold against balances which have been accumulated by remittance of all sorts of bills other than demand, but there are several large American institutions whose foreign exchange business consists principally of the regulation selling of cables against remittances of demand bills. By reason of their large deposits they are in a position to carry full balances abroad, while in the course of their regular business a good deal of sight exchange of high class comes across their counters. All the necessary elements for doing the business being there, it only remains for such an institution to employ a man capable of directing the actual transactions. The risk is trifling, the advertisement is world-wide, the accommodation of customers is being attended to, and there is considerable actual money profit to be made. The business in many respects is thus highly desirable.
3.Selling "Demand" Bills Against Remittances of Long Bills
If there is a stock operation in the conduct of a foreign exchange business it is the selling by bankers of their demand bills of exchange against remittances of commercial and bankers' long paper. Bills of the latter class, as has been pointed out, make up the bulk of foreign exchange traded in, and its disposal naturally is the most important phase of foreign exchange business. For after all, all cabling, arbitraging in exchange, drawing of finance bills, etc., is only incidental. What the foreign exchange business really is grounded on is the existence of commercial bills called into existence by exports of merchandise.
There are houses doing an extensive exchange business who never buy commercial long bills, but the operations they carry on are made possible only by the fact that most other houses do. A foreign exchange department which does not handle this kind of exchange is necessarily on the "outside" of the real business—is like a bond broker who does not carry bonds with his own money but merely trades in and out on other people's operations.
Buying and remitting commercial long bills is, however, no pastime for an inexperienced man. Entirely aside from the question of rate, and profit on the exchange end of the transaction, there must be taken into consideration the matter of the credit of the drawer and the drawee, the salability of the merchandise specified in the bill of lading, and a number of other important points. This question of credit, underlying to so great a degree the whole business of buying commercial long paper, will be considered first.
The completely equipped exchange department has at its disposal all the machinery necessary for investigating expeditiously the standing and financial strength of any firm whose bills are likely to be offered in the exchange market. Such facilities are afforded by subscription to the two leading mercantile agencies, but in addition to this, the experienced exchange manager has at his command private sources of information which can be applied to practically every firm engaged in the export business. The larger banks, of course, all have a regular credit man, one of whose chief duties nowadays is to assist in the handling of the bank's foreign exchange business. So perfect does the organization become after a few years of the actual transaction of a foreign exchange business that the standing of practically any bill taken by a broker into a bank, for sale, can be passed upon instantly. New firms come into existence, of course, and have to be fully investigated, but the experienced manager of a foreign department can tell almost offhand whether he wants a bill of any given name or not.
Where documents accompany the draft and the merchandise is formally hypothecated to the buyer of the draft, it might not be thought that the standing of the drawer would be of such great importance. Possession of the merchandise, it is true, gives the banker a certain form of security in case acceptance of the bill is refused by the parties on whom it is drawn or in case they refuse to pay it when it comes due, but the disposal of such collateral is a burdensome and often expensive operation. The banker in New York who buys a sixty-day draft drawn against a shipment of butter is presumably not an expert on the butter market and if he should be forced to sell the butter, might not be able to do so to the fullest possible advantage. Employment of an expert agent is an expensive operation, and, moreover, there is always the danger of legal complication arising out of the banker's having sold the collateral. It is desirable in every way that if there is to be any trouble about the acceptance or payment of a draft, the banker should keep himself out of it.
A concrete illustration of the dangers attendant upon the purchase of commercial long bills from irresponsible parties is to be found in what happened a few years ago to a prominent exchange house in New York. This house had been buying the bills of a certain firm for some little time, and everything had gone well. But one day acceptance of a bill for £2,000 was refused by the party abroad, and the news cabled that the bill of lading was a forgery and that no such shipment had ever been made. Wiring hurriedly to the inland city in which was located the firm which drew the bill, the New York bank received the reply that both partners had decamped. What had happened was that, about to break up, the "firm" had drawn and sold several large bills of exchange, with forged documents attached, received their money for them, and then disappeared. Neither of them was ever apprehended, and the various bankers who had taken the exchange lost the money they had paid for it. Forgery of the bill of lading in this case had been a comparatively easy matter, the shipment purporting to have been made from an obscure little cotton town in the South, the signature of whose railroad agent was not at all known.
This forgery is only one example of the trickery possible and the extreme care which is necessary in the purchase of bills of this kind. And not only must the standing of the drawer be taken into consideration, but the standing of the drawee is a matter of almost equal importance—after the "acceptance" of the bill, the parties accepting it being equally liable with its maker. The nature of the merchandise, furthermore, and its marketability are further considerations of great importance. Cotton, it will readily appear, is an entirely different sort of collateral from clocks, or some specialty in which the market may vary widely. The banker who holds a bill of lading for cotton shipped to Liverpool can at any moment tell exactly what he can realize on it. In the case of many kinds of articles, however, the invoice value may differ widely from the realizable value, and if the banker should ever be forced to sell the merchandise, he might have to do so at a big loss.
Returning to the actual operation of selling bankers' demand against remittances of long bills, it appears that the successive steps in an actual transaction are about as follows:
The banker in New York having ascertained by cable the rate at which bills "to arrive" in London by a certain steamer will be discounted, buys the bills here and sends them over, with instructions that they be immediately discounted and the proceeds placed to his credit. On this resulting balance he will at once draw his demand draft and sell it in the open market. If, from selling this demand draft, he can realize more dollars than it cost him in dollars to put the balance over there, he has made a gross profit of the difference.
To illustrate more specifically: A banker has bought, say, a £1,000 ninety days' sight prime draft, on London, documents deliverable on acceptance. This he has remitted to his foreign correspondent, and his foreign correspondent has had it stamped with the required "bill-stamp," has had it discounted, and after having taken his commission out of the proceeds, has had them placed to the credit of the American bank. In all this process the bill has lost weight. It arrived in London as £1,000, but after commissions, bill-stamps and ninety-three days' discount have been taken out of it, the amount is reduced well below £1,000. Thenetproceeds going to make up the balance on which the American banker can draw his draft are, perhaps, not over £990. He paid so-and-so many dollars for the £1,000 ninety-day bill, originally. If he can realize that many dollars by selling a demand draft for £990 he is even on the transaction.
No attempt will be made in this little book to present the tables by which foreign exchange bankers figure out profit possibilities in operations of this kind. The terms obtainable from foreign correspondents vary so widely according to the standing and credit of the house on this side and are governed by so many different influences that a manager must work out each transaction he enters according to the conditions by which he, particularly, and his operations are governed. Such calculations, moreover, are all built up along the general line of the scheme presented below: