Read Ebook: Elements of Foreign Exchange: A Foreign Exchange Primer by Escher Franklin

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f 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, .50, for buying or selling francs 100,000. In handling sterling, the broker is lucky if he makes his five points , which means that for turning over ?10,000 he would be rewarded with the sum of . 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 to 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 . 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.

HOW MONEY IS MADE IN FOREIGN EXCHANGE. THE OPERATIONS OF THE FOREIGN DEPARTMENT

Complete description 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.

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 ,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 ,870. It cost him ,860 to buy the commercial draft, and he has sold his own draft against it for ,870. His gross profit on the transaction, therefore, is .

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.

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 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 . That means that on every ?10,000, the gross profit would be .00. A daily turnover of ?50,000, therefore, would result in a gross profit of a day.

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.

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:

Assume that the rate for demand bills is 4.85, that discount in London is 3-1/2 per cent, and that the amount of the long bill remitted for discount and credit of proceeds is ?100.

Commission charged by the banker in London 1/40 per cent. [CO].12

Discount, 93 days at 3-1/2 per cent. 4.38

Total charges on the ninety days' sight ?100 bill amount to .74. On one pound, therefore, the charge would be $.0474. From which it is evident that each pound of a ninety-day bill, under the conditions given, is worth $.0474 less than each pound in a bankers' demand bill. From which it is evident that if such a demand bill were sold at 4.85 against a ninety-day bill bought at 4.8026 the remitting banker would come out even in the transaction.

The foregoing has been introduced at the risk of confusing the lay reader, on the idea that all the various calculations regarding the drawing of "demand" against the remitting of long bills are founded on the same general principle, and that where it is desired to go more deeply into the matter the correct conditions can be substituted. Discount, of course, varies from day to day, "payment" bills do not go through the discount market at all, but are "rebated," the commissions charged different bankers and by different bankers vary widely. Under the circumstances the value of presenting a lot of hard-and-fast calculations worked out under any given set of conditions is extremely doubtful.

As to the profit on business of this kind it can be said that the average, where the best bills are used, runs not much over twenty points . From that, of course, profits actually made run up as high as one cent or even two cents per pound, according to the amount of risk involved. The buying of cheap bills is, however, a most precarious operation. One single mistake, and the whole profit of months may be completely wiped out. The proposition is a good deal like lending money on insecure collateral, or like lending to doubtful firms. There are banking houses which do it, have been doing it for years, and by reason of an intuitive feeling when there is trouble ahead have been able to avoid heavy losses. Such business, however, can hardly be called high-class banking practice.

In its influence upon the other markets, there is perhaps no more important phase of foreign exchange than the making of foreign loans in the American market. How great is the amount of foreign capital continually loaned out in this country has been several times suggested in previous pages. The mechanics of these foreign loaning operations, the way in which the money is transferred to this side, etc., will now be taken up.

To begin at the very beginning, consider how favorable a field is the American market for the employment of Europe's spare banking capital. Almost invariably loaning rates in New York are higher than they are in London or Paris. This is due, perhaps, to the fact that industry here runs on at a much faster pace than in England or France, or it may be due to the fact that we are a newer country, that there is no such accumulated fund of capital here as there is abroad. Such a hypothesis for our own higher interest rates would seem to be supported by the fact that in Germany, too, interest is consistently on a higher level than in London or Paris, Germany, like ourselves, being a vigorous industrial nation without any very great accumulated fund of capital saved by the people. But whatever the reason, the fact remains that in New York money rates are generally on so much more attractive a basis than they are abroad that there is practically never a time when there are not hundreds of millions of dollars of English and French money loaned out in this market.

To go back no further than the present decade, it will be recalled how great a part foreign floating capital played in financing the ill-starred speculation here which culminated in the panic of May 9, 1901. Europe in the end of 1900 had gone mad over our industrial combinations and had shovelled her millions into this market for the use of our promoters. What use was made of the money is well known. The instance is mentioned here, with others which follow, only to show that all through the past ten years London has at various times opened her reservoirs of capital and literally poured money into the American market.

To take up the actual operation of loaning foreign money in the American market, suppose conditions to be such that an English bank's managers have made up their minds to loan out ?100,000 in New York--not on joint account with the American correspondent, as is often done, but entirely independently. Included in the arrangements for the transaction will be a stipulation as to whether the foreign bank loaning the money wants to loan it on the basis of receiving a commission and letting the borrower take the risk of how demand exchange may fluctuate during the life of the loan, or whether the lender prefers to lend at a fixed rate of interest, say six per cent., and himself accept the risk of exchange.

Loans made under the first conditions are known as sterling, mark, or franc loans; the other kind are usually called "currency loans." At the risk of repetition, it is to be said that in the case of sterling loans the borrower pays a flat commission and takes the risk of what rate he may have to pay for demand exchange when the loan comes due. In the case of a currency loan the borrower knows nothing about the foreign exchange transaction. He receives dollars, and pays them back with a fixed rate of interest, leaving the whole question and risk of exchange to the lending banker.

To illustrate the mechanism of one of these sterling loans. Suppose the London Bank, Ltd., to have arranged with the New York Bank to have the latter loan out ?100,000 in the New York market. The New York Bank draws ?100,000 of ninety days' sight bills, and, satisfactory collateral having been deposited, turns them over to the brokerage house of Smith & Jones. Smith & Jones at once sell the ?100,000, receiving therefor, say, 4,000.

What each of the bankers concerned makes out of the transaction is plain enough. As to what Smith & Jones' ninety-day loan cost them, in addition to the flat three-eighths per cent. they had to pay, that depends upon what they realize from the sale of the ninety days' sight bills in the first place and secondly on what rate they had to pay for the demand bill for ?100,000. Exchange may have gone up during the life of the loan, making the loan expensive, or it may have gone down, making the cost very little. Plainly stated, unless they secured themselves by buying a "future" for the delivery of a ?100,000 demand bill in ninety days at a fixed rate, Messrs. Smith & Jones have been making a mild speculation in foreign exchange.

From all of which it is plainly to be seen that when the London bankers are willing to lend money here and figure that the exchange market is on the down track, they will insist upon doing their lending on the "currency loan" basis--taking the risk of exchange themselves. Conversely, when loaning operations seem profitable but rates seem to be on the upturn, lenders will do their best to put their money out in the form of "sterling loans." Bankers are not always right in their views, by any means, but as a general principle it can be said that when big amounts of foreign money offered in this market are all offered on the "sterling loan" basis, a rising exchange market is to be expected.

As to the collateral on these foreign loans, it is evident that there is as much chance for different ways of looking at different stocks as there is in regular domestic loaning operations. Not only does the standing of the borrower here make a difference, but there are certain securities which certain banks abroad favor, and others, perhaps just as good, with which they will have nothing to do.

Excepting the case of special negotiation, however, it may be said that the collateral put up the case of foreign loans in this market is of a very high order. Three years ago this could hardly have been said, but one of the many beneficial effects of the panic was to greatly raise the standard of the collateral required by foreign lenders in this market. It used formerly to be more a case of the standing of the borrower. Nowadays the collateral is usually deposited here in care of a banker or trust company.

From what has been said about the mechanism of making these foreign loans, it is evident that no transfer of cash actually takes place, and that what really happens is that the foreign banking institution lends out its credit instead of its cash. For in no case is the lender required to put up any money. The drafts drawn upon him are at ninety days' sight, and all he has to do is to write the word "accepted," with his signature, across their face. Later they will be presented for actual payment, but by that time the "cover" will have reached London from the banker in America who drew the "nineties," and the maturing bills will be paid out of that. The foreign lender, in other words, is at no stage out of any actual capital, although it is true, of course, that he has obligated himself to pay the drafts on maturity, by "accepting" them.

Where, then, is the limit of what the foreign bankers can lend in the New York market? On one consideration only does that depend--the amount of accepted long bills which the London discount market will stand. For all the ninety days' sight bills drawn in the course of these transfers of credit must eventually be discounted in the London discount market, and when the London discount market refuses to absorb bills of this kind a material check is naturally administered to their creation.

Too great drawings of loan-bills, as the long bills drawn to make foreign loans are called, are quickly reflected in a squeamish London discount market. It needs only the refusal of the Bank of England to re-discount the paper of a few London banks suspected of having "accepted" too great a quantity of American loan-bills, to make it impossible to go on loaning profitably in the New York market. In order to make loans, long bills have to be drawn and sold to somebody, and if the discount market in London will take no more American paper, buyers for freshly-created American paper will be hard to find.

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