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.