Elements of Foreign Exchange: A Foreign Exchange Primer

by Franklin Escher

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.

To get back to the part foreign loaning operations play in the foreign exchange market here, it is plain that as no actual money is put up, the business is attractive and profitable to the bank having the requisite facilities and the right foreign connection. It means the putting of the bank's name on a good deal of paper, it is true, but only on the deposit of entirely satisfactory collateral and only in connection with the assuming of the same obligation by a foreign institution of high standing. There are few instances where loss in transacting this form of business has been sustained, while the profits derived from it are very large.

As to what the foreign department of an American bank makes out of the business, it may be said that that depends very largely upon whether the bank here acts merely as a lending agent or whether the operation is for "joint account," both as to risk and commission. In the former case (and more and more this seems to be becoming the basis on which the business is done) both the American and the European bank stands to make a very fair return—‌always considering that neither is called upon to put up one real dollar or pound sterling. Take, for instance, the average sterling loan made on the basis of the borrower taking all the risk of exchange and paying a flat commission of three-eighths of one per cent. for each ninety days. That means that each bank makes three-sixteenths of one per cent. for every ninety days the loan runs—‌the American bank for simply drawing its ninety-day bills of exchange and the English bank for merely accepting them. Naturally, competition is keen, American banking houses vying with each other both for the privilege of acting as agents of the foreign banks having money to lend, and of going into joint-account loaning operations with them. Three-sixteenths or perhaps one-quarter of one per cent. for ninety days (three-quarters of one per cent. and one per cent. annually) may not seem much of an inducement, but considering the fact that no real cash is involved, this percentage is enough to make the biggest and best banking houses in the country go eagerly after the business.

5. The Drawing of Finance-Bills

Approaching the subject of finance-bills, the author is well aware that concerning this phase of the foreign exchange business there is wide difference of opinion. Finance bills make money, but they make trouble, too. Their existence is one of the chief points of contact between the foreign exchange and the other markets, and one of the principal reasons why a knowledge of foreign exchange is necessary to any well-rounded understanding of banking conditions.

Strictly speaking, a finance-bill is a long draft drawn by a banker of one country on a banker in another, sometimes secured by collateral, but more often not, and issued by the drawing banker for the purpose of raising money. Such bills are not always distinguishable from the bills a banker in New York may draw on a banker in London in the operation of lending money for him, but in nature they are essentially different. The drawing of finance-bills was recently described by the foreign exchange manager of one of the biggest houses in New York, during the course of a public address, as a "scheme to raise the wind." Whether or not any collateral is put up, the whole purpose of the drawing of finance-bills is to provide an easy way of raising money without the banker here having to go to some other bank to do it.

The origin of the ordinary finance-bill is about as follows: A bank here in New York carries a good balance in London and works a substantial foreign exchange business in connection with the London bank where this balance is carried. A time comes when the New York banking house could advantageously use more money. Arrangements are therefore made with the London bank whereby the London bank agrees to "accept" a certain amount of the American banker's long bills, for a commission. In the course of his regular business, then, the American banker simply draws that many more pounds sterling in long bills, sells them, and for the time being has the use of the money. In the great majority of cases no extra collateral is put up, nor is the London bank especially secured in any way. The American banker's credit is good enough to make the English banker willing, for a commission, to "accept" his drafts and obligate himself that the drafts will be paid at maturity. Naturally, a house has to be in good standing and enjoy high credit not only here but on the other side before any reputable London bank can be induced to "accept" its finance paper.

The ability to draw finance-bills of this kind often puts a house disposed to take chances with the movement of the exchange market into line for very considerable profit possibilities. Suppose, for instance, that the manager of a house here figures that there is going to be a sharp break in foreign exchange. He, therefore, sells a line of ninety-day bills, putting himself technically short of the exchange market and banking on the chance of being able to buy in his "cover" cheaply when it comes time for him to cover. In the meantime he has the use of the money he derived from the sale of the "nineties" to do with as he pleases, and if he has figured the market aright, it may not cost him any more per pound to buy his "cover" than he realized from the sale of the long bills. In which case he would have had the use of the money for the whole three months practically free of interest.