Elements of Foreign Exchange Part 3

[Ill.u.s.tration: Form 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_

[Ill.u.s.tration: Form of Bankers' Long Draft]

In describing the nature of bankers' drawings of long bills, great care must be taken to differentiate between the _different kinds_ of 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 antic.i.p.ate the payment abroad for an incoming shipment of wool or sh.e.l.lac, 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 circ.u.mstances 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 const.i.tute 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 const.i.tute so important a part of the bankers' long bills to be had in the market, necessitates their cla.s.sification 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

The foreign 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 const.i.tuted 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 cla.s.s 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 ent.i.tled 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 cla.s.ses 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

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.

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 ill.u.s.trates the principle. For whether the banker sends over in every mail a bewildering a.s.sortment 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 a.n.a.lyze 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 doc.u.mentary 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 cla.s.s.

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.