Elements of Foreign Exchange Part 4

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 circ.u.mstances, 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 circ.u.mstances 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 const.i.tutes 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 acc.u.mulated by remittance of all sorts of bills other than demand, but there are several large American inst.i.tutions whose foreign exchange business consists princ.i.p.ally 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 cla.s.s comes across their counters. All the necessary elements for doing the business being there, it only remains for such an inst.i.tution to employ a man capable of directing the actual transactions. The risk is trifling, the advertis.e.m.e.nt 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 cla.s.s, 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 a.s.sist 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 pa.s.sed 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 doc.u.ments 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 b.u.t.ter is presumably not an expert on the b.u.t.ter market and if he should be forced to sell the b.u.t.ter, 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 ill.u.s.tration 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 doc.u.ments 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 ill.u.s.trate more specifically: A banker has bought, say, a 1,000 ninety days' sight prime draft, on London, doc.u.ments 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. The _net_ proceeds 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:

a.s.sume 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.

_The various expenses are as follows:_

Commission charged by the banker in London 1/40 per cent. $0.12

Discount, 93 days (3 days of grace) at 3-1/2 per cent. 4.38

English Government bill stamp 1/20 per cent. 0.24 ------ $4.74

Total charges on the ninety days' sight 100 bill amount to $4.74. 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 (=4.74 cents) 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 (found by subtracting 4.74 cents from 485 cents) 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 subst.i.tuted.

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 circ.u.mstances 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 (one-fifth of a cent per pound sterling). 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-cla.s.s banking practice.

4. _The Operation of Making Foreign Loans_

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 acc.u.mulated 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 acc.u.mulated 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.

Even the experience of 1901 did not daunt the foreign lenders, and in 1902 fresh amounts of foreign capital, this time mostly German, were secured by our speculators to push along the famous "Gates boom." That time, however, the lenders' experience seemed to discourage them, and until 1906 there was not a great deal of foreign money, relatively speaking, loaned out here. In the summer of that year, chiefly through Mr. Harriman's efforts, English and French capital began to come largely into the New York market--made possible, indeed, the "Harriman Market of 1906." This was the money the terror-stricken withdrawal of which during most of 1907 made the panic as bad as it was. After the panic, most of what was left was withdrawn by foreign lenders, so that in the middle of 1908 the market here was as bare of foreign money as it has been in years. Returning American prosperity, however, combined with complete stagnation abroad, set up another hitherward movement of foreign capital which, during the spring and summer of 1909, attained amazing proportions. By the end of the summer, indeed, more foreign capital was employed in the American market than ever before in the country's financial history.

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.

What the foregoing means will perhaps become more clear if it is realized that in the first case the American agent of the foreign lender draws a ninety days' sight sterling bill for, say, 100,000 on the lender, and hands the actual bill over to the parties here who want the money. Upon the latter falls the task of selling the bill, and, ninety days later, when the time of repayment comes, the duty of returning a _demand_ bill for 100,000, plus the stipulated commission.

In the second kind of a loan the borrower has nothing to do with the exchange part of the transaction, the American banking agent of the foreign lender turning over to the borrower not a sterling draft but the dollar proceeds of a sterling draft. How the exchange market fluctuates in the meantime--what rate may have to be paid at the end of ninety days for the necessary demand draft--concerns the borrower not at all. He received dollars in the first place, and when the loan comes due he pays back dollars, plus four, five or six per cent., as the case may be. What rate has to be paid for the demand exchange affects the banker only, not the borrower.

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 repet.i.tion, 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 ill.u.s.trate 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, $484,000.

The bills sold by Smith & Jones find their way to London by the first steamer, are accepted and discounted. Ninety days later they will come due and have to be paid, and ten days prior to their maturity the New York Bank will be expecting Smith & Jones to send in a _demand_ draft for 100,000, plus three-eighths per cent. commission, making 375 additional. This 100,375, less its commission for having handled the loan, the New York Bank will send to London, where it will arrive a couple of days before the 100,000 of ninety days' sight bills originally drawn on the London Bank, Ltd., mature.

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.

If the same loan had been made on the other basis, the New York Bank would have turned over to Smith & Jones not a _sterling bill_ for 100,000, but the _dollar proceeds_ of such a bill, say a check for $484,000. At the end of ninety days Smith & Jones would have had to pay back $484,000, plus ninety days' interest at six per cent, $7,260, all of which cash, less commission, the New York Bank would have invested in a demand bill of exchange and sent over to the London Bank, Ltd.

Whatever more than the 100,000 needed to pay off the maturing nineties such a demand draft amounted to, would be the London Bank, Ltd.'s, profit.

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 inst.i.tution 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.