Elements of Foreign Exchange Part 5

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 quant.i.ty 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 a.s.suming of the same obligation by a foreign inst.i.tution 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, compet.i.tion 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 princ.i.p.al 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.

It is plain speculating in exchange--there is no getting away from it, and yet this practice of selling finance-bills gives such an opportunity to the exchange manager shrewd enough to read the situation aright to make money, that many of the big houses go in for it to a large extent. During the summer, for instance, if the outlook is for big crops, the situation is apt to commend itself to this kind of operation. Money in the summer months is apt to be low and exchange high, affording a good basis on which to sell exchange. Then, if the expected crops materialize, large amounts of exchange drawn against exports will come into the market, forcing down rates and giving the operator who has previously sold his long bills an excellent chance to cover them profitably as they come due.

About the best example of how exchange managers can be deceived in their forecasts is afforded by the movement of exchange during the summer and fall of 1909. Impelled thereto by the brilliant crop prospects of early summer, foreign exchange houses in New York drew and sold finance-bills in enormous volume. The corn crop was to run over three billion bushels, affording an unprecedented exportable surplus--wheat and cotton were both to show record-breaking yields. But instead of these promises being fulfilled, wheat and corn showed only average yields, while the cotton crop turned out decidedly short. The expected flood of exchange never materialized. On the contrary, rise in money rates abroad caused such a paying off of foreign loans and maturing finance bills that foreign exchange rose to the gold export point and "covering" operations were conducted with extreme difficulty.

In the foreign exchange market the autumn of 1909 will long be remembered as a time when the finance-bill sellers had administered to them a lesson which they will be a good while in forgetting.

6. _Arbitraging in Exchange_

Arbitraging in exchange--the buying by a New York banker, for instance, through the medium of the London market, of exchange drawn on Paris, is another broad and profitable field for the operations of the expert foreign exchange manager. Take, for example, a time when exchange on Paris is more plentiful in London than in New York--a shrewd New York exchange manager needing a draft on Paris might well secure it in London rather than in his home city. The following operation is only one of ten thousand in which exchange men are continually engaged, but is a representative transaction and one on which a good deal of the business in the arbitration of exchange is based.

Suppose, for instance, that in New York, demand exchange on Paris is quoted at five francs seventeen and one-half centimes per dollar, demand exchange on London at $4.84 per pound, and that, _in London_, exchange on Paris is obtainable at twenty-five francs twenty-five centimes per pound. The following operation would be possible:

Sale by a New York banker of a draft on Paris, say, for francs 25,250, at 5.17-1/2, bringing him in $4,879.23. Purchase by same banker of a draft on London for 1,000, at 4.84, costing him $4,840. Instructions by the American banker to his London correspondent to buy a check on Paris for francs 25,250 in London, and to send it over to Paris for the credit of his (the American banker's account). Such a draft, at 25.25 would cost just 1,000.

The circle would then be complete. The American banker who originally drew the francs 25,250 on his Paris balance would have replaced that amount in his Paris balance through the aid of his London correspondent. The London correspondent would have paid out 1,000 from the American banker's balance with him, a draft for which amount would come in the next mail. All parties to the transaction would be satisfied--especially the banker who started it, for whereas he paid out $4,840 for the 1,000 draft on London, he originally took in $4,879.23 for the draft he sold on Paris.

Between such cities as have been used in the foregoing ill.u.s.trations rates are not apt to be wide enough apart to afford any such actual profit, but the chance for arbitraging does exist and is being continuously taken advantage of. So keenly, indeed, are the various rates in their possible relation to one another watched by the exchange men that it is next to impossible for them to "open up" to any appreciable extent. The chance to make even a slight profit by shifting balances is so quickly availed of that in the constant demand for exchange wherever any relative weakness is shown, there exists a force which keeps the whole structure at parity. The ability to buy drafts on Paris relatively much cheaper at London than at New York, for instance, would be so quickly taken advantage of by half a dozen watchful exchange men that the London rate on Paris would quickly enough be driven up to its right relative position.

It is impossible in this brief treatise to give more than a suggestion of the various kinds of exchange arbitration being carried on all the time. Experts do not confine their operations to the main centers, nor is three necessarily the largest number of points which figure in transactions of this sort. Elaborate cable codes and a constant use of the wires keep the up-to-date exchange manager in touch with the movement of rates in every part of Europe. If a chance exists to sell a draft on London and then to put the requisite balance there through an arbitration involving Paris, Brussels, and Amsterdam, the chances are that there will be some shrewd manager who will find it out and put through the transaction. Some of the larger banking houses employ men who do little but look for just such opportunities. When times are normal, the margin of profit is small, but in disturbed markets the parities are not nearly so closely maintained and substantial profits are occasionally made. The business, however, is of the most difficult character, requiring not only great shrewdness and judgment but exceptional mechanical facilities.

7. _Dealing in "Futures_"

As a means of making--or of losing--money, in the foreign exchange business, the dealing in contracts for the future delivery of exchange has, perhaps, no equal. And yet trading in futures is by no means necessarily speculation. There are at least two broad cla.s.ses of legitimate operation in which the buying and selling of contracts of exchange for future delivery plays a vital part.

Take the case of a banker who has bought and remitted to his foreign correspondent a miscellaneous lot of foreign exchange made up to the extent of one-half, perhaps, of commercial long bills with doc.u.ments deliverable only on "payment" of the draft. That means that if the whole batch of exchange amounted to 50,000, 25,000 of it might not become an available balance on the other side for a good while after it had arrived there--not until the parties on whom the "payment" bills were drawn chose to pay them off under rebate. The exchange rate, in the meantime, might do almost anything, and the remitting banker might at the end of thirty or forty-five days find himself with a balance abroad on which he could sell his checks only at very low rates.

To protect himself in such case the banker would, at the time he sent over the commercial exchange, sell his own demand drafts for future delivery. Suppose that he had sent over 25,000 of commercial "payment"

bills. Unable to tell exactly when the proceeds would become available, the banker buying the bills would nevertheless presumably have had experience with bills of the same name before and would be able to form a pretty accurate estimate as to when the drawees would be likely to "take them up" under rebate. It would be reasonably safe, for instance, for the banker to sell futures as follows: 5,000 deliverable in fifteen days; 10,000 deliverable in thirty days, 10,000 deliverable in from forty-five to sixty days. Such drafts on being presented could in all probability be taken care of out of the prepayments on the commercial bills.

By figuring with judgment, foreign exchange bankers are often able to make substantial profits on operations of this kind. An exchange broker comes in and offers a banker here a lot of good "payment" commercial bills. The banker finds that he can sell his own draft for delivery at about the time the commercial drafts are apt to be paid under rebate, at a price which means a good net profit. The operation ties up capital, it is true, but is without risk. Not infrequently good commercial "payment" bills can be bought at such a price and bankers'

futures sold against them at such a price that there is a substantial profit to be made.

The other operation is the sale of bankers' futures, not against remittances of actual commercial exchange but against exporters'

futures. Exporters of merchandise frequently quote prices to customers abroad for shipment to be made in some following month, to establish which fixed price the exporter has to fix a rate of exchange definitely with some banker. "I am going to ship so-and-so so many tubs of lard next May," says the exporter to the banker, "the drafts against them will amount to so-and-so-much. What rate will you pay me for them--delivery next May?" The banker knows he can sell his own draft for May delivery for, say, 4.87. He bids the exporter 4.86-1/2 for his lard bills, and gets the contract. Without any risk and without tying up a dollar of capital the banker has made one-half cent per pound sterling on the whole amount of the shipment. In May, the lard bills will come in to him, and he will pay for them at a rate of 4.86-1/2, turning around and delivering his own draft against them at 4.87.

Selling futures against futures is not the easiest form of foreign exchange business to put through, but when a house has a large number of commercial exporters among its clients there are generally to be found among them some who want to sell their exchange for future delivery. As to the buyer of the banker's "future," such a buyer might be, for instance, another banker who had sold finance-bills and wants to limit the cost of "covering" them.

The foregoing examples of dealing in futures are merely examples of how futures may figure in every-day exchange transactions. Like operations in exchange arbitrage, there is no limit to the number of kinds of business in which "futures" may figure. They are a much abused inst.i.tution, but are a vital factor in modern methods of transacting foreign exchange business.

The foregoing are the main forms of activity of the average foreign department, though there are, of course, many other ways of making money out of foreign exchange. The business of granting commercial credits, the exporting and importing of gold and the business of international trading in securities will be taken up separately in following chapters.

CHAPTER VII

GOLD EXPORTS AND IMPORTS

Gold exports and imports, while not const.i.tuting any great part of the activity of the average foreign department, are nevertheless a factor of vital importance in determining the movement of exchange. The loss of gold, in quant.i.ty, by some market may bring about money conditions resulting in very violent movements of exchange; or, on the other hand, such movements may be caused by the efforts of the controlling financial interests in some market to attract gold. The movement of exchange and the movement of gold are absolutely dependent one on the other.

Considering broadly this question of the movement of gold, it is to be borne in mind that by far the greater part of the world's production of the precious metal takes place in countries ranking very low as to banking importance. The United States, is indeed, the only first-cla.s.s financial power in which any very considerable proportion of the world's gold is produced. Excepting the ninety million dollars of gold produced in the United States in 1908, nearly all of the total production of 430 million dollars for that year was taken out of the ground in places where there exists but the slightest demand for it for use in banking or the arts.

That being the case, it follows that there is to be considered, first, the _primary_ movement of nearly all the gold produced--the movement from the mines to the great financial centers.

Considering that over half the gold taken out of the ground each year is mined in British possessions, it is only natural that London should be the greatest distributive point. Such is the case. Ownership of the mines which produce most of the world's gold is held in London, and so it is to the British capital that most of the world's gold comes after it has been taken out of the ground. By every steamer arriving from Australia and South Africa great quant.i.ties of the metal are carried to London, there to be disposed of at the best price available.

For raw gold, like raw copper or raw iron, has a price. Under the English banking law, it is true, the Bank of England _must_ buy at the rate of seventy-seven shillings nine pence per ounce all the gold of standard (.916-2/3) fineness which may be offered it, but that establishes merely a minimum--there is no limit the other way to which the price of the metal may not be driven under sufficiently urgent bidding.

The distribution of the raw gold is effected as follows: Each Monday morning there is held an auction at which are present all the representatives of home or foreign banks who may be in the market for gold. These representatives, fully apprised of the amount of the metal which has arrived during the preceding week and which is to be sold, know exactly how much they can bid. The gold, therefore, is sold at the best possible price, and finds its way to that point where the greatest urgency of demand exists. It may be Paris or Berlin, or it may be the Bank of England. According as the representatives present at the auction may bid, the disposition of the gold is determined.

The _primary_ disposition. For the fact that Berlin, for instance, obtains the bulk of the gold auctioned off on any given Monday by no means proves that the gold is going to remain for any length of time in Berlin. For some reason, in that particular case, the representatives of the German banks had been instructed to bid a price for the gold which would bring it to Berlin, but the conditions furnishing the motive for such a move may remain operative only a short time and the need for the metal pa.s.s away with them. Quarterly settlements in Berlin or the flotation of a Russian loan in Paris, for instance, might be enough to make the German and French banks' representatives go in and bid high enough to get the new gold, but with the pa.s.sing of the quarter's end or the successful launching of the loan would pa.s.s the necessity for the gold, and its _re_-distribution would begin.

In other words, both the primary movement of gold from the mines and the secondary movement from the distributive centers are merely temporary and show little as to the final lodgment of the precious metal. What really counts is exchange conditions; it is along the lines of the favorable exchange that the great currents of gold will inevitably flow.

For example, if a draft for pounds sterling drawn on London can be bought here at a low rate of exchange, anything in London that the American consumer may want to possess himself of can be bought cheaper than when exchange on London is high. The price of a hat in London is, say, 1. With exchange at 4.83 it will cost a buyer in New York only $4.83 to buy that hat; if exchange were at 4.88, it would cost him $4.88. Similarly with raw copper or raw gold or any other commodity.

Given a low rate of exchange on any point and it is possible for the outside markets to buy cheaply at that point.

And a very little difference in the price of exchange makes a very great difference so far as the price of gold is concerned. As stated in a previous chapter, a new gold sovereign at any United States a.s.say office can be converted into $4.8665, so that if it cost nothing to bring a new sovereign over here, no one holding a draft for a pound (a sovereign is a gold pound) would sell it for less than $4.8665, but would simply order the sovereign sent over here and cash it in for $4.8665 himself. Always a.s.suming that it cost nothing to bring over the actual gold, every time it became possible to buy a draft for less than $4.8665, some buyer would s.n.a.t.c.h at the chance.

Such a case, with 1 as the amount of the draft and the a.s.sumption of no charge for importing the gold, is, of course, mentioned merely for purposes of ill.u.s.tration. From it should, however, become clear the whole idea underlying gold imports. A new sovereign laid down in New York is worth, at any time, $4.8665. If it is possible to get the sovereign over here for less than that--by paying $4.83 for a 1 draft on London, for instance, and three cents for charges, $4.86 in all--it is possible to bring the sovereign in and make money doing it.

Whether the gold imported is in the form of sovereigns or whether it consists of bars makes not the slightest difference so far as the principle of the thing is concerned. A sovereign is at all times worth just so and so much at any United States a.s.say office, and an ounce of gold of any given fineness is worth just so and so much, too, regardless of where it comes from. So that in importing gold, whether the metal be in the form of coin or bars, the great thing is the cheapness with which it can be secured in some foreign market. If it can be secured so cheaply in London, for example, that the price paid for each pound (sovereign) of the draft, plus the charge of bringing in each sovereign, is less than what the sovereign can be sold for when it gets here, it will pay to buy English gold and bring it in.

Exactly the same principle applies where the question is of importing gold bars instead of sovereigns, except that bars cannot be bought in London at a fixed rate. That, however, in no way affects the underlying principle that in importing gold the profit is made by selling the gold here for more dollars than the combined dollar-cost of the draft on London with which the gold is bought and the charges incurred in importing the metal. To ill.u.s.trate, if the draft cost $997,000 and the charges amounted to $3,000, the gold (whether in the form of sovereigns, eagles or bars) would have to be sold here for at least $1,000,000, to have the importer come out even.

With exports, the theory of the thing is to sell a draft on, say, London, for more dollars than the dollar-cost of enough gold, plus charges, to meet the draft. As will be seen from the figures of an actual shipment, given further on, the banker who ships gold gets the money to buy the gold from the Treasury here, by selling a sterling draft on London. Suppose, for example, a New York banker wants to create a 200,000 balance in London. Figuring how many ounces of gold (at the buying price in London) will give him the 200,000 credit, he buys that much gold and sends it over. Suppose the combined cost of the gold and the charge for shipping it amounts to $976,000. If the banker here can sell a 200,000 draft against it at 4.88, he will just get back the $976,000 he laid out originally and be even on the transaction.