Where documents 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 butter is presumably not an expert on the butter market and if he should be forced to sell the butter, 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 illustration 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 L2,000 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 documents 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 illustrate more specifically: A banker has bought, say, a L1,000 ninety days' sight prime draft, on London, documents 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 L1,000, but after commissions, bill-stamps and ninety-three days' discount have been taken out of it, the amount is reduced well below L1,000. The net proceeds going to make up the balance on which the American banker can draw his draft are, perhaps, not over L990. He paid so-and-so many dollars for the L1,000 ninety-day bill, originally. If he can realize that many dollars by selling a demand draft for L990 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:

Assume 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 L100.

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 L100 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 substituted. 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 circumstances 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-class 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 accumulated 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 accumulated 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 L100,000 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, L100,000 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 L100,000, 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 repetition, 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 illustrate 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 L100,000 in the New York market. The New York Bank draws L100,000 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 L100,000, 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 L100,000, plus three-eighths per cent. commission, making L375 additional. This L100,375, 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 L100,000 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 L100,000. 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 L100,000 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 L100,000, 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 L100,000 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 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.

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 L1,000, 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 L1,000.

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 L1,000 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 L1,000 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 illustrations 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 classes 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 documents deliverable only on "payment" of the draft. That means that if the whole batch of exchange amounted to L50,000, L25,000 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 L25,000 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: L5,000 deliverable in fifteen days; L10,000 deliverable in thirty days, L10,000 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 institution, 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 constituting 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 quantity, 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-class 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 quantities 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 pass 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 passing of the quarter's end or the successful launching of the loan would pass 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, L1. 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 assay 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 assuming 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 snatch at the chance.

Such a case, with L1 as the amount of the draft and the assumption of no charge for importing the gold, is, of course, mentioned merely for purposes of illustration. 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 L1 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 assay 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 illustrate, 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 L200,000 balance in London. Figuring how many ounces of gold (at the buying price in London) will give him the L200,000 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 L200,000 draft against it at 4.88, he will just get back the $976,000 he laid out originally and be even on the transaction.

Before passing from the theory to the practice of gold exports and imports, there is to be considered the fact that bar gold sells in London at a constantly varying price, while in New York it sells at a definitely fixed price. In New York an ounce of gold of any given fineness can always be sold for the same amount of dollars and cents, but in London the amount of shillings and pence into which it is convertible varies constantly. So that a New York banker figuring on bringing in bar gold from London has to take carefully into account what the price per ounce of bar gold over there is. Sovereigns are seldom imported because they are secured in London not by weight but by face value,—even if the sovereigns have lost weight they cost just as many pounds sterling to secure. Where the New York banker is exporting gold, on the other hand, the price at which bar gold is selling in London is just as important as where he is importing. For the price at which the gold can be disposed of when it gets to London determines into how many pounds sterling it can be converted.

These matters of the cost of gold in one market and the crediting of the gold in some other market are not the easiest thing to grasp at first thought, but will perhaps become quite clear by reference to the accompanying calculation of actual gold export and gold import transactions. All the way through it must be remembered that the figures of such calculations can never be absolute—that insurance and freight charges vary and that different operations are conducted along different lines. The two operations described embody, however, the principle of both the outward and inward movement of bar gold at New York.

Export of Bars to London

In the transaction described below about a quarter of a million dollars' worth of bar gold is shipped to London, the money to pay for the gold being raised by the drawing and selling of a demand draft on London. Assuming that the draft is drawn and the gold shipped at the same time, the draft will be presented fully three days before the gold is credited, that being the time necessary for assaying, weighing, etc. In other words, there will be an "overdraft" for at least three days, interest on which will have to be figured as a part of the cost of the operation.

Following is the detailed statement:

13,195-1/2 ounces bar gold (.9166 fine) purchased from U.S. Treasury or Sub-Treasury at $18.9459 per ounce $250,000

Assay office charge (4 cents per $100) 100

Cartage and packing 20

Freight (5/32 per cent.) 390

Insurance (1/20 per cent.) 125

Interest on overdraft in London (from time draft has to be paid until the gold is credited) 3 days at 4 per cent. 83 ————- Total expense of buying and shipping the gold $250,718

13,195-1/2 ounces of gold credited in London at 77 shillings 10-1/2 pence L51,380

Draft on London for L51,380, sold by shipper of the gold, at 487.96 $250,718

In the transaction described above, the "overdraft" caused by the inevitable delay in assaying and weighing the gold on its arrival in London lasted for three days, the American banker being charged interest at the rate of four per cent. 487.96 being the rate at which the banker exporting the gold was able to sell his demand draft at the time, was, under those conditions, the "gold export point."

In this particular operation, which was undertaken purely for advertising purposes, the shipper of the gold came out exactly even. Suppose, however, that he had been able to sell his draft, against the gold shipped, at 4.88 instead of 4.87-3/4. That would have meant twenty-five points (one-quarter cent per pound) more, which, on L51,380, would have amounted to $128.25.

This question of the profit on gold exports is both interesting and, because it has a strong bearing at times on the question of whether or not to ship gold, important. No rule can be laid down as to what profit bankers expect to make on shipments. If, for instance, a banker owes L200,000 abroad himself and finds it cheaper to send gold than to buy a bill, the question of profit does not enter at all. Then, again, many and many an export transaction is induced by ulterior motives—it may be for the sake of advertising, or for stock market purposes, or because some correspondent abroad needs the gold and is willing to pay for it. Any one of these or many like reasons may explain the phenomenon, occasionally seen, of gold exports at a time when conditions plainly indicate that the exporter is shipping at a loss.

As a rule, however, when exchange is scarce and the demand so great that bankers who do not themselves owe money abroad see a chance to supply the demand for exchange by shipping gold and drawing drafts against it, the profit amounts to anywhere from $400 to $1,000 on each million dollars shipped—for less than the first amount named it is hardly worth while to go into the transaction at all; on the other hand, conditions have to be pretty much disordered to force exchange to a point where the larger amount named can be earned.

Import of Bars from London

Turning now to the discussion of the conditions under which gold is imported, it will appear from the following calculation that interest plays a much more important part in the case of gold imports than in the case of exports. With exports, as has been shown, the interest charge is merely on a three days' overdraft, but in the case of imports the banker who brings in the gold loses interest on it for the whole time it is in transit and for a day or two on each end, besides. A New York banker, carrying a large balance in London, for instance, orders his London correspondent to buy and ship him a certain amount of bar gold. This the London banker does, charging the cost of the metal, and all shipping charges, to the account of the New York banker. On the whole amount thus charged, therefore, the New York banker loses interest while the gold is afloat. Even after the gold arrives in New York, of course, the depleted balance abroad continues to draw less interest than formerly, but to make up for that the gold begins to earn interest as soon as it gets here.

The transaction given below is one which was made under the above conditions—the importer in New York had a good balance in London and ordered his London correspondent to buy and ship about $1,000,000 of gold, charging the cost and all expenses to his (the New York banker's) account. In this particular case the interest lost in London was at six per cent. and lasted for ten days.

Cost in the London market of 52,782 ounces of gold (.9166 fine) at 77 shillings, 11-3/4 pence per ounce L205,795

Freight (5/32 per cent.) 320

Insurance 102

Boxing and carting 9

Commission for buying the gold 26

Interest on cost of gold and on charges, while gold is in transit, 10 days at 6 per cent. 343 ————— L206,595

Proceeds, at U.S. Sub-Treasury in New York, of the 52,782 ounces of gold at $18.9459 per ounce $1,000,000

$1,000,000 invested in a cable on London at $484.04 L206,595

In the above calculation it will be seen that the proceeds of the gold imported were exactly enough to buy a cable on London sufficiently large to cancel the original outlay for the gold and the expenses incurred in shipping it over here. On the whole transaction the banker importing the gold came out exactly even; a trifle over 4.84 was the "gold import point" at the time.

In a general way it can be said that the profit made on gold import operations is less than where gold is exported. Banking houses big enough and strong enough to engage in business of this character are more apt to be on the constructive side of the market than on the other, and will frequently bring in gold at no profit to themselves, or even at a loss, in order to further their plans. It does happen, of course, that gold is sometimes shipped out for stock market effect, but the effect of gold exports is growing less and less. Gold imports, on the other hand, are always a stimulating factor and are good live stock market ammunition as well as a constructive argument regarding the price of investments in general.

Exports of Gold Bars to Paris—the "Triangular Operation"

Calculations have been given regarding the movement of bar gold between London and New York—what is ordinarily known as the "direct" movement. "Indirect" movements, however, have figured so prominently of recent years in the exchange market that at least one example ought perhaps to be given. Far and away the most important of such "indirect movements" are those in which gold is shipped from New York to Paris for the sake of creating a credit balance in London.

Before examining the actual figures of such an operation it may be well to glance at the theory of the thing. A New York banker, say, for any one of many different reasons, wants to create a credit balance in London. Examining exchange conditions, he finds that sterling drafts drawn on London are to be had relatively cheaper in Paris than in New York. In the natural course of exchange arbitrage the New York banker would therefore buy a draft on Paris and send it to his French correspondent with instruction to use it to buy a draft on London and to remit such draft to London for credit of his (the American banker's) account.

But exchange on Paris is not always plentiful in the New York market, and very likely the New York banker will find that if he wants to send anything to Paris he will have to send gold. Assume, then, that he finds conditions favorable and decides to thus transfer a couple of hundred thousand pounds to London by sending gold to Paris. The operation might work out as follows:

Cost of 48,500 ounces of bar gold (.995 fine) at U.S. Sub-Treasury, New York, at $20.5684 per ounce $997,567

Insurance (4-1/2 cents per $100) 450

Freight (5/32 per cent.) 1,555

Assay office charges (4 cents per $100) 400

Cartage and packing 60

Commission in Paris 250

Interest from time gold is shipped from New York until draft on new credit in London can be safely drawn and sold, 6 daysat 2 per cent. 333 —————- $1,000,615

The gold arrives in Paris and is bought by the Bank of France—

48,500 ounces at fcs. 106.3705 per ounce, equals fcs. 5,158,969

That amount of francs then invested in a check on London, and the check sent to London for credit of the American banker, fcs. 5,158,969 at 25 francs 10 centimes per L L205,536

New York banker sells his draft on London for L205,536 at 4.86832 $1,000,615

Conditions principally affecting the shipment of gold by the triangular operation, it will be seen from the above calculation, are the rate of exchange on London at New York, and the rate of exchange on London at Paris. The higher the rate at which the New York banker can sell his bills on London after the gold has been shipped, the more money he will make. The lower the rate at which his Paris agent can secure the drafts drawn on London, the greater the amount of pounds sterling which the gold will buy. High sterling exchange in New York and low sterling exchange in Paris are therefore the main features of the combination of circumstances which result in these "triangular operations."

Gold Shipments to Argentina

Of the many other ways in which gold moves, one way seems to be becoming so increasingly important that it is well worthy of attention. Reference is made to the shipment of gold from New York to the Argentine for account of English bankers who have debts to discharge there.

Owing to Argentine loans placed in the English market and to heavy exports of wheat, hides, and meat from Buenos Aires to London, there exists almost a chronic condition of indebtedness on the part of the London bankers to the bankers in the Argentine. Not offset by any corresponding imports, these conditions are putting Buenos Aires each year in a better and better condition to make heavy demands upon London for gold, demands which have recently grown to such an extent as to make serious inroads on the British banks' reserves. Unwilling to comply with this demand for gold, the powers in charge of the London market have on several occasions deliberately produced money conditions in London resulting in a shifting of the Argentine demand for gold upon New York. The means by which this has been accomplished has been the raising of the Bank of England rate to a point sufficiently high to make the dollar-exchange on New York fall. Able, then, to buy dollar-drafts on New York very cheaply, the London bankers send to New York large amounts of such drafts, with instructions that they be used to buy gold for shipment to the Argentine.

The very general confusion of mind regarding these operations in gold comes perhaps from the fact that they are constantly referred to as being a result of high exchange on London, at New York. Which is true, but a most misleading way of expressing the fact that low exchange on New York, at London, is the reason of the shipments. High sterling exchange at New York and low dollar-exchange at London are, of course, one and the same thing. But in this case, what counts is that dollar-exchange can be cheaply bought in London.

No attempt is made in this little work to cover the whole field of operations in gold, infinite in scope as they are and of every conceivable variety. But from the examples given above it ought to be possible to work out a fairly clear idea as to why gold exports and imports take place and as to what the conditions are which bring them about.

While not failing to realize the importance to the markets of the movement back and forth of great amounts of gold, it may nevertheless be said that from the standpoint of the foreign exchange business the importance of transactions in gold is very generally overestimated. Most dealers in foreign exchange steer clear of exporting or importing gold whenever they can, the business being practically all done by half-a-dozen firms and banks. As has been seen, the profit to be made is miserably small as a rule, while the trouble and risk are very considerable. Import operations, especially, tie up large amounts of ready capital and often throw the regular working of a foreign department out of gear for days and even weeks. There is considerable newspaper advertising to be had by being always among the first to ship or bring in gold, but there are a good many houses who do not want or need that kind of advertising. Some of the best and strongest banking houses in New York, indeed, make it a rule to have nothing to do with operations in gold one way or the other. Should they need drafts on the other side at a time when there are no drafts to be had, such houses prefer to let some one else do the gold-shipping and are willing to let the shipping house make its one-sixteenth of one per cent. or one-thirty-second of one per cent. in the rate of exchange it charges for the bills drawn against the gold.

Particular attention has been paid all through the foregoing chapter to the gold movement in its relation to the New York markets, the movement between foreign points being too big a subject to describe in a work of this kind. In general, however, it can be said that of the three great gold markets abroad, London is the only one which can in any sense be called "free." In Paris, the ability of the Bank of France to pay its notes in silver instead of gold makes it possible for the Bank of France to control the gold movement absolutely, while in Germany the paternalistic attitude of the government is so insistent that gold exports are rarely undertaken by bankers except with the full sanction of the governors of the Reichsbank.

It is a question, even, whether London makes good its boast of maintaining Europe's only "free" gold market. The new gold coming from the mines does, it is true, find its way to London, for the purpose of being auctioned off to the highest bidder, but as the kind of bids which can be made are governed so largely by arbitrary action on the part of the Bank of England, it is a question whether the gold auction can be said to be "free." Suppose, for instance, that the "Old Lady of Threadneedle Street" decides that enough gold has been taken by foreign bidders and that exports had better be checked. Instantly the bank rate goes up, making it harder for the representatives of the foreign banks to bid. Should the rise in the rate not be sufficient to affect the outside exchange on London, the Bank will probably resort to the further expedient of entering the auction for its own account and outbidding all others. Not having any shipping charges to pay on this gold it buys, the Bank is usually able to secure all the gold it wants—or, rather, to keep anybody else from securing it. The auction is open to all, it is true, but being at times conducted under such circumstances, is hardly a market which can be called "free."

If there is any "free" gold market in the world, indeed, it is to be found in the United States. All anybody who wants gold, in this country, has to do, is to go around to the nearest sub-treasury and get it. If the supply of bars is exhausted, the buyer may be disappointed, but that has nothing to do with any restriction on the market. The market for gold bars in the United States is at the Treasury and the various sub-treasuries, and as long as the prospective buyer has the legal tender to offer, he can buy the gold bars which may be on hand. And at a fixed price, regardless of how urgent the demand may be, who he is, or who else may be bidding. First come first served is the rule, and a rule which is observed as long as the bars hold out. After that, whoever still wants gold can take it in the form of coin.

How such conditions have worked out, so far as our gaining or losing gold is concerned, can be seen from the following table, introduced here for the purpose of giving a clear idea as to just where the United States has stood in the international movement of gold during the five-year period given below:

Exports of Excess of Gold from U.S. Imports Imports

1913 $77,762,622 $69,194,025 [1]$8,568,597 1912 57,328,348 48,936,500 [1]8,391,848 1911 22,509,653 73,607,013 51,097,360 1910 118,563,215 43,339,905 [1]75,223,310 1909 91,531,818 44,003,989 [1]47,527,829

[1] Excess of exports

In conclusion, it may be said that the prediction that as international financial relationships between banks are drawn closer, gold movements will tend to decrease, seem hardly to be borne out by the figures of the table given above. Banks here and banks abroad are working together in a way unknown ten or even five years ago, but as yet there are no signs of any lessening in the inward or outward movement of specie. More liberal granting of international credits, increased international loaning operations, far from putting an end to the physical movement of gold in large quantities,—these are influences tending to make gold move more freely than ever. The day of the treasure galleons is over, but in their place we have swift-moving steamers by which gold can be shifted from one point to another with safety and ease. Gold movements seem as though they were to play an important part in the markets for a good many years to come.



CHAPTER VIII

FOREIGN EXCHANGE IN ITS RELATION TO INTERNATIONAL SECURITY TRADING

On account of the huge fixed investment of foreign money in the United States, on account of Europe's continuous speculative interest in our markets, and the activity of the "arbitrageurs" in both bonds and shares, dealings in securities between ourselves and the Old World are always on a very great scale. Not infrequently, indeed, Europe's position on American securities is an influence of dominating importance.

From the maturities, refunding operations, and interest remittances alone, growing out of the permanent investment of foreign money in our securities, there results a very great amount of international security and exchange business. Whether Europe's investment here amounts to three billions or four billions or five billions, it is impossible to say; the fact remains that it is so large that every year a very great amount of foreign-held bonds come due and have to be paid off or refunded, and, further, that the remitting abroad of coupon and dividend money each year calls for upward of $150,000,000.

This matter of maturing investments, alone, calls for continuous international security trading and on a large scale. Each year there comes due in this country an amount of railroad and other bonds running well up into the hundreds of millions, of which a large proportion are held on the other side. Some of these maturities are paid off in cash—more often, refunding bonds are offered in exchange; seldom, indeed, are the maturing investments allowed to remain unreplaced. European investors, especially, have consistently done well with money placed in this country, and the running off to maturity of a foreign-held American bond is nearly sure to be followed up by replacement with some other American security.

Bond houses doing an international business are therefore keenly watchful of the maturity of issues largely held abroad, and are ever ready with offers of new and attractive investments. Knowledge of the location of American investments in Europe is thus a business asset of the greatest importance, and records are carefully kept. The fact that a dealer here knows that some bank in London has a wealthy client who holds a big block of certain bonds about to mature, may very possibly mean that the house here may be able to make a very profitable trade. Information of this character is carefully gathered wherever possible and as carefully guarded. The longer a house has been in business, naturally, and the closer its financial relationship with investment interests abroad, the more of this sort of information it is bound to possess.

Foreign exchange growing out of these renewals and refundings is on a very large scale. Sometimes the placing of a new issue abroad means such immediate drawing of drafts on foreign buyers of the securities as to depress the exchange market sharply. Sometimes, as in the case of new issues of railroad stock, where payments are usually made in instalments covering a year or more, the drawing of exchange is distributed in such a way that its influence, if felt at all, is felt merely as an underlying element of weakness.

Of a somewhat different character are the foreign exchange transactions originating from what might be called Europe's "floating" investment in American securities and from the out-and-out speculations carried on in this market by the foreigners.

There is never a time, probably, when the floating foreign investment in American stocks and bonds does not run up with the hundreds of millions of dollars. "Speculation," such operations would probably be called by many people, but whether speculation or not, a form of activity which is continually giving rise to big dealings in foreign exchange. For this "floating" investment is very largely for account of bankers whose international connections and credit make it possible for them to carry stocks and bonds through the agency of the exchange market, and without having to put up any actual money. The ingenious method by which this is accomplished is about as follows:

A banker here, for instance, decides that a certain low-priced bond is cheap and that if purchased it will show a substantial profit within six months or a year. Not wanting to buy the bonds and borrow on them here, he invites his foreign correspondent into the deal on joint account, arranging to raise the money with which to buy the bonds by drawing a ninety-day sight draft on the foreign correspondent. This he does, drawing, say, a L50,000 draft at ninety days' sight, and selling it in the exchange market at, let us say, $4.83.

The $241,500 received from the sale of the draft, the American banker uses to buy the bonds. Ninety days later the draft will come due in London, and have to be covered (or renewed) from this side, but in the meantime, a profitable chance to sell the bonds may present itself. If not, the draft can be "renewed" at the end of the ninety days, and again and again if necessary, until the bankers are willing to close out the bonds.

This operation of "renewing" long drafts drawn for the purpose of carrying securities is one of the most interesting phases of foreign exchange business in connection with international security dealings. The draft has been drawn, say, for L50,000. The end of the ninety-day period comes, the draft is due, is presented, and has to be paid. But the bankers do not choose to sell out the bonds and close the deal. They arrange instead to renew the maturing draft. This they do by paying the original ninety-day draft out of the proceeds of a new ninety-day draft.

The original draft for L50,000 comes due let us say on October 19, so that about October 10th the New York banker will be under the necessity of sending over to London a demand draft for L50,000. The rate realizable for ninety-day drafts being always considerably lower than the price of demand drafts, it follows that if the banker proposes to buy L50,000 of demand out of the proceeds of a fresh ninety-day bill he will have to draw his fresh bill for more than L50,000. If the demand rate happened to be 4.86, the L50,000 he needs would cost him $243,000. In order to raise $243,000 by selling a ninety-days' sight draft (say at 4.83) he would have to make the new draft for L50,310. The extra L310 would constitute the interest. Each time he renewed the draft he would have to draw for more and more.

Requiring the tying up of no actual capital, this form of financing "floating investments" has become exceedingly popular and is carried on on a large scale. Where the relationships between the foreign and the American houses are close, there is almost no limit to the number of times an original bill may be renewed. As for the constantly increasing amount of the drafts which have to be drawn, that is taken care of by the interest on the investment carried.

Not all the floating investment in American securities is carried in this way, but in whatever form the financing is done it is bound to involve foreign exchange operations and to necessitate the drawing of drafts by banking houses in this country on their correspondents abroad. Quiet conditions may result in long periods when investments of this kind are left undisturbed, but even then, the constant remitting and renewing of drafts originates a good deal of exchange market activity. And with considerable frequency occur periods when the floating investment is strongly affected by immediate conditions, and when purchases, sales, and transfers of securities stir the exchange market to a high pitch of excitement.

Speculative operations in this market for foreign account, are, however, the cause of the greatest amount of exchange market activity caused by international security transactions. There are times, as has been said, when individuals and banking houses abroad speculate heavily and continuously in this market, at which times the exchange market is strongly affected by the buying and selling of exchange which necessarily takes place. Such periods may last for weeks or even months, and during all of the time, London's immediate attitude toward the market is apt to be the controlling influence on the movement of exchange rates.

Concerning arbitraging in stocks, operations of this kind will be found to divide themselves readily into two classes—trades which are closed off at both ends at once, and trades which are allowed to run over night or even for a day or two. The former is a class of business out of which a dozen or twenty well-equipped houses in New York are making a great deal of money. With an expert "at the rail" on the floor of the New York Stock Exchange, and continuous quotations as to prices on the various stock exchanges in Europe coming in, these houses are in a position to take advantage of the slightest disparity in prices. The chance to buy a hundred shares of some stock, in London, for instance, and to sell it out at the same time in New York, at one-eighth or one-quarter more, is what the arbitrageurs are constantly on the lookout for. With the proper facilities, an expert, in the course of the hour during which the London and New York Stock Exchanges are simultaneously in session, is often able to put through a number of profitable trades.

Such operations are possible, primarily, because of the fact that the same influences affect different markets in different ways. A piece of news which might cause a little selling of some stock in London, for instance, might have exactly the opposite effect in New York. With the wires continually hot between the two markets and a number of experts on the watch for the chance to make a fraction, quotations here and abroad can hardly get very far apart, at least in the active issues, but occasionally, it does happen that the arbitrageur is able to take advantage of a substantial difference. Always without risk, the bid in one market being in hand before the stock is bought in the other market.

But not so in the case of the other kind of arbitrage, where stocks bought in one market are carried over night for the sake of selling them out in some other market the next morning. There a decided risk is taken, the success of the operation depending absolutely upon the judgment of the operator. Under the stimulus of some favorable development, for instance, which becomes known here only after the Stock Exchanges abroad are closed for the day, the New York market closes buoyant. The chances are that the receipt of the news abroad over night will make the London market open up strong in the morning. To buy stock right at the closing of the market here for the purpose of selling it out next morning in London at the opening is an operation not without risk, but one which is likely to make money. A lower opening abroad would, of course, spoil the whole plan, and force a loss, but just there comes in the ability and judgment of the man who is handling the business. His judgment need by no means be infallible for the house to make a great deal of money.

Concerning arbitraging in bonds, practically everything depends not only on the judgment and skill, but on the facilities and connections of the man in charge. In the great "open" market in New York and in the great "open" market in London, American bonds are being continually bid for and offered in a way which gives an expert in touch with both markets a chance to buy here and sell there, or vice versa, at a profit. Such men are employed by bond houses with international connections, and spend their time doing practically nothing else but keeping in close touch with open market bids and offers for stocks and bonds and trying to buy in one market and sell in another. Such trades are frequently put through on a very profitable basis, profits of a clear point or more being not at all uncommon.

As for the degree of risk to be taken in business of this kind, that is entirely at the discretion of the arbitrageur. Where a firm bid of ninety-nine, good for the day, for instance, is given, there is no risk in cabling a bid of ninety-eight to London, but where the bid is not firm at all, or where it is only firm for five minutes, or in many other cases, the man who cables his own bid of ninety-eight is taking a certain amount of risk. Often enough he gets the bonds in London at ninety-eight, only to find that the ninety-nine bid in New York has been withdrawn.

Knowledge of what risks to take and of what risks to leave alone constitutes expertness in this line of business. Seldom can the transaction be absolutely closed at both ends and any substantial profit be made. Most of the time the correctness of the bond expert's judgment as to how he can sell somewhere else what he has bought, is what determines the amount of money he will make or lose.



CHAPTER IX

THE FINANCING OF EXPORTS AND IMPORTS

Interesting as the movement of gold and the international money markets may be, it is in its application to the every-day importing and exporting of merchandise that foreign exchange has its greatest interest for the greatest number of people. Every bale of cotton exported from the country, every pound of coffee brought in, is the basis of an operation in foreign exchange, such operations involving usually the issue of what is known as "commercial credits."

Broadly speaking, commercial credits are of two classes, those issued to facilitate the import of merchandise and those issued to facilitate its export. Considering the question from the standpoint of New York, import credits are so much more important than export credits and issued in so much larger volume, they will be taken up first.

Not all the merchandise imported into the United States is brought in under commercial letters of credit, but that is coming to be more and more the way in which payment for imports is being arranged. Formerly an importer who had bought silk or white-goods in France went around to his banker, bought a draft on Paris for the required amount of francs and sent that over in payment. In some cases that is still the method by which payment is made, but in the very great majority of cases where the business is being run on an up-to-date basis, a commercial letter of credit is arranged for before the importation is made. Of how great advantage such an arrangement is to the merchant importing goods the following practical illustration of how a "credit" works will show.



To exemplify the greatest number of points of importance possible in connection with the commercial credit business, the case of a shipment of raw silk from China will, perhaps, serve best. A silk manufacturer in Paterson, New Jersey, we will assume, has purchased by cable ten bales of raw silk in Canton, China. Understanding of the successive steps in the financing of such a transaction will mean a pretty satisfactory understanding of the general principles under which the financing of most of our imports is arranged.

The purchase of the silk having been consummated by cable, the first thing the purchaser would do would be to go to his banker in New York, lay before him an exact statement of the conditions under which the purchase was made, and get him (the banker) to open a commercial letter of credit covering those terms. Such a credit, of which a reprint is given herewith, would be in the form of a letter to the issuing banker's London correspondent, requesting him to "accept" the drafts of the sellers of the silk in Canton up to a certain amount and under certain conditions. These conditions, having to do with the "usance" of the drafts (whether they were to be drawn at three, four, or six months' sight) and with the shipping documents to accompany the drafts, are all very fully set forth in the letter of credit itself. If the silk has been bought on the basis of four months, for instance, the credit would read that drafts are to be drawn at four months' sight. Mention is also made as to whose order the bills of lading are to be made, as to where the insurance is to be effected, etc., etc.

The silk importer having received this letter of credit from the banker in New York, sends it by first mail (or, if the case be urgent, cables its contents) to the seller of the silk out in Canton. The latter, having received it, is then in a position to go ahead with his shipment. The first thing he does is to put the silk aboard ship, receiving from the steamship company a receipt (bill of lading) stating that the ten bales have been put aboard, and making them deliverable to the order of the banker in New York, who issues the credit. The bill of lading being made out to his order is useless to anybody else. He and he only can get the silk out of the ship when it arrives in New York.

The shipper in Canton having received this bill of lading from the steamship company and having properly insured the goods and received a certificate stating that he has done so, is then in a position to go ahead and draw his draft for the cost of the silk. The London correspondent of the New York banker, to whom the letter of credit is addressed, is, say, the Guaranty Trust Company of London. Upon that institution the Canton silk firm, therefore, draws his draft in pounds sterling for the cost of the silk, attaching to the draft the bill of lading, an invoice, and the insurance certificate.

A pertinent inquiry at this point is as to why the letter of credit for silk shipped from a city in China directs that drafts be drawn on London—as to why London figures in the transaction at all? The answer is that drafts on London are always readily negotiable, and that London is the only city in the whole world drafts on which are readily negotiable in all places and at all times. A draft on New York or on Berlin might be negotiated at a point like Canton, but to be sure that the exporter of the silk will get the best rate of exchange for his drafts, the drafts must be drawn on London, the financial center of the world. One of the chief points to the whole business of taking out a credit, in fact, is to provide a point on which the shipper can draw satisfactorily.

Assume now that the silk has been put aboard ship bound for the United States, that the shipper has drawn, say, a draft for L1,000 at four months' sight on the Guaranty Trust Co., London, and has attached thereto the bill of lading and the insurance certificate. Taking this draft around to his bank the shipper sells it for local currency at the then prevailing rate for four months' sight drafts drawn on London. The fact that it is drawn at four months' sight means that he will get a lower rate of exchange for it than if it were drawn payable on demand, but that was the arrangement with the buyer in New York—that the drafts against the silk were to have four months to run.

Having sold this draft to his bank in Canton and received local currency therefor, the shipper of the silk is out of the transaction. He has shipped the goods and he has his money. What becomes of the draft he drew is the next important point to consider. But so far as the exporter is concerned, the transaction is closed, and he is ready for the next operation.

The silk has now been set afloat for New York, and the draft purchased by the Canton banker is on its way to London for acceptance. Long before the silk gets to New York the draft will have reached London and will have been presented to the cashier of the Guaranty Trust Co., there, who, of course, was apprised of the credit opened on his bank at the time such credit was originally issued in New York. Examining the draft and the documents carefully to see that they conform with the terms of the credit, the cashier of the Guaranty Trust Co., London, formally "accepts" the draft, marking it payable four months from the date it was presented to him. The accepted draft he hands back to the messenger of the bank who brought it in; the bill of lading, insurance certificate, and invoice he keeps. By the next mail steamer he dispatches these papers to the banker in New York who issued the credit.

For the time being, at least, that is to say, till the accepted draft comes due, the London banker is out of the transaction, which is now narrowed down to the importer of the silk in Paterson and the banker in New York who issued him the credit.

Assume now that a week has passed and that the New York banker finds himself in possession of a bill of lading for ten bales of silk, merchandise deliverable to his order. A few days later, perhaps, the goods arrive overland by fast freight from Seattle. The Paterson silk manufacturer, who is eagerly awaiting their arrival, comes around to the banker: "Endorse over the bill of lading to me," he says, "so that I can get the silk and start manufacturing it."

If the banker does it, he will be giving over the only security he has for the payment at maturity of the draft his London correspondent accepted, and for which he himself is responsible. Still, the manufacturer has to have his silk.

A number of different agreements exist between bankers and importers to whom the bankers issue credits, as to the terms on which the importers are to be allowed to take possession of the merchandise when it arrives here. Sometimes the goods are put into store and handed over to the merchant only when he shows that he has sold them and needs them to make delivery. Sometimes they are warehoused at once, and parcelled out to the importer only in small lots, as he needs them. But more often the goods are delivered over to the importer on his signing one form or other of what is known as a "trust receipt."



Such difference of opinion exists among foreign exchange men as to the goodness of the trust receipt system that the author refrains from making comment on it, confining himself strictly to description of what the system is. As will be seen from the accompanying reprint of the trust receipt used by one of the largest issuers of commercial credits in the country, the document is simply a pledge on the part of the importer to hold the merchandise in trust for the banker, and, as the merchandise is sold, to hand over the proceeds to apply against the draft drawn by the shipper of the goods. The theory of the thing is that by the time all the merchandise has been sold more than enough money will have been handed over to the New York banker to take care of the draft accepted by his London correspondent, the excess constituting the importer's profit.

The kind of trust receipt under which bankers are willing to give over the merchandise (the only collateral they have) naturally varies according to the standing of the house in question. In the case of some importers the bankers would be willing to let the bill of lading pass out of their hands on almost any kind of a receipt; in the case of others a very strict and binding contract is invariably signed. But whatever the form of the contract, it is to be borne in mind that when the banker issuing the credit hands over the bill of lading to the importer on trust receipt, he is allowing the only security he has to pass out of his hands, and is putting himself in the position of having made an unsecured loan to the importer.

Returning now to the particular transaction in question, the point has been reached where the silk is in the importer's hands, that result having been accomplished without the importer having put up a cent of money. Moreover, for nearly four months to come there will be no necessity of the importer's putting up any money (unless he should sell some of the silk, in which case he is bound to turn over the money to the New York banker as a "prepayment"). But in the ordinary course of events the importer of the silk has nearly the four full months in which to fabricate the goods and sell them. At the end of that time the draft drawn by the firm in Canton and accepted by the Guaranty Trust Co., London, will be coming due, and the silk importer will be under the necessity of remitting funds to meet it. Twelve days before the actual maturity of the L1,000 draft in London, the New York banker will send to the manufacturer in Paterson a memorandum for L1,000 at, say, 4.86 (whatever is the current rate) plus commission. The silk firm pays in dollars; the New York banker uses the dollars to buy a demand draft for L1,000; a day or two before the four months' sight draft comes due in London this demand draft ("cover") is received in London from New York, and the whole operation is closed.

It has been deemed advisable to set forth the whole course of one of these import-financing transactions, in order that each successive step may be clearly understood. The question of just why this credit business is worked as it is will now be taken up.

The whole purpose of the business, it is plain enough, is to give the importer here a chance to bring in goods without putting up any actual money—in other words, of letting him use a larger capital than he is actually possessed of. There are persons so conservative as to consider this in itself a wrong idea, but with business carried on along the lines on which it is actually done nowadays, bank credits play so important a part that conservatism of this order has little place. Theory and practice prove that there is no reason why a silk importer, for instance, with a capital of $100,000 should not be able to use safely a credit of as much more than that, the standing and credit of the firm being always the prime consideration. Granted that a manufacturer stands well and is doing a safe, non-speculative business on the basis of $100,000 capital, there is no reason why he should not be able to secure an import credit for an additional L20,000. Not only is there no reason why he should not get it, but there are any number of good banking concerns only too glad to furnish it to him.

So much for the transaction from the importer's standpoint—what does the seller of the goods get out of it? Payment for his goods as soon as he is ready to ship them. No waiting for a remittance, no drawing of a dollar-draft on an obscure firm in Paterson, N.J., which no Canton bank will be willing to buy at any price. The credit constitutes authority for the shipper to draw in pounds sterling on London—the one kind of draft which he can always be sure of turning at once into local currency and at the most favorable rate of exchange. He ships the goods, he draws the draft, he sells the draft, he has his money, and he is out of it. From the shipper's standpoint, surely a most satisfactory arrangement and one which will induce him to quote the very best price for merchandise.

As to the banker's part in the transaction, the whole question is one of commission. The London banker on whom the credit is issued gets a commission from the American banker for "accepting" the drafts, and the American banker, of course, gets a substantial commission from the party to whom the credit is issued. Sometimes the banker in New York and the banker in London work on joint-account, in which case both risk and commissions are equally divided. But more often, perhaps, the London bank gets such-and-such a fixed commission for accepting drafts drawn under credits, and the New York banker keeps the rest of what he makes out of the importer.

Before proceeding with discussion of what commissions amount to, it is well to note the fact that in those commercial credit transactions neither banker is ever under the necessity of putting up a cent of actual money. As in the case of foreign loans previously described, the banker's credit and the banker's credit only is the basis of the whole operation. The London bank never pays out any actual cash—it merely "accepts" a four months' sight draft, knowing that before the draft comes due and is presented at its wicket for payment, "cover" will have been provided from New York. The New York banker, on the other hand, merely sends over on account of the maturing draft in London the money he receives from the importer. He is under an obligation to the London banker to see that the whole L1,000 is paid off before the four months are over, but he knows the party to whom he issued the credit, and knows that before that time all the silk will have been manufactured and sold and the proceeds turned over to him. At no time is he out of any actual cash.

That being the case, the amount of commission he charges is really very moderate—one-quarter of one per cent. for each thirty days of the life of drafts drawn under credits being the "full rate." Under such an arrangement an importer taking a credit stipulating that the drafts are to be drawn at thirty days' sight would have to pay one-quarter of one per cent.; at sixty days' sight, one-half of one per cent.; at ninety days' sight, three-quarters of one per cent., etc. Such commission to be collected at the time the drafts drawn under the credits fall due.

These are the "full rates"—naturally, few importers are required to pay them, actual rates being largely a matter of individual negotiation and standing. Where the drafts under the credits run for ninety days, for instance, as in the case of coffee imported from Brazil, the full rate would be three-quarters of one per cent., but very few firms actually pay over three-eighths of one per cent. Similarly with credits issued for the importation of merchandise of almost every other kind. Silk credits, with drafts running four months, ought at the regular rate to cost one per cent.; but as a matter of fact there are any number of good houses willing to do the business for five-eighths of one per cent. One large international bank in New York, indeed, is going so far as to offer to issue credits under which drafts run six months for a commission of five-eighths of one per cent. Such a commission is entirely inadequate and no fair compensation for the trouble and risk the banker takes. It means little more than that the bank is willing to take business at any price for advertising or other purposes.

Assume that an importer has taken out a ninety-day credit and is to pay three-eighths of one per cent. on all drafts drawn thereunder, what rate of interest is he actually paying, figured on an annual basis? The life of the draft is ninety days, and he pays three-eighths of one per cent.; in each year there are four ninety-day periods; figured on an annual basis, therefore, the importer is paying four multiplied by three-eighths of one per cent., equalling one and one-half per cent. interest. Not a very high charge, and made possible only because the banker lends his credit and not his cash.

THE END