173. Underlying Principles

Underlying the whole business of foreign exchange is the system by which the creditor draws a draft upon the debtor - by which, for instance, a cotton firm in Nashville, Tenn., which has sold 100 bales of cotton to a spinner in Liverpool, draws a draft upon the Liverpool firm for £1,000. That is the origin of practically all foreign exchange business - some one is owed money and in order to get it draws upon the man who owes it to him. The draft he draws is called a bill of exchange.

How this simple operation develops into a transaction in foreign exchange is best shown by using a concrete example. Take the case of the cotton merchant who has sold his 100 bales and drawn his draft for £1,000 on Liverpool. Such a draft, in pounds sterling, is in itself of no use to him. Before he can make use of it he must manage to convert it into American money - find someone who will buy it and give him dollars for it. Such a man is the foreign exchange banker. He keeps an account in Liverpool, and is willing to buy the draft from the cotton man in order to send it over there and have it placed to the credit of his account. "The price of a pound sterling to-day is $4.86," he says. "I can pay you $4,860 for your draft on Liverpool for £1,000." The cotton merchant accepts, takes his check, and is out of it. He has sold his cotton, got his money, and is ready for a new transaction.

But why was the banker willing to buy that draft for £1,000, and why does he keep an account in pounds sterling over in Liverpool? Simply because customers who have payments of one kind or another to make on the other side are continually coming to him to buy drafts in pounds, and he wants to be in a position to sell them what they want. When he takes that £1,000 draft off the hands of the cotton merchant and sends it over to be deposited to his credit in Liverpool, he knows very well that he can always draw his own draft for £l,000 and sell it for dollars at whatever happens to be the current rate of exchange. If he paid $4,860 for the £1,000 draft he bought, and sells his own £1,000 draft for, say, $4,870, he has clearly made $10 on the transaction. And that is what the foreign exchange banker is in business for - to buy drafts, deposit them abroad for his credit, and then sell his own drafts against the balance at a higher rate of exchange.

Needless to say, the illustration given is elementary; bankers do make money exactly as stated, - the operation described is the very simplest and would not result in bankers making much money. At the same time it is the principle underlying the whole business, the principle on which a clear understanding of the foreign exchange business as it is carried on absolutely depends. Everything is built up around it. Every move the foreign exchange banker makes depends upon his being able to buy bills drawn by creditors on debtors, and on his being able readily to sell bills drawn against balances he is carrying abroad.

Guaranty Trust Company Of New York.

Exchange for

£...........................................................Stg. New York,...........................................................................191............

On demand please pay................................................................................................................................................................

or order (Original being unpaid) the sum of............................................................................................................Sterling which charge to New York account

To

Guaranty Trust Company of New York,

33 Lombard Street, No..................................... London.

Manager

It is customary for bankers who are doing a regular foreign exchange business to carry a balance with their foreign correspondent (they often have several in each big city) and then by each mail-steamer to remit a great quantity of different kinds of exchange, drawing their own drafts against the bills they are remitting, and so keeping the original balance about stationary. A large house will frequently send over as much as £500,-000 worth of bills in one mail for the credit of its account. The descriptive sheet accompanying this mass of bills is apt to have recorded on it about every kind of foreign exchange in general use. Following is a description of different kinds of bills taken from the remittance sheet of one of the largest drawers of exchange in the country.