International transactions are settled by means of foreign bills of exchange on the same principles and in much the same way as domestic transactions are settled by the use of domestic bills of exchange. London holds much the same position with respect to the trade of the world that New York holds in the trade of the United States, and is therefore the chief center of international exchange. As New York exchange has been the chief instrument for settling balances between different cities in the United States, so has the London draft, or "sterling exchange," as it is commonly called, become the medium of exchange between countries. Carrying the comparison one step further it may be noted that just as balances between debtors and creditors in the United Stales are settled finally in some form of currency, so in the settlement of balances between nations money must ultimately be shipped. In making international settlements, however, gold either in the form of coin or bullion is the only universally acceptable medium.
The essential principles underlying the foreign exchange business may be shown by a simple concrete example. A cotton factor or dealer in New Orleans sells 100 bales of cotton to an importing house in Liverpool and draws a draft for £1,000 on the Liverpool firm. The factor takes the draft or bill of exchange to his banker who buys it at the current rate of exchange, say, 4.86, and gives the customer $4,860. The banker sends the bill of exchange to his correspondent in Liverpool or London, who collects the draft and places the amount to his credit. The banker in New York or New Orleans is willing to buy these sterling bills because American importers of foreign merchandise are continually wanting such bills to meet their obligations abroad. With the £1,000 to his credit in Liverpool he can sell his own draft to a customer for that amount at the current rate of exchange. Of course he will expect to make a profit on the transaction, and will sell his draft for, say, $4,870, thus making a profit of $10. In the same way British merchants exporting goods to the United States draw upon the American importer and sell their drafts to London bankers who send them to their New York correspondent for payment or for acceptance and collection, receiving credit for the amount. While the process of foreign exchange is not always so simple and direct as in the example just cited, yet it serves to show the nature of the foreign exchange banker's business, which consists in the buying of bills of exchange, deposting them with correspondent bankers abroad, and selling drafts against the credit thus obtained at a higher rate of exchange.