Simply expressed, it is this: White owes Black $100. Black likewise owes White $100. They meet and present bills against each other for the amounts. Each receipts his bill and hands it to the other, the two debts offsetting. No money has changed hands. This is the simplest form of "exchange," but upon it is based its whole intricate and complicated system. A " bill of exchange" is one of the earliest forms of credit.
"Exchange" is a method of effecting payments at distant points without the actual shipment of money or bullion. When these points are in different countries, it is "foreign exchange" and the instrument by which the payment is effected is called a "bill of exchange."between two points of the same country this method of transferring the equivalent of money is called "domestic exchange" in America and "inland exchange" in Great Britain.1
In the United States the term "domestic exchange" is not commonly used to designate what are strictly such transactions. We are more apt to say, "New York Funds," "Chicago Funds," or " check" or "draft on New York," etc.
The terms "inland exchange" and "foreign exchange" have a different meaning from a legal standpoint under our State laws, as, for-example, the Statutes of Michigan define an "inland bill of exchange" as one which on its face purports to be both drawn and payable within that State. Any other bill is considered a "foreign bill" so long as drawn without the State whether in this country or abroad. Example: One drawn in Detroit and payable in Grand Rapids is an "inland bill;" one drawn in Detroit and payable in Chicago, or drawn in Chicago and payable in Detroit, or in the same manner between New York and Paris, is, in each instance, a "foreign bill" from this standpoint.
A. K. Fiske very clearly describes a " bill of exchange " in this way: " The New York exporter, when he sends a cargo of wheat or cotton to England, draws a bill of exchange, which is in effect a draft payable to himself for the amount due, upon his consignee or upon a banker with whom that consignee has the necessary credit and upon whom the America exporter is instructed to draw for his payment."
If Allen in New York buys $1,000 worth of wool of Wright, in London, and the latter ships the wool and writes an order on Allen for the $1,000, this order or " bill of exchange ' is deposited by Wright with his London bankers, and is known as "New York Exchange;" that is, it is good when presented in New York for $1,000, providing, of course, Allen can pay the same when presented. Now, instead of actually sending the order to New York and collecting the money for shipment to Wright, the common procedure is as follows: Some other London merchant, say Russell, becomes indebted to a New York merchant for $1,000; the former not wishing to go to the expense of shipping money to New York, applies, we will say for simplicity's sake, to the same bankers with which Wright deposited his order upon Allen; they sell an order against their New York agents for $1,000, to whom, in the meantime, the order upon Allen & Company had been sent for collection, the amount being collected and held by the New York agents to the credit of the London bankers. Russell forwards an order, representing the " New York Exchange," to the merchant in that city to whom he is indebted; this merchant presents the order to the New York agents of the London bankers and obtains payment. It will be seen, therefore, that one debt is made to offset another, and no money, in this case, has actually been transferred. This is the business of " exchange," so-called. The bankers buying and selling the same charge a reasonable profit for their services.
Such "exchange " as above is known as "foreign exchange," and quotations appear in the newspapers of the United States as "Sterling (or ' Sterling exchange ') 4.87 1/2," meaning that "exchange " on London could be bought in this country at the rate of $4.87 1/2¹ for each "pound sterling " English money. Or "Sterling at Berlin 20.44," or "at Paris 25.15 1/2," which indicates that London "exchange" was selling at 20.44 marks German money and 25 francs 15 1/2 centimes French money, at those points respectively.
Formerly, orders in the form of a "bill of exchange" were used, but in present practice the buyer of a " bill of exchange" simply gets a check on the banker's agent at the foreign point desired.
¹Sterling Exchange touched a low figure of $3.15 in February, 1920.
In some cases, especially in a settlement of debts between North and South American points, " exchange " is not bought directly upon the city owed, but upon London. A New York merchant pays a Brazilian merchant by buying a " bill of exchange " on London, which is acceptable to the merchant in Brazil, London being the common financial centre for much international business.
In a similar way, there may be a common financial centre for domestic points. New York is the best example in our country.
This same business is going on between cities in the same country, as, for instance, between New York and San Francisco. The expense of shipping money back and forth between such distant points is considerable, hence the debts of the merchants between the two cities are adjusted, as far as possible, by the buying and selling of " exchange," the same as between two points in different countries.
"Exchange "is at a discount or premium according to whether there is too much or too little to supply the demand. This establishes the " rate of exchange." The shipment of gold from one country to another is the final adjustment of this "exchange" business. When debts accruing in one country against merchants in another are so great that there are not enough " bills of exchange," then gold, the usual form of export money, is shipped to adjust the difference.
The price of " exchange " may also be affected by the supply of gold (bullion) available for the debtor country to ship in case of need. The likelihood of there being a scarcity of gold would cause " exchange " to go to a greater premium than would result from a scarcity of actual exchange, with a good available gold supply at the debtor point. (See " International Movement of Gold.") " Domestic exchange" can always be figured in one currency, but " foreign exchange " has to be calculated in the currencies of the two different countries. In the case of buying a "bill" on an international "exchange" point, as in the South American example, three currencies have to be taken into account.
"Foreign exchange" is always computed on gold as a basis; viz., that gold of equal weight and fineness is of equal value the world over. " Foreign exchange" is drawn in the currency of the country where payable, and paid for in the currency of the country of issue.