The Foreign Exchange Market of London

John Atkin

• Publisher: Routledge
• Year: 2004
• ISBN:
  9781134273942
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

Foreign Exchange is big business in the City of London. At the last official count, turnover on the London foreign exchange market averaged a staggering $504 billion a day. No other financial centre in the world even comes close to matching this total. Thirty one per centof global foreign exchange activity takes place in the United Kingdom, compared with only sixteen per centin the United States andnine per cent in Japan.

However, thishas not always been so. A hundred years ago, the London foreign exchange market played second fiddle to more important centres in New York, Paris and Berlin. This book charts the inexorable rise of foreign exchange in London over the past century and is the first full-length study of this amazing transformation.

1
The somnolent years 1900-14

At the dawn of the twentieth century, the City of London held an unrivalled position as an international financial and commercial centre. Markets located in the City were the focal point of global trading in gold, commodities, insurance and shipping; the London Stock Exchange served as the principal forum for trading international securities; and British-based merchant banks and finance houses arranged the lion’s share of international capital issues. Each of these activities contributed significantly to the City’s wealth and reputation, but none of them were able to match the contribution made by its star performer, the sterling bill market.

Prior to 1914, it is reckoned that around 90 per cent of British external trade and as much as 50 per cent of world trade were financed by means of the sterling bill of exchange.¹ The widespread use of sterling in financing international trade enriched those institutions involved in accepting, discounting and collecting the unending supply of paper entering the sterling bill market. However, the success of this market had one damaging side effect. It hindered the expansion of foreign exchange trading in London. Whereas the City boasted world leadership in most areas of financial activity, it struggled to compete with Paris, Berlin and New York as a foreign exchange centre.

The old adage ‘London draws few bills, but accepts many’, hints at the main competitive disadvantage suffered by the London foreign exchange market. This was that Britain’s overseas trade brought few foreign currency bills to London. It was noted at the time that:

Every import that we take from France or any other country means that somebody there has a claim on our money, and can draw a bill on us. Every export that we make means that someone abroad has a claim to meet here and wants to buy a bill on us.²

Such behaviour ensured that the bulk of the foreign exchange business arising out of British overseas trade was conducted in foreign centres rather than in London. Those selling goods to this country invariably would have sold the sterling bills they had drawn to local banks for domestic currency, whereas those buying goods from this country invariably would have bought a sterling bill or draft with domestic currency from a local bank.

Sterling bills, however, were not just drawn in connection with British overseas trade. The depth and liquidity of the sterling acceptance market ensured that they were also used to intermediate both third country trade and international capital movements. It was common practice, for instance, for the unspent proceeds of foreign bond issues in London to be remitted home through the medium of a sterling bill drawn on the issuing house involved, and for British banks wishing to place short-term funds abroad to instruct their foreign agent or correspondent to draw on them in sterling. The sterling bills so created typically would have been sold in the local exchange market with the purchaser taking the responsibility of sending them to London to be accepted.

If sterling’s international role hindered the expansion of the London foreign exchange market, it positively stimulated the development of markets abroad. Around the world companies and individuals had a constant need to acquire sterling to settle their external obligations, and a constant need to dispose of sterling obtained from their international transactions. In most overseas markets the key exchange rate was that for the local currency against sterling. In the words of a contemporary US observer:

What proportion of the total exchange dealt in the New York market consists of sterling is impossible to determine, but that it is as great as the volume of all the other kinds of exchange put together can be safely said.³

London seeks a position

Despite suffering from low trading volumes, London still managed to carve out a credible role on the pre-1914 global foreign exchange market. Little attempt was made to rival Paris, Amsterdam, Vienna and Berlin in trading the key continental European currencies. Instead emphasis was placed on exploiting the opportunities created by Britain’s farflung political and economic ties. London was the pre-eminent market in Europe for trading the currencies of the British Empire. It was also a key centre for exchanging the Latin American currencies. But the jewel in its currency crown was the US dollar. The heavy ebb and flow of securities between the New York and London stock exchanges created a natural market for dollars in London, and it was towards this market that the other European centres turned when they wished to trade the US currency.⁴

During the first two decades of the twentieth century, the market had a physical presence at the Royal Exchange—which had served as a centre of commercial and currency trading since the sixteenth century.⁵ Dealers and brokers met there twice a week, on Tuesdays and Thursdays, to buy and sell foreign bills. The exchange rates fixed during each session on Change were published the following day in the national press under the title of the London Course of Exchange. Daily quotes also were published in the papers, but these were for rates against sterling quoted in foreign centres.

Foreign exchange trading in London was not confined just to two meetings a week at the Royal Exchange.⁶ While this part-time physical market in foreign currency bills more than met the needs of those with only light or occasional trading requirements, it failed to satisfy the needs of international arbitrageurs, stockbrokers and investors. These operators needed to buy and sell foreign exchange throughout the week, and to service their requirements dealers and brokers would engage in bilateral transactions—which were conducted either face-to-face or over the telephone—both on the days when the Royal Exchange was closed as well as after the formal sessions on Tuesdays and Thursdays. Deals struck during ‘after hours’ trading on these two days invariably were done at rates different to those fixed during the formal sessions. The rates published for transactions on Change, therefore, were fairly symbolic given that, even on the days when it was in session, a significant volume of foreign exchange business, especially in telegraphic transfers, was being conducted elsewhere in the City.

Prior to 1914, it was common practice, although not a requirement, for deals struck between banks to be intermediated by a broker. In 1900, there were around twenty exchange brokers serving the London market. Some of these firms were highly specialised (R.W.Carter & Co limited itself to broking only the eastern silver currencies), some were fairly specialised (M. Marshall & Son—which in 1922 evolved into the more familiar M.W.Marshall & Co—were renowned for broking the US dollar), and some just sought whatever business they could find. Exchange broking scarcely provided a steady living, and only a few of the firms listed in The Bankers’ Almanac in 1900 were to survive into the post-First World War period.

The comparatively low turnover on the London market meant that it was a price taker rather than a price maker. Around this time, it was noted that:

As the bills drawn on London from abroad vastly outnumber the bills drawn on abroad from London, the demand and supply of the former exercise a proportionately greater influence over the course of exchange than the latter. In other words, the actual rise or fall takes place on the foreign market, and London in most instances merely adjusts its rates according to the rates telegraphed from abroad.⁷

The reference to the telegraph in the above quotation, which is taken from a text published in 1894, confirms that technology had made inroads into the operations of the market by the end of the nineteenth century. By that time, the telegraph was being used to convey financial information, to expedite communications with overseas business associates and to execute some exchange transactions; the telephone was being used to a limited extent to conduct transactions within the London market; and mechanical calculating machines were being used as dealing tools.

The foreign exchange market, however, was by no means in the forefront of those exploiting the new technology of the Victorian and Edwardian periods. The telephone was a case in point. The earliest telephone links with the Continent were established with Paris (in 1891) and with Brussels (1903). London stockbrokers wasted little time in using these connections to initiate arbitrage transactions with continental bourses.⁸ Foreign exchange traders, in contrast, did not use the telephone to initiate foreign exchange transactions with continental Europe until after the First World War.

In the early 1900s, a three-minute telephone call from London to Paris cost 8s, or ten times more than a telegram.⁹ Stockbrokers were not put off by the cost of a continental telephone call because (a) fast moving stock prices justified the use of this costly but speedy means of communication and (b) the high unit value of some of their cross-border transactions made them more willing than others to absorb high telephone charges. Foreign exchange dealers had less incentive to act in the same way. Many of their deals were for sums measured in the tens or hundreds of pounds and many of the currencies in which they dealt were not prone to violent price changes. Accordingly, they lacked both the need and the desire to make early use of the international telephone. The same factors that caused foreign exchange dealers to eschew early use of the international telephone also persuaded them to ration their use of the international telegraph.

Indeed, in the early years of the twentieth century, the operations of the foreign exchange market still bore a close resemblance to those of the midnineteenth century. While foreign exchange dealers were making some use of the telephone and of the telegraph for initiating big transactions (especially with far distant centres), the bulk of their business was conducted in a more ‘low tech’ way. Foreign bills and drafts still were their main stock-in-trade, and the mail remained their principal means of communication with the outside world (hardly surprising given that foreign bills ultimately had to be mailed to a foreign centre for settlement). The market also continued to operate at a fairly leisurely pace. For instance, it was common practice to exchange offers between London and the Continent by post, which were accepted or refused by cable on the following day.¹⁰

Tranquil exchange rates under the gold standard

There was little urgency behind dealing because the currency market in those days was in a state of somnolence. Currencies were prone to only minor and infrequent fluctuation due to the widespread adoption of the gold standard. By the end of the nineteenth century, virtually all of the major currencies of Europe and North America had established mint parities based on their respective gold content. Fluctuations around these parities were confined within narrow bands set by specie import and export points (which reflected the costs—shipping, insurance, packing etc.—of moving gold between countries).

The gold standard parity for the US dollar against sterling was fixed at $4.8665. Prior to 1914, the point at which it paid to buy and export gold to the United States instead of purchasing dollars was reckoned to be around $4.827, and the point at which it paid to import gold from the United States instead of selling dollars was reckoned to be around $4.890¹ For much of the time, the US dollar/sterling rate traded well within these points.

It was not just the gold pegged currencies of Europe and the United States that displayed low volatility. A number of countries that eschewed the gold standard still had sought, by the opening years of the twentieth century, to stabilise the external value of their currencies by giving them a fixed parity against one or other of the gold currencies, most commonly sterling or the US dollar. Chief among this group were India, Mexico, Brazil and Argentina. Countries on the gold exchange standard defended their parities by buying or selling assets denominated in the gold currency against which their own currencies were fixed.

There were only lean pickings for traders looking for volatility during the classical gold standard era. The main excitement was provided by some of the silver based currencies of the East and by the few floating currencies, such as the Chilean peso, still remaining in Latin America. Mint parities could be established between two silver currencies, but not between a silver standard and a gold standard currency. In normal circumstances, the exchange rate between currencies on these two different standards would fluctuate—sometimes quite significantly—in step with changes in the ratio between gold and silver prices. For instance, between 1900 and 1914, the year-end rate between the silver Shanghai tael and sterling oscillated in a range between 2s 2d and 3s 1d.

From Britain’s standpoint, the most important of the silver based currencies was the Indian rupee. Trading in this currency, however, was a soporific activity, because of India’s adoption of the gold exchange standard. In 1899, the rupee had been given a central rate of 1 rupee=1s 4d, and fluctuations between it and sterling were kept within a very narrow range by the actions of the Indian authorities who bought rupees with sterling at 1s

and sold rupees for sterling at 1s .

The general stability of exchange rates, in the pre-1914 period, diminished—but did not entirely remove—the need for operators to protect themselves against currency risk either by purchasing long-dated foreign currency bills, or by engaging in forward exchange transactions. Markets in forward exchange, in which rates are fixed today for currencies to be delivered or received at a future date, had developed in continental Europe during the second half of the nineteenth century. Instability in the Austrian gulden, which eventually was replaced by a stable gold linked currency in the 1890s, had encouraged forward exchange trading in Vienna, whereas active arbitrage dealings between Austria and Germany had fostered the development of a forward market in Berlin, on which deals also were struck in Russian roubles, the South American currencies and even sterling.¹²

Exchange risk between two gold standard currencies may have been low, but it was not entirely absent. Indeed, it was not unheard of for a gold currency to rise or fall rapidly between (and, in a crisis, even beyond) its lower and upper specie points. For instance, during the US financial panic of October 1907, it was observed that, ‘Within two or three days perhaps a million shares of American stocks were jettisoned…[on the New York market]…by the foreigners, while exchange rose by leaps and bounds nearly 10 cents to the pound, to the unheard of price of 4.91’.¹³

When it is recognised that the gold currencies also were prone to fluctuation against some of the silver and South American currencies, it is not too surprising to find that even in London an embryonic forward market had developed by the start of the twentieth century. Its existence is confirmed in a note sent on 2 May 1907 by the London City and Midland Bank’s chief trader, Mr H.van Beek, to Edward Holden (at that time the bank’s managing director). According to van Beek:

Another part of the transactions which pass through our account consists of business done from one to three months previously on forward transactions. Of course, when this Bank entered into this business we could not very well refuse to quote for forward transactions, as all other Banks here do so, and a considerable business is carried on.¹⁴

Exchange rate sensitive transactions arising out of gold and stock market arbitrage also provided the forward market in London with a stream of early business. The simplest way for a bank to cover a forward sale of a currency was by immediately purchasing the appropriate amount of the currency involved and placing it on deposit in the relevant foreign centre. Accordingly, the development of a healthy and viable forward market depended on two things. The first was the presence of stable banking conditions in those countries whose currencies were being traded on the forward market. The second was the ability of traders to transfer deposits freely and speedily between these countries.

In the early 1900s, the mail often would be delivered in a day or so to foreign exchange centres on the near Continent, such as Paris and Amsterdam. However, it took about eight days for sea-borne mail to reach New York, and six weeks for it to reach the Far East. It follows, that the remittance of funds by mail was an inappropriate way of supporting forward exchange activity between far distant countries. Telegraphic transfers were far more suitable for this purpose.

In order to remit funds by way of a telegraphic transfer, a bank needed to maintain an operating account either with a branch, or with a correspondent bank abroad. Instructions to move money out of this account would be telegraphed to the latter using an agreed code (for security) and test word (in lieu of a signature).

The birth of cable

The telegraph wires to the United States were set in deep submarine cables, and shortly after the first transactions were transmitted across these wires, in the 1870s, the moniker of ‘cable’ was adopted for telegraphic transfers between Britain and the United States. The US dollar/sterling exchange rate has retained this nickname ever since.

Telegraphic transfers eventually would become the basic method of executing foreign exchange transactions. But they were used only sparingly before the First World War, because broadly stable exchange rates diminished the need for urgency in most exchange transactions. In the tranquil conditions prevailing at that time, the majority of banks and companies needing to buy or sell fo...