If you take a walk through the streets of London you will not find the Money Market, as you would find, say, Leadenhall or Smithfield Markets if you searched for them. The Money Market, while it has a name, has no local habitation. The term must not be considered to indicate a particular place where a particular type of business is transacted, but the organised relationships that have grown up in connection with a certain class of financial dealings. What are those dealings, and between whom do these organised relationships exist? To answer those questions is to describe the London Money Market and that it is now proposed to do.
A Market, in the sense in which the word is used in the phrase “the money market,” means the organised bringing together on a payment basis of entities with complementary needs. Any market has two major features therefore, it can be considered firstly with regard to the thing dealt in, secondly with regard to those who deal.
The money market is concerned with “ short-term money ” and “short term paper.” Let me explain what is meant by these terms. First of all, short term money. To describe what is meant by short term money it is necessary to digress for a moment to give an account of how a bank works. What follows will seem heretical to the “credit creationists” and the followers of Major Douglas, but it is nevertheless a mere description of facts known to anyone who is familiar with banking practice.
The business of banking in its essentials is a very simple affair. It is only in certain uninstructed and perverse minds that the banker is regarded as a Cagliostro, who out of nothing creates something, who spends what he never had, and lends what he never received. In fact the banks are not magicians, but in the main plodding creatures of routine who borrow money with the one hand and lend or invest nearly all of it with the other. What the banker lends is determined by what he has of his own, and what he can borrow. The banker borrows by accepting deposits from customers. Those deposits he undertakes to repay either on demand, that is, when the deposits are on current account, or after some stipulated period of notice has been given, that is, when the deposits are “time” deposits. The banker, then, can be considered as starting out in business with the capital with which the bank was founded plus the funds lent to him in the form of deposits by depositors. Accumulated profits in the form of undistributed reserves will in the process of time add to the funds which he can employ in his business. Having acquired funds in this way the banker’s object is to employ them as profitably as he can, consistently with the safety of his business. It would not do for him to sink all the funds entrusted to him into, say, a gold mine, even if over a period of years it promised to yield huge profits, for he must hold himself prepared to repay his depositors at any time. His object is, therefore, to keep a “liquid” position, i.e., to invest the bulk of his funds in such a form that they can easily be converted into cash at any moment that may be necessary, without any, or at least only a small risk of loss.
A large portion of a banker’s assets will, therefore, be held in an easily realisable form. First of all, there will be his actual cash reserve consisting of notes and coin in his own till, and current account balances with other banks. The Clearing Banks hold their balances with the Bank of England, the private banks hold theirs with the Clearing Banks and the Bank of England. But cash in the till, and in a current account, earns nothing, and the banker’s object is to make profits, so that only a limited amount is held in this way. The next liquid item among the banker’s assets is his short-term money. This consists of his cash surplus which he does not want to keep in the till and which he is prepared to lend for short-term at a rate of interest. There exists a special class of borrowers—the discount brokers of whom I will have more to say later—who are in a position to utilise funds liable to be called from them at short notice. Short-term money, therefore, can be stated to be that part of a banker’s cash which he is willing to lend with the right to recall at a moment’s notice, or, in some instances, at a few days’ notice. It is the duty of The manager who "keeps the till” in each head office of a bank to make an estimate first thing each morning, of his probable incomings and outgoings. Suppose that on a particular day he estimates that he will receive £5,000,000 more than he will have to pay out, and that he has sufficient cash in the till, and a large enough balance in the Bank of England. He then decides that he can lend £5,000,000 of short-term money. On the other hand, if he estimates that his payments will exceed his receipts he will decide to demand repayment of some of the short-term money that he has lent. Not all the short-term money with which the money market works represents bankers' surpluses, but for present purposes this is a sufficient approximation to the truth. In passing, it might be pointed out that the banks in lending or demanding repayments of short-term money, in order to adjust their cash positions, throw a revealing light on modern financial controversies regarding the power of bankers to “create credit.” A bank regulates the amount of short-term money it lends in the light of the relationship between its daily receipts and daily outgoings. If it receives more than it pays out it lends money; if it pays out more than it receives, it demands repayment of money lent, in the language of the market it "calls.” No bank manager faced with an excess of payments over receipts has ever been known to say: “I won’t call in any of my short-term money. I’ll create some credit to fill in the gap,” even although that would be a simpler and much more profitable way in which to meet the situation if such a thing were possible. No! he does just what an ordinary individual does in similar circumstances, he realises part of his assets. He does not create new assets. The reason is simply that a bank like you or me, has not yet discovered the philosopher's stone and cannot “create” credit. The banker can only direct into certain channels the funds entrusted to him.
So much for short-term money. What of “short-term paper”? Short-term paper falls into two categories—“commercial” paper and ”government” paper. By paper is meant bills which fall due for payment at some future date. In London few bills run for more than three months (or 90 days), many only run for 30 or 60 days. Perhaps it will help to make the matter clear if I give a brief account of how commercial bills originate. The following is a typical example:—
A merchant in London may wish to buy hides from an exporter in Montevideo. The latter is willing to sell but wishes to be assured of payment. The merchant, therefore, goes to his bank and arranges for a “letter of credit ” to be opened in favour of the Montevideo exporter to cover the cost of the shipment. In other words, the merchant arranges for the bank to advise the exporter that he can “draw a bill” on them which they undertake to pay. This undertaking by the bank is sufficient guarantee for the exporter, who accordingly ships the hides and draws a bill on the bank for the cost. The bill will be made out in something like this form: “To such-and-such a bank in London please pay to X. ninety days after sight £1,000 in connection with shipment of hides per s.s. * Darien.* Signed —-."
This exporter’s bill is payable in sterling ninety days after being presented to the London bank. Now the exporter does not want English currency after ninety days but local currency immediately, so he sells the bill to an exchange bank in Montevideo. The latter send it to their London agents, who present it to the bank on which it is drawn. If it is in order the latter will then “accept" it, that is, they will write their name across the front of it. By so doing the bank definitely admits its liability to pay the bill on maturity.
This is known as accepting a bill, and. the bill, after acceptance, is known as a “first-class bank acceptance." If a bill is drawn not on a bank but on an importer, and accepted by him, it is not a bank acceptance, and its ranking in the world of bills will be dependent upon the standing of the acceptor. But to revert to the accepted bill which is in the hands of the London agents of the Montevideo exporter. This entitles them to receive its face value after 90 days. But they may want funds at once. They can obtain them by selling the bill now for something less than its face value. This is known as "discounting" the bill. It is the discount brokers whom I have mentioned already who specialise in discounting bills, i.e., in giving cash here and now in exchange for promises to pay cash at a later date. So much for commercial bills, which are bills arising out of ordinary trading transactions.
Now we come to Government short-term paper, i.e,, Treasury Bills. The Treasury’s collection of revenue from taxation does not coincide in point of time with its expenditure. Sometimes it is paying out faster than revenue is coming in. At other times, vice versa. To smooth out the flow of revenue and expenditure, therefore, the Treasury wants to borrow at “short-term." This it does by issuing Treasury Bills which are nothing more than promises by the Treasury (i.e., the Government) to pay the amount indicated on the face of them at a given date. Each week the Treasury announces the amount of Treasury Bills it proposes to issue, and they are tendered for by the banks and discount houses. The highest bidders, i.e., those who are willing to charge the least for lending cash to the Treasury, have the bills allotted to them.
Having considered the things dealt with in the money market, i.e., short-term money and short-term paper, let us turn to those who form the market. They form a hierarchy. First, we have the discount companies. These are mostly private and partnership concerns working with very little capital of their own. Their business is to borrow short-term money whenever they can and to utilise it by discounting bills. Their profit consists in the difference between the rate at which they borrow and the rate at which they discount. The margin will be very small, probably only 1/32 of one per cent., but this is calculated on their turnover during the year, and the sum may be very large in proportion to their own capital.
At the end of 1932 the three large discount houses, whose capitals total £3¼ millions, had discounted £177,000,000 of bills. If short-term money is scarce relative to the demand for it the price will rise, i.e., the rate of interest payable on loans will rise. This will lead the discount brokers to charge more for discounting bills.
Above the discount houses come the lenders of short-term money, the joint stock banks, the merchant banks, and accepting houses. They have already been referred to, and here it is only necessary to add that not only do they supply the discount houses with the funds with which they work, but they also buy bills from the discount houses if they wish to increase their own bill holdings. At the top of the money market hierarchy stands the Bank of England. It occupies its position of importance because it is to it that the market has to have recourse in times of stringency. If the banks are demanding repayment of their loans and the discount houses cannot otherwise obtain the means to carry all their bills, their only remedy is to seek assistance from the Bank of England. This can be done in one of two ways, either by discounting approved bills at the Bank at the official rate of discount, i.e., the Bank rate, or by borrowing at the Bank's rate for short-term loans, which is half per cent, above Bank rate. The Bank of England does not lend for less than a week. As the market rate of discount is normally below the Bank rate, the discount houses will not have recourse to the Bank of England unless they are compelled, as it involves them in loss on their bills. At a time, therefore, when short-term money is scarce, and the market has to have recourse to the Bank, the Bank rate will tend to rise and the open market rate to follow. In turn, short-term money rates will rise.
The Bank of England, therefore, in times when money is “tight," that is, when the supply of short money available at the lending thanks is insufficient to meet the market’s requirements, is able to determine money rates. At times of monetary ease the Bank of England cannot so easily control rates, and the gap between the official rate of discount and the open market rate will tend to widen. Unless the Bank of England then takes steps to draw off some of the excess of short-term funds by selling, in the open market, securities out of its holdings, the official rate will move downwards in sympathy with the open market rates.
This adjustment of rates throughout the market in response to changes in monetary conditions is one of the most convincing pieces of evidence available to show how delicate a mechanism the London Money Market is. The fact that it weathers storms such as those produced by the outbreak of War in 1914 and the slump of 1930 is evidence of its strength.
As long as Capitalism functions through instruments as finely attuned in their responses and as tough in their resistances to shock as the London Money Market, it is folly to believe that its walls will collapse at the blowing of trumpets by the Maxtons or Communists of the world.
B. S.
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