What is a “Bill of Exchange”?

This past Friday we got a question about bills of exchange, the financial instruments we’ve been talking about for some time.  Specifically, someone said, “‘discounting bills of exchange’ is something that I have been trying to wrap my head around for a while. In layman's terms, what does it mean?”

Good question.  Most simply put, “bills of exchange” are a form of “money.”  That means to understand bills of exchange, we need at least a working definition of money.

Adam Smith

“Money” is anything that can be accepted in settlement of a debt.  It is the medium of exchange, by means of which we exchange what we produce, for what others produce so that goods and services can be consumed.  (This is "Say's Law of Markets.") As Adam Smith pointed out, and which formed the basis for his economic theories, the sole purpose of production is consumption.

Money facilitates both production and consumption.  It does this by providing a convenient way to obtain what we need to produce, and to trade what we produce for what others produce.

All money is therefore a contract, just as (in a sense) all contracts are money.

All contracts consist of “offer,” “acceptance,” and “consideration.” “Consideration” is whatever of value is being exchanged, something that has been or will be produced.

Benjamin Anderson

There are two basic types of contracts by means of which exchanges are carried out.  These are called “mortgages” and “bills of exchange.”  Financial historian Benjamin Anderson claimed that the first principle of finance is to know the difference between a mortgage and a bill of exchange.

A mortgage is a contract conveying an interest (ownership stake) in the present value of an existing good or service. A bill of exchange is a contract conveying an interest in the present value of a future good or service.

All things being equal, the present value of the existing good or service conveyed by a mortgage, and the face value of the mortgage, are the same. A mortgage pays interest on the face amount of the mortgage, and it passes as money at the face value.

All things being equal, the present value of the future good or service conveyed by a bill of exchange, and the face value of the bill are not the same. Usually the present value of a bill of exchange is less than the face value. It therefore passes at a discount. A bill of exchange does not pay interest. The gain to the holder comes from the difference between the discounted amount, and the face value when redeemed.

This is why “accepting” a bill of exchange is also called “discounting” for the first acceptance, and “rediscounting” for subsequent acceptances.

The term “acceptance” is also used, because the bill or note is “accepted” by the other party to the transaction.  If another individual or business other than a bank accepts a bill or note, it is called a “merchants acceptance” or “trade acceptance.”  If a bank accepts a bill or note, it is called a “bankers acceptance.”

Example

Suppose you want to plant a crop, but don’t have seed and other supplies or equipment. You estimate how much the final crop will sell for when harvested in 90 days, as well as how much the supplies and equipment will cost. You have a reasonable expectation that the crop will sell for $250,000. The supplies and equipment will cost you $98,000.

You offer a contract called a bill of exchange that has a face value of $100,000 to a commercial bank, since the discount rate for a 90-day bill is 2%. The banker “accepts” or “discounts” your bill, making it a “bankers acceptance.”  To purchase the bill, the banker issues a promissory note obliging the bank to pay you $98,000 now in exchange for your $100,000 in 90 days.  The banker then creates a demand deposit in your name in the amount of $98,000, using the promissory note as backing for the checking account.  (The bill of exchange obliges you to pay, while the promissory note obliges the bank.)

You purchase the supplies and equipment, put in the crop, and harvest it.  You realize $250,000 from the sale of the crop, and go to the bank with $100,000 and redeem your bill.  This cancels your bill and the bank’s promissory note.  The bank makes $2,000 on the deal, and you make $150,000.

You could also offer bills directly to your suppliers, making them “merchants acceptances” or “trade acceptances,” but the bank’s word is probably better known.  In any event, it is extremely inconvenient to go around issuing a lot of small bills to a lot of people, instead of one bill to one institution that specializes in accepting bills and mortgages.

Before the invention of coined money in the west, cir. 2,700 years ago, all exchanges were carried out this way with mortgages, bills of exchange, and promissory notes.  The vast bulk of documents from the ancient world, in fact, consist of financial instruments of this sort, whether on clay, papyrus, parchment, or anything else.

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