A well-functioning money market is essential to financial and macroeconomic stability (DeFiore et al. 2019). Money market instruments are short-term debt instruments issued by the government, financial institutions or other private sector borrowers. When backed by private debts, money market instruments are subject to an informational problem. For these instruments to remain highly liquid, it is essential that investors do not ask questions or gather information about the underlying debts (Dang et al. 2015, Gorton 2012). However, in the absence of information production, credit booms can arise, followed by ‘collateral crises’ or financial panics (Gorton and Ordoñez 2014).
The world’s money market during the first globalisation
In a recent paper (Accominotti et al. 2019) we explore how the informational problem in money markets was resolved during the first globalisation of 1880-1914. At that time, Pound Sterling was the global currency, London was the world’s financial centre, and the reference asset for money market transactions was the ‘sterling bill of exchange’ (Flandreau and Jobst 2005). We rely on a unique dataset that reports systematic information on all sterling bills discounted by the Bank of England in the year 1906 (23,493 bills). This allows us to analyse in detail how these instruments were originated and distributed and to describe the industrial organisation of the London money market at that time.
Borrowers through sterling bills were numerous and scattered across the world (Figure 1). Among them stood many small merchants, trading houses, and industrial or financial firms operating in the world’s large capitals as well as in smaller cities. Given the information technologies available at the time, informational asymmetries between these foreign borrowers and London money market investors must have been very severe. Yet, once they accessed the London money market, even the bills backed by remote and obscure borrowers’ debts were transformed into highly liquid and safe assets. How was this possible?
Figure 1 Geographical location of London money market borrowers (drawers of sterling bills), 1906
Note: This map shows the geographical location (at the city level) of the 3,554 drawers of sterling bills re-discounted by the Bank of England in 1906.
Source: Accominotti et al. (2019).
The devil in the details: The design of money market instruments
To answer this question, one first needs to understand how sterling bills of exchange were designed. For centuries before WWI, the bill of exchange had been the most common instrument used in international payments and credit operations (Accominotti and Ugolini 2019). While the instrument’s legal form remained practically unchanged for centuries, its use varied greatly across time and space. Bills were commonly used to finance international trade (as in the example described in Figure 2). However, their highly flexible form allowed them to be employed in a variety of short-term credit operations not at all limited to trade finance.
A bill of exchange was a private written order addressed by one party (the drawer) to another (the drawee or acceptor), requiring the latter to pay a given sum to a third person (the beneficiary or discounter) at a given date in the future. By accepting a bill, the acceptor committed to pay the specified sum to the discounter at the specified date and therefore guaranteed the bill’s payment. The bill of exchange was a negotiable instrument and a bill’s first discounter could always resell (or endorse) it to another investor (the re-discounter) at any time before maturity. In that case, the first discounter’s claim on the acceptor was transferred to the new bill holder.
By originating a bill, a drawer was able to borrow from a money market investor in London (a discounter or re-discounter) thanks to the guarantee provided by an acceptor. Once countersigned by a London-based acceptor, the bill could be sold on the London money market where numerous investors placed their short-term funds. Just before maturity, the drawer (or her trading partner) reimbursed the acceptor who in turn reimbursed the final bill holder (the re-discounter) on due date.
Figure 2 Example of a commercial transaction financed by a sterling bill of exchange
Panel A Operations at issue
Panel B Operations at maturity
Source: Schematic representation of transactions described by contemporaries.
Source: Accominotti et al. (2019).
Reducing informational asymmetries: The role of acceptors
A bill’s acceptor was legally bound to repay its holder at maturity even if she had not herself been reimbursed by the original borrower. Therefore, a bill’s acceptor was its primary guarantor.
Because they were the first exposed if borrowers defaulted, acceptors had strong incentives to gather extensive information about them. Archival and quantitative evidence confirms that acceptors played a key role in resolving informational asymmetries on the London money market. The structure of the industry of accepting (guaranteeing) bills was typical of the business of relationship banking, where a financial intermediary’s main function is to gather – via multiple interactions – proprietary information about debtors. Drawers of sterling bills were in a relationship with a limited number of London acceptors who had gathered private information about them and could therefore guarantee their debts.
The quality of an acceptor’s signature depended on her reputation, and reputational effects might have led to market concentration in the accepting industry. However, we do not find that this industry was excessively concentrated (Figure 3). While a few very large acceptors (the so-called ‘accepting houses’, featuring well-known merchant banks like Kleinwort, Schröder, Baring, and Rothschild) were present on the market, their overall market share remained relatively limited. A large number of small UK firms (typically, merchants or trading houses) also accepted bills drawn on them by their trading partners at home or abroad.
Figure 3 Market shares of top acceptors and top discounters
Note: This figure shows the market share of the top 3, top 5, top 10, and top 15 acceptors and discounters.
Source: Accominotti et al. (2019)
Reducing informational asymmetries: The role of discounters
A significant share of the bills circulating on the London money market were therefore accepted (guaranteed) by small, non-financial firms of modest reputation and on which little public information was available. How could such bills become liquid and circulate as money market instruments?
An important feature of bills of exchange was that all successive sellers (endorsers) of a bill had to put their signature on it and were therefore jointly liable for its payment. This joint-liability rule created a system of multiple guarantees. In case the acceptor defaulted at maturity, the holder of a bill could always ask to be paid by the person from whom she had initially bought it. Therefore, while the acceptor of a bill of exchange was its primary guarantor, its first discounter provided an additional, secondary guarantee to the instrument.
After being originated by a borrower and signed by an acceptor, a bill was generally distributed to a final investor (the re-discounter) through the intermediation of a first, wholesale discounter. When distributing bills on the market, wholesale discounters endorsed them and thus guaranteed their payment. This secondary guarantee was especially important in the case of bills initially accepted (guaranteed) by small and/or unknown firms.
Our data allow identifying these two roles. On the one hand, multinational banks (known as Anglo-foreign banks) endorsed bills originating from the geographical regions where they specialised and remitted to them by their correspondents there, who had previously screened the borrowers. They therefore acted as wholesale discounters as they then distributed (and guaranteed) these bills to final investors. On the other hand, money market funds (the so-called ‘discount houses’) invested in bills originating from anywhere in the world, provided that they had previously been guaranteed by a London-based acceptor or endorser on whom they held information. The distinction between these two roles is clearly apparent when looking at the geographical composition of the bills these actors re-discounted to the Bank of England (Figure 4). While the bill portfolios of Anglo-foreign banks (Canadian Bank of Commerce, Chartered Bank of India Australia & China, Bank of Tarapaca & Argentina) were heavily skewed towards their geographical areas of specialization, the portfolios of the large London discount houses (Union Discount Co., Ryder Mills & Co., National Discount Co.) did not differ significantly from the aggregate, market portfolio.
Figure 4 Discount houses versus Anglo-foreign banks’ portfolios of drawers
Notes: The figure displays the geographical distribution (via colour key) of the drawers of bills discounted by three discount houses (Union Discount Co.; Ryder Mills & Co.; and National Discount Co.) and three Anglo-foreign banks (Canadian Bank of Commerce; Chartered Bank of India, Australia & China; and Bank of Tarapaca & Argentina) as well as the geographical distribution of drawers in the market portfolio (the aggregate portfolio for all discounters in our data set).
Source: Accominotti et al. (2019).
Overall, our analysis reveals the importance of intermediaries and instrument design in resolving informational problems in the money market. The specific characteristics of sterling bills of exchange created incentives for intermediaries to produce information about the debts underlying these instruments. The certification of bills by the successive intermediaries involved in their origination and distribution allowed resolving informational asymmetries so that the risky private debts of foreign merchants could be transformed into highly liquid and safe instruments.
The specific organisation of London’s money market prevented the occurrence of endogenous crises such as the 2008 panic. However, the money market remained vulnerable to large exogenous shocks similar in nature to the 2020 coronavirus pandemic. When the outbreak of WWI in July 1914 directly endangered the liquidity and solvency of London intermediaries, grave troubles arose on the sterling bill market and a full-blown financial crisis was only averted thanks to the massive intervention of fiscal and monetary authorities (Ugolini 2020). Nevertheless, London’s deep and liquid money market remained a key advantage for the United Kingdom even during that crisis as it could be mobilised to meet the UK government’s ballooning funding needs and absorb the large amounts of Treasury bills issued to finance the war.
The intensive information production provided by London-based specialised intermediaries during the first globalisation also stands in sharp contrast to the absence of information production in the second globalization’s money markets where informational problems are often simply assumed away, resulting in recurrent money market panics. All this suggests that any reflection about how to reconstruct a resilient money market after the current crisis should start from the design of money market instruments and the way to incentivise the production of information by intermediaries. As always, the devil is in the details.
Accominotti, O, D Lucena and S Ugolini (2019), “The Origination and Distribution of Money Market Instruments: Sterling Bills of Exchange during the First Globalisation”, CEPR Dicussion Paper 14058.
Accominotti, O and S Ugolini (2019), “The structure of global trade finance: A very long-run view”, VoxEU.org, 5 August.
Dang, T V, G Gorton and B Holmström (2015), “Ignorance, Debt and Financial Crises”, Working paper, Columbia University.
De Fiore, F, M Hoerova and H Uhlig (2019), “The macroeconomic consequences of impaired money markets”, VoxEU.org, 25 May.
Flandreau, M and C Jobst (2005), “The Ties That Divide: A Network Analysis of the International Monetary System, 1890–1910”, The Journal of Economic History 65(4): 977-1007.
Gorton, G (2012), Misunderstanding Financial Crises: Why We Don’t See Them Coming, Oxford: Oxford University Press.
Gorton, G and G Ordoñez (2014), “Collateral Crises”, American Economic Review 104(2): 343-378.
Ugolini, S (2020), “The normality of extraordinary monetary reactions to huge real shocks”, VoxEU.org, 4 April.