By Edmond Smith
Bills of Exchange are one of the financial instruments that allowed the global economy to expand at incredible rates over the past millennium. They enabled the exchange of money and goods between people worlds apart, helped standardise the way we do business the world over, and gave consumers access to markets and money. They represented a written agreement between agents for the exchange of a particular product, and relied on a single principle: trust.
The Nobel Prize winning economist, Douglas North, identified a number of institutional trends underpinning the modern financial system. These were the formal and informal codes of conduct that allowed the economy to function effectively. Essentially, these societal restraints made it possible for people to rely on their communities to enforce agreements, either through legal proceedings or through the influence of social networks. If someone failed to hold up their end of an agreement they ran the risk of losing their trusted status in the network, in turn losing their creditability, their worth, and their future access to finance.
“The inability of societies to develop effective, lowcost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment”
Bills of exchange and promissory notes, and later paper currency, were all ways for people to operate without cash – which at the time would have consisted of big lumps of rare metals. These agreements had numerous benefits. They reduced risk, guaranteeing that the signatories alone could use the Bill, which limited the risks of fraud and theft. They gave access to money, or the extension of credit, during a period when access to cash was very difficult. They didn’t depend on the state, and were enforced by social networks and local laws and regulations. They were independent of influence from national currencies, currency fluctuations and devaluation.
Figure 1: Bill of Exchange from Diamante and Altobianco degli Alberti to Francesco di Marco Datini and Luca del Sera, Bruges-Barcelona, September 2, 1398, sheet of paper; 73 x 224 mm. Prato, Archivio di Stato, b. 1145/1403803.
Although these sorts of agreements date back at least 5000 years (and can probably be seen in civilisations across the world in some fashion) we can see their expansion and development particularly strongly in the past five hundred years. Just like double entry bookkeeping or modern banking, Renaissance Italy was probably the birthplace of European finance. Early examples of Bills of Exchange emerge in the twelfth century, and can be found at the large international trading points of the era – such as the Champagne fairs in France. Unlike later Bills, these early examples were formally notarised, and could be accompanied by a recommendation letter that was used to demonstrate that the bearer was a trusted agent of the original distributor of the Bill. The example we have here (figure 1), of a bill of exchange from 1398, was used to facilitate trade between Barcelona and Bruges. It represents how these agreements enabled cashless, borderless payments in the early modern world, and how trust across the mercantile network was vital for enabling transactions.
In England, where international trade was less developed than much of continental Europe, similar mechanisms for the exchange of credit and goods can be found from a similar period, and were used as instruments for day-to-day business. Limited access of hard cash meant that many people in England used credit mechanisms like these to get by. As with Bills of Exchange, the trust of different members of a social group was essential for them individuals to function effectively within their local economies. There was a ‘cultural currency’ built on trust that underpinned exchanges. However, as the economy expanded from the late sixteenth century trust became less dependable for enforcing these contracts, and we can see a huge increase in debt litigation. From here, credit agreements, such as bills of exchange, would still be issued through shared expectations of trust, and the creditability of partners understood by their place in the commercial network, but failure to live up to agreements would be increasingly likely to result in time in front of a judge.
“Bills of exchange were the dominant means of international payment in the seventeenth century”
By the end of the sixteen century, these earlier forms of agreement were standardised in northern Europe with the Bill of Exchange. These, of course, were built on the principles seen in southern Europe from the Renaissance, and as mature mechanisms of cashless payment they enabled more transactions, completed faster, with greater security. Not only were individuals able to issue Bills of Exchange, but also corporations. For example, the East India Company was issuing Bills of Exchange from its foundation, with two senior merchants from the community selected as Treasurers. While the Company itself was, they hoped, a trusted institution, these two merchants also acted as guarantors for the Bill. The Company did not just use Bills of Exchange to relieve reliance of cash; they used them to guarantee the exchange of commodities, stock and goods. The Bills were also used as a means of accessing foreign bullion, exchanging English credit for Spanish gold to take advantage of international exchanges rates and national regulations. Once trade with Asia was fully established, Bills of Exchange were sent overseas in lieu of cash, removing much of the risk from sea voyages – at least for the Company! In this example (figure 2), a simple ‘IOU’ Bill of Exchange is shown. It was not notarised, not issued by a state or bank, but could be carried internationally with faith that it could be a trusted representation of value.
Figure 2: Bill of Exchange, July 5, 1728. Hancock Family Collection, Baker Library Historical Collections. Harvard Business School.
By the eighteenth century, Bills of Exchange developed a further characteristic that set them apart from their predecessors. Originating in Amsterdam, a policy developed where Bills could act as the foundation for further extensions of credit, and a Bill of Exchange from a trusted source could act as collateral for someone to issue a further Bill on their own behalf. Essentially, the bearer of a Bill would write their name on the back of a Bill, promising in turn to act as a guarantor for its validity – it could then be passed on to another, essentially a form of paper currency bearing the transactional record of all previous bearers. Although not freely transferable like cash, this innovation was vital for Bills of Exchange to continue to underpin the expansion of trade into the nineteenth century, where personal relationships were increasingly unlikely to provide a large enough network to trade. Instead, creditability became increasingly institutionalised, both in terms of accepting houses taking on some of the risk when parties failed to meet Bills of Exchange promises, and partly as merchant bankers increasingly acted as issuers of Bills to facilitate the activities of others. Merchants specialising in these transaction would form the core of the emerging merchant banking, and later private banking, organisations.
Although the use of Bills of exchange declined into the twentieth century, as banks became reliable middlemen for transferring wealth, Bills aren’t just remnants of the financial past. The principals that made Bills of Exchange so useful still underpin much of the financial world. Trustworthiness is vital for an institution or an individual to succeed. How we validate it, how we account for it, and how register it may have changed, but modern finance in the end depends on a single principle: trust.