Like many people, I suspect, I tend to think of finance as having been invented in my lifetime. How could finance be finance without computers? How could finance be finance without the comforting framework of Black-Scholes? But, of course, mankind has been using money for millennia – very little in the world of finance is ever really new. That is certainly true of FX and interest rates – as a fascinating and brand new academic paper shows [1].

The paper is in the latest edition of the prestigious Economic History Review, which hit my doormat with a thump last Friday morning. I find the quarterly arrival of this dense grey book to be an occasion of great excitement (a facet of my personality that explains why I am so very rarely invited to parties). This study was a proper cracker.

It concerns interest rates in the middle ages. Why would anyone care? Primarily, because the measurement of interest rates allows historians to figure out how the medieval economy functioned. The conventional picture of a world that didn’t really have access to finance (a lack which – it used to be thought – stopped the economy growing) has been progressively challenged ever since the 1920s. But trying to work out how high and how variable interest rates were is very tricky.

Records of loans are exceptionally patchy (the key textbook of interest rate history – Homer and Sylla’s ‘Interest Rates’ – hasn’t updated the medieval pages since first being published in 1963). What’s more, the sketchy records that do exist tend to be for lending to city-states or to sovereigns – numbers that do not really translate very well into commercial interest rates.

Why so patchy? In part it is just because the middle ages were a long time ago and not every record has survived. But much more important than this was the attitude of the Catholic Church. The Church thought that charging interest was a sin – the sin of usury. At worst, its punishment was excommunication. This was a guarantee (to the medieval mind) of eternal, not just mortal, torment.

Despite this, loans at interest were made. But because of this they mainly exploited loopholes in the ecclesiastical law (e.g. it was not a sin if the interest was paid ‘voluntarily’), and it appears that lenders were not overly keen to fully document these potentially hell-risking transactions. This means that deciphering the rates that were charged in the few deals that actually were documented is now pretty difficult after the passage of centuries.

But one way that commercial loans were made means that interest rates can be inferred from other data – data that is very widely available but which, until the recent paper, has not been heavily mined. This data comes from the FX markets and relates to a product called the bill of exchange.

Bills of exchange were meant to be a means of facilitating trade. The idea was that a merchant who wanted to buy goods in Genoa, say, and take them to Bruges to sell would go to a richer merchant (a ‘banker’ in all but name) and ‘draw’ a bill of exchange. He would get Florins with which to buy goods in Genoa and would make a promise to pay back the banker’s correspondent in Bruges with a certain amount of Groats after he’d sold his goods. Bills were available to and from all major trading centres.

Because getting from place to place would take time (as would selling the stuff), the bill of exchange had a term (‘usance’) which roughly varied with – and was slightly longer than – the time needed to travel the distance between the two trading points. Also, the number of Groats (in the example) that needed to be paid back would be calculated to give the banker appropriate interest to make up for the credit risk, FX risk and some profit.

The Church was fine with all this though. They operated under the doctrine of ‘cambium non est mutuum’ (exchange is not a loan). Because the banker was taking FX risk, the implicit interest was not usury. Of course, humans being human, medieval merchants found an early form of financial engineering to exploit the rules. They would transact a bill of exchange between Genoa and Bruges (from Florins to Groats) and, later, a bill of rechange between Bruges and Genoa (from Groats to Florins) whereby the Groat leg would cancel out. The net effect? A Florin loan equal in tenor to the sum of the two legs’ usances.

Now the church hated this practice (so called ‘cambium secco’ or ‘dry exchange’) but the possibility of it happening gave the modern-day researchers a way of assessing rates.  According to the report’s authors:

“Since successful FX trading involved predicting the future movement of exchange rates, the merchant who had better and more up-to-date information about exchange rates in other banking centres enjoyed an advantage over his uninformed peers.” (So no change there, then.)

That’s why, when writing to their correspondents, merchants (bankers) would regularly include a list of local exchange rates. The researchers got hold of thousands of FX records from discussions of bills of exchange for the period 1380 to 1411 which were kept by a merchant in Prato called Datini and which – crucially – have all survived the passage of time.

To analyse the records,  the researchers first had to make these handwritten notes into an electronic database. Method? Eyeball-wrecking hours staring at documents and RSI-inducing typing. As part of all this they had to decipher the slang and weird market conventions used by the FX dealers of the day. Then they had to match up the dates of the exchange and rechange legs between 88 pairs of centres so that they could calculate implicit interest rates.

The results: thousands of rates estimates – a dataset richer by far than any other ever seen from the same period.   What were the main findings?

  • Average annualized (compounded) interest rates in the range 10-16%
  • Standard deviations of annual interest rates approximately 4-7%
  • Chances of loss on FX exchange-rechange of about 5-10%  (so lenders really were at risk)
  • Sharpe ratios of lending of about 1.0 (with a ‘risk free’ rate of 8% being used – the rate of ‘voluntary’ interest loans).

Eyeballing the reported data it also looks like the longer the tenor, the higher the average rate (as you’d expect). Overall, everything about the data suggests perfectly sensible behaviour by modern standards.

Why do I like this study so much? First off, because it shows the pursuit of economic history in all its geeky, data-obsessed, library-bashing glory.  Searching for clues in unlikely places; painstaking analysis.  What’s not to like about this level of studious obsessiveness?

But more than this, I love the way that the commercial behaviour of people 600 years ago – a period that in many ways seems utterly alien and remote to me – emerges from the data as rational, sensible and (at times) cunning. In short, as completely human and as understandable as the way we act today.

History shifts and changes, but the all-too-human drivers of the money and FX markets seem to be eternal.  I find that oddly comforting.



[1] ‘Cambium non est mutuum: exchange and interest rates in medieval Europe.  Bell, Brookes and Moore. The Economic History Review · August 2016 (May 2017 edition).

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