Bills of exchange developed during the Middle Ages as a means of transferring funds and making payments over long distances without physically moving bulky quantities of precious metals. In the hands of thirteenth-century Italian merchants, bankers, and foreign exchange dealers, the bill of exchange evolved into a powerful financial tool, accommodating short-term credit transactions as well as facilitating foreign exchange transactions.
The invention of the bill of exchange greatly facilitated foreign trade. The mechanics of this can be seen in the following example: Assume that a merchant in Flanders sold goods to a Venetian merchant and accepted in payment a bill of exchange drawn on the Venetian merchant promising to pay an agent of the Flemish merchant in Venice at a certain date in the future, and in a certain currency. The bill of exchange allowed the Venetian merchant to accept delivery on the goods from Flanders, sell them, and take the proceeds to redeem the bill of exchange in Venice, probably in Venetian currency.
Bills of exchange were also instruments for foreign exchange transactions. Merchants in Italy and major trading centers in Europe bought bills of exchange payable at future dates, in other places, and different currencies. In the example above, the Flemish merchant could sell the bill of exchange to an exchange dealer for currency of his own choosing. In turn, the exchange dealer could sell the bill of exchange to a Flemish merchant engaged in buying goods in Venice. When the bill came due for payment in Venice, the Flemish merchant would use it to buy goods in Venice where the bill of exchange was paid. While this process seems complicated, it substantially reduced the transportation of precious metals. In our example, a Venetian merchant bought goods from Flanders, and a Flemish merchant bought goods from Venice without any foreign currency leaving Venice or Flanders.
Bills of exchange gave cover to bankers evading usury laws by hiding interest charges in exchange rate adjustments that governed foreign exchange transactions. A Florentine bank could advance a sum to an Italian merchant and receive a bill of exchange payable at a future date to an agent of the Florentine bank in a foreign market. When the bill of exchange matured, the Florentine agent in the foreign market would draw another bill of exchange on the Italian merchant, payable at a date in the future at the Florentine bank that drew the first bill of exchange on the Italian merchant. The Italian merchant would be borrowing the use of money for the time it took for these transactions to be completed, and the interest would be embedded in the fees for handling the bills of exchange. Bills of exchange drawn only to grant credit were called dry bills of exchange.
Credit transactions involving bills of exchange are difficult to untangle, even challenging the talents of Adam Smith, who cited the difficulty of the subject of bills of exchange as credit instruments in the Wealth of Nations:
The practice of drawing and redrawing is so well known to all men of business that it may perhaps be thought unnecessary to give an account of it. But as this book may come into the hands of many people who are not men of business, and as the effects of this practice are not perhaps generally understood even by men of business themselves, I shall endeavor to explain it as distinctly as I can.
Smith goes on to describe a process by which bills of exchange are drawn and then redrawn with interest charges added, turning the bill of exchange into a form of long-term credit.
Bills of exchange circulated as money substitutes, partially playing the role of paper money, and economizing on the need to move specie between countries. When London became the financial center of world during the eighteenth century, bills of exchange became less important as credit instruments. Uninfluenced by church doctrines toward usury, the London financial markets developed financial instruments that clearly stated what interest rate was paid.