I just had a quick tour of the British Museum inspired by an article I read in The Telegraph about their exhibition of British bubbles and bankruptcies.
The exhibition traces back schemes from the 1600s, such as the Darien Disaster, right through the Railway Mania and Overend and Gurney Bank failure of 1866 through to Northern Rock and the credit crisis today.
Here are the key disasters you can check out if you visit the Museum before the end of May.
With all this talk of greed and corruption in the City (more on that later too), everyone is demanding a return to basic banking.
I’ve heard this several times in the past week and over the past few years.
Just yesterday, over lunch, my colleague was recalling the days when you needed credit from the bank. This was way back in the 1960s, before credit cards were introduced, and the only way to get credit was to borrow from your family or put on your best suit, tie and clean shoes and stand before the bank manager.
The bank manager would be seated and would eye you up and down very suspiciously .
He was always a he in those days - no equality in society then (or now) - and, after asking for the loan, his first question would not be:
“What do you do for a living?”
“What security can you offer?”
“How will you pay it back?”
“Why do you need this loan?”
But: “What does yoru father do?”
You were not the borrower: your guarantor was.
This meant that no-one over borrowed or over-leveraged.
How different today.
Another friend was talking about how they grew up in Wales, and their father was a bank manager.
He knew all his clients intimately and would know what they did for a living, who their family were, what assets they owned and whether they were good for the money.
He looked after a lot of farmers and would regularly visit their farms, talk to them about the business, shake the hands of their workers and even know the cows by name.
How different today.
The core rot that sink into the banking system was retailing.
Banking is not about selling credit – or it shouldn’t be – it is about managing risk,.
During the 1990s and 2000s, credit became easy and banks became populated by retailers.
This was the era when Andy Hornby took over HBOS, having been a golden boy working at Argos.
The focus of all banks became sales.
Get as much mortgage, loans and credit cards out there as possible.
The economy was booming because the days of the boom-bust era were over, according to then Chancellor Gordon Brown.
This was the greatest consumer-driven boom ever.
It wasn’t.
It was a credit-driven boom, as we now know.
The reason credit retailing became the norm is that the retail bank could easily gain access to funding through the wholesale markets.
The wholesale markets fuelled the credit markets through credit default swaps and all the other toxic derivatives that are now being paid back big time.
How different today.
Having had the biggest credit driven boom, we now have the greatest austerity driven bust.
So do we return to basic banking?
Do we return to the days of George Bailey in It’s a Wonderful Life:
Or George Banks in Mary Poppins:
If you invest your tuppence
Wisely in the bank
Safe and sound
Soon that tuppence,
Safely invested in the bank,
Will compound
And you'll achieve that sense of conquest
As your affluence expands
In the hands of the directors
Who invest as propriety demands
You see, Michael, you'll be part of
Railways through Africa
Dams across the Nile
Fleets of ocean greyhounds
Majestic, self-amortizing canals
Plantations of ripening tea
All from tuppence, prudently
Fruitfully, frugally invested
Ah, the good old days of banking.
Balderdash.
Going back to a rose-tinted nostalgic past is just blust and thunder.
Britain has staked its economy on financial services and made it the key market sector for our economy and position in global commerce.
As a result, trying to melt it down to some localised trade is just ridiculous.
Instead, we need to recognise that every boom is followed by a bust, but the booms create progress whilst busts create innovation.
When you have expansionism, you don’t care about risk as much as when you have contraction.
When you have contraction, you care far more about stretching investment dollars than you do when you have expansion.
This is why stability is the last thing we want.
We need booms and busts to progress and innovate, and this is just one of those defining moments when the world turns and life moves on.
“In Italy, for thirty years under the Borgias, they had warfare, terror, murder and bloodshed, but they produced Michelangelo, Leonardo da Vinci and the Renaissance. In Switzerland, they had brotherly love, they had five hundred years of democracy and peace – and what did that produce? The cuckoo clock.”
Oscar Welles as Harry Lime in the Third Man
So what we need now is a return to banking basics in a modern form.
That means that we continue to take risks, invest with leverage, stretch our assets and resources ... we just need to do that with appropriate limits (Basel III), a better sense of risk (derivatives collateralisation) and an improved knowledge of what the hell we are investing in (improved governance).
We're getting there, but the idea of returning to an era of fifty years ago or more, is a bit like asking everyone to return to wearing bowler hats and suits.
Oh!
I had an interesting dialogue over lunch yesterday.
One of my colleagues had just got his iZettle dongle.
iZettle is a Square for Europe, offering Chip & Signature payments on smartphones (Square reads the mag stripe).
It was originally going to be Chip & PIN, but the PIN terminal detail is too costly to rollout today.
If you’re interested in how it works, watch the video:
So as we’re talking, I’m struck by how many different ways there are to pay-by-mobile today.
There’s SMS text payments; contactless payments; proximity payments; P2P payments via apps; in-app payment services; QR code payments; dongle payments … too many payment services.
The fact is that I get pinged every day with a new way to pay by mobile, and sometimes more than once a day.
A few stand out – M-PESA, Pingit, Square – and these are the ones I blog about every day … and then there’s a shiftload of others.
As we talked, it made me remember the last wave of payments innovations disrupted by technology way back in 1998-99.
Back then, the internet world was rocking downstream with a shiftload of companies getting into the viral payments space: eBay had Billpoint, Citibank had c2it, Yahoo! used PayDirect, Western Union offered BidPay, and there were loads more out there. There were even interesting but short-lived ideas of new virtual currencies, like Beanz and Flooz, but none of these were around for long.
Now, looking back over the last ten to fifteen years, we see one major firm ruled all: PayPal.
How?
Well, that’s a story I wrote up a long while ago on their tenth birthday, and several times before that.
What this means is that each time we have a major disruption in technology, there will be a sudden splurge of new businesses spawned to leverage the opportunities the new tech offers.
Over time, these firms will compete, merge, acquire, win and die, until eventually one firms will rule them all.
In the internet era, that firm was PayPal.
In the mobile internet era, which firm will win out is still to be determined but it will not be the many of today, but the one or two of tomorrow.
Did you ever wonder why Wall Street is called Wall Street?
We all talk about Occupy Wall Street, an area of downtown New York that stretches across eight blocks from Broadway to South Street on the East River in Lower Manhattan.
Over time, the phrase has come to symbolise the financial markets of the United States as a whole.
This is down to the fact that Wall Street is the home of the New York Stock Exchange, as well as several other major exchanges who have or had headquarters in the Wall Street area including NASDAQ, the New York Mercantile Exchange, the New York Board of Trade, and the former American Stock Exchange.
But do you ever wonder why it’s called Wall Street?
Here’s the lowdown.
Wall Street traces its origins to the original early settlers of America.
Back in the 17th century, way before Independence and pucker stock markets prevailed, early Dutch settlers were building what has now become New York, originally known as New Amsterdam of course.
The key man at this time was one Peter Stuyvesant, he of the famous cigarette brand and wooden leg.
Of course, tobacco was one of the things traded by colonists, but back in 1647 things were very different. Manhattan Island was owned by the Dutch West India Company and they appointed Peter – or Pieter or Petrus if you prefer – to be the new Director General of New Amsterdam, the main fort and colony settled on the tip of the island.
Various trips and battles took place between the Dutch and other settlers – the British, Spanish and French – throughout this period, and during these moments Peter would lead troops to fight, only to find, on his return to New Amsterdam, that the Native Americans had laid plunder to the town.
One particular occasion was a major issue for Stuyvesant.
He had sailed with seven ships and 700 men to Wilmington, Delaware, and fought a battle with the Swedish settlers who had laid claim to the land, naming it New Sweden.
Stuyvesant won but it angered the Susquehannock Nation, who were close trading partners with the Swedish and liked them. The Susquehannocks gathered their warriors and, with other allied Native Americans, attacked several New Netherland settlements with New Amsterdam being the focal point, in September 1655.
Stuyvesant was incandescent when he returned to find the devastation reaped upon his lands and colony, and ordered the building of a strong 12 foot high wall around New Amsterdam to protect them from further incursions.
Thus began the building of "de Waal Straat".
Waal Straat followed the path of a bustling commercial thoroughfare which joined the banks of the East River with the Hudson River in the west, and was home to many early merchants’ warehouses and shops.
The wall also provided a good meeting spot for trading, and merchants and traders would gather there by a buttonwood tree that had been planted on Waal Straat, for the auctions of their goods through the buying and selling of shares and bonds in their shipping ventures.
A century later, after the Dutch ceded New Amsterdam to the British who renamed it New York in 1664, merchants were fed up with the fees being charged by the auctioneers for their goods, shares and bonds.
Therefore, in March 1792, twenty-four of the largest merchants decided to change the way the securities business was run. These merchants signed the Buttonwood Agreement, named after their traditional meeting place.
The agreement called for the signers to trade securities only among themselves, to set trading fees, and not to participate in other auctions of securities. These twenty-four men had founded what was to become the New York Stock Exchange, which is still there today at 11 Wall Street.
If this is of interest, I might post a few more historical pieces over time but, for the moment, if you ever wondered why Wall Street is called Wall Street ... now you know!
I’ve been debating some future presentations with various folks today, and a little ray of light went off in my head.
The light was triggered by a comment: “can you talk about what impact regulatory change may have on bank to corporate relationships using examples historically?”
The question was really asking about the unintended impact of regulatory change in the past and what it might mean for their future, but it made me think about something else.
Each time we have seen a major bubble burst, the cause has been a coagulation of several forces of change.
Forces for change come from four major directions: Political, Economic, Social and Technological (PEST).
These forces for change are used in many ways, and can be seen in my banking history discussions (and soon to be published book) which talks about many historical periods including the Italian Renaissance, the Great Depression and the Credit Crisis.
In each of these, we can see Political, Economic, Social and Technological forces working together at the same time to drive change.
In the fall of the Renaissance Italians, it was a mixture of change between the break from the Catholic Church with the Protestant and other movements (Political), mixed with the ruin of the Italian banks due to over-extension of credit to overseas Royal Houses (Economic), along with expansion of merchant shipping and colonisation (Technological).
In the Great Depression, we saw the end of the Industrial Revolution (Technological) combined with post-war wrangling over the gold standard (Political and Economic).
Right now, we see a major world of change too.
We have the rebalancing of power between America and Asia/China (Economic) combined with an internet revolution that is connecting everyone on the planet (Technological), leading to changes in society, where a Molly Katchpole can reverse a bank’s policy and an #Occupy movement can change global thinking (Social).
The Political outcome of all of this is what is driving bank regulations right now.
And the outcome of all of this will be a massive change.
A New World Order?
Probably not.
We already have a New World Order as China is expected to be the world’s largest economy by 2018 (ten years ago, it was estimated to be 2047).
But we will see a restructured playing field and one that is not level.
We can see this already as one major economy (America) bans prop trading whilst another (UK) just separates prop trading from retail bank operations.
Even more pronounced are the differences between the US and EU on OTC Derivatives regulations and how to define and regulate Systemically Important Financial Institutions (SiFi).
From CME Group in October 2011:
“In an ideal world, global financial regulators would function something like a team of horses, with policymakers in the United States, Europe, Asia and elsewhere all pulling at once in the same direction, and moving toward a common goal.
“Reality is turning out be far more chaotic, however. Regulators and lawmakers are having a tough time forming a consensus even within their own national borders, let alone across international boundaries. The result is turning out be a patchwork of overlapping and often inconsistent approaches to regulation in the aftermath of the financial crisis that gripped global markets in 2008 and 2009. Many financial experts fear that the inconsistent global regulatory framework will alter the flow of capital around the world, as trades are directed to the cheapest jurisdiction, a process known as regulatory arbitrage.”
So we end up with a world where the politicians are trying to react to the implosion of markets at the end of another revolution – Globalisation – and find that they are seriously lacking consistency, vision, leadership or agreement.
The Eurozone is one of the best illustrations of this, although America and China aren’t guaranteed to come out of this stainless as the American elections will change ground again, as will China’s challenges of a property market bubble and inflationary pressures.
All in all, the PEST approach to the world today says that we are going through a momentous change from all angles – Political, Economic, Social and Technological.
Where will it end up?
Probably in a place no-one expects and one which, on this blog, I’m going to avoid predicting decisively.
From Reuters:
“By 2020, the workforce in western Europe will shrink by 2.4 percent, including a 4.2 percent contraction in Germany, according to a Boston Consulting Group study.
Looking further ahead, HSBC projects that Germany's working population will shrivel by 29 percent by 2050, Russia's by 31 percent and Japan's by 37 percent.
Over the same period, the population of many African countries will double. Nigeria will log a rise of 3 percent a year in its workforce - in contrast to a 1 percent decline in Russia and Japan - and will have as many people as the United States by 2050.
On current projections, Pakistan will be the sixth most-populous nation by the middle of the century. And the Philippines could be the world's 16th-biggest economy, HSBC reckons.”
This is the final part of a series about how the City of London developed its financial prowess and system. Previous entries include:
Once the City had been deregulated in 1986, things really started to move.
Trading became more focused, frenetic and competitive, and markets moved millions and then trillions in minutes, instead of the old ways which were days or months.
London was now rocking, with many overseas banks basing themselves here, the Eurocurrency markets thriving and electronic trading growing fast into program trading, algorithmic trading and now high frequency trading.
FX trading globally grew from half a trillion dollars a day to five trillion a day over the 1988-2011 period …
Most of such trading is electronic:
With London dealing with a third of such trading.
The London Stock Exchange is now processing over €100 billion of trades a month (around €5 billion a day), although that still leaves the markets dwarfed by Tokyo and New York:
During this time, the London markets had become attractive to overseas firms due to the open access to skills and capabilities that, by comparison to anywhere else in Europe, is second to none.
This is illustrated by London’s importance as a European financial centre, with the UK managing 36% of the EU's wholesale finance industry and a 61% share of the EU's net exports of international transactions in financial services (from the December report of Open Forum Europe).
But none of this would have happened if the deregulation of the markets that took place in 1986 hadn’t internationalised the London markets, and made them more open to overseas entry and automation.
This was based upon an easy way of doing business using principles-based light-touch regulation.
The phrase principles-based light-touch regulation is one ew use regularly now.
Under Thatcherism it was actually a move towards self regulation, with each industry segment - insurance, retail banking, investment banking, building societies and more - having their own industry body to manage their activities.
It created a free and open industry, attractive to all for its ease of doing business, and regulated by industry elected officials.
This light touch regulatory environment was reinforced by New Labour, who succeeded Thatcher’s Tories in the mid-1990s.
The new government rapidly introduced change, the most major of which was to take monetary policy from the Treasury and give these powers to the Bank of England.
This was followed by the Financial Services and Markets Act 2000, to improve regulations after the collapse of Barings Bank and Equitable Life, where the light-touch self-regulatory approach was seen to fail.
The new Act therefore moved all financial markets regulation into one body: the Financial Services Authority (FSA) in 2000.
This all powerful body had been created as a principles-based light-touch regulator, in keeping with the self-regulatory approach under the previous system, but with more powers to enforce the rules.
The markets were now faced with a co-ordinated agency with two key roles: to create effective regulation and to police and ensure that firm’s comply with the regulations through their general conduct of business.
It was a move that was applauded by many, and emulated by many, and further enhanced the City’s reputation as an open platform for finance, where it was easy to do business with effective governance.
However, it also created a tense relationship between the FSA, the Bank and the Treasury, as none of them had the complete ownership of their turf.
The FSA regulated the firms; the Bank looked after monetary policy; and the Treasury managed fiscal policy.
The division often overlapped and therefore created friction, as demonstrated by activities in 2002 when the Treasury Select Committee accused the FSA of being ‘asleep on the job’ over the split-capital debacle. The same committee accused the Bank of England of being ‘asleep on the job’ over Northern Rock five years later.
Neither were asleep on the job if we’re truthful. The truth is that they are just understaffed, underfunded and under capable.
The markets move faster than regulators, and the real challenge is to come up with regulatory structures that are effective enough.
The FSA was not far away from that, but it cracked under the pressure of two forces – lack of competent people; and a global financial crisis that no country anticipated.
In the first instance, the FSA lacked truly competent people to manage City firms. In fact, they lacked competent people all around.
The FSA admit, for example, that they did not manage Northern Rock well.
Why?
Because Northern Rock was over 200 miles north of London and so the bank would receive no visits for months or, sometimes, years. There was one period where Northern Rock had no visit from the FSA for over 18 months.
From the FSA’s review:
“The Internal Audit review identifies the following four key failings specifically in the case of Northern Rock:
But it goes deeper than this, in that most banks try to find gaps in regulations to make money.
It’s called regulatory arbitrage, and banks are very good at this.
As Michael Lewis quotes Salomon Smith Barney’s General Counsel in Liar’s Poker: “my role is to find the chinks in the regulator’s armour”.
So regulators can only keep up if they have the best people but, in the case of investment markets, the best people cost too much.
With a high cost for a decent investment banker, hiring a lot of them to be auditors, regulators and police is just too tough.
This was illustrated well by the second challenge: the Global Financial Crisis.
The crisis has been covered well over the last few years – if you’re keen to know more then you should buy my book about it (recently reprinted and updated) – and the core of the coverage says that regulators, governments, bankers and all messed up.
This is discussed in depth in a recent interview with the current Chair of the FSA, Adair Turner:
The FSA made mistakes “but you do have to place them within that wider context—the whole system… was deeply, deeply wrong … the global regulatory system in total failed.”
The framework for setting capital levels, designed by committees of senior bankers across the world, “was an enormous amount of intellectual effort over ten years which completely failed to address the fundamental issues …
“We constructed an economic theory that this was all fine because financial markets had got so much more sophisticated—that liquidity problems wouldn’t emerge because markets across the world had become more liquid and sophisticated, [that] the banks could run with lower capital because the techniques of risk management had become more sophisticated. And all this was just hugely wrong …
“There was a belief that light-touch regulation, or limited-touch, would make the City bigger, and that the City was a source of employment and tax revenue. And therefore there was clear pressure on the FSA at times to say, ‘Go easy on the City.’ The FSA never used the phrase ‘light-touch,’ but politicians did, and they did it in speeches which were directed at the FSA.”
Which politicians?
“Oh—ministers right at the top. Prime ministers. Chancellors of the exchequer, made speeches of that sort, in the last government.”
There was also pressure for the regulator to be an advocate for the City, he said. Regulators “mustn’t do crazy things that will necessarily harm [the sector]. But the moment you introduce an idea that they are part regulator and part, as it were, sponsor, spokesman, for an industry, that’s dangerous, that’s confusing.”
The result was that London became a centre for some of the most damaging financial activity. One example was AIG Financial Products, which specialised in issuing credit default swaps (CDS), a form of insurance against borrowers failing to meet their debts. In the run-up to the crash, the Mayfair-based AIG FP issued over $2 trillion worth of derivatives, activity that enhanced the spread of the global crisis.
“Well, AIG Financial Products in Curzon Street was actually regulated by the French,” said Turner. “It was the French regulator. There is a major issue here about clarity of who is responsible. If you set up in London, as a branch of a European legal entity, then the single market rules are very clear that the local regulator has only limited control over what you do …
“One sometimes feels that this financial system is like some incredibly complicated waterbed, where you try and deal with something here and then something happens at the other end. We’re just not clever enough to see it.”
In hindsight, it’s easy to beat up on all the things that went wrong – governance, government, regulator, shareholder, markets, the world – but the bottom-line is that the credit crisis has seriously damaged London’s reputation for getting things right when, in retrospect, it got things so wrong (more in the FSA’s more recent moratorium into the collapse of the Royal Bank of Scotland).
Going forward, the answer is not necessarily the action being taken by the UK and European governments today however.
On the one hand, you have a transaction tax that Europe wants to impose, which is sound in principle but not in practice.
Sweden has already shown that such taxes don’t work, and the only place that will be seriously hit by such a tax is London – remember that 61% of all international financial transactions in Europe take place in London today – which is why David Cameron exercised his veto on the European treaty at the end of 2011.
Then you have the UK’s plans to separate commercial and investment banks. It’s like a Glass-Steagall, but allows the UK to have ring-fences rather than complete separation.
Again, everyone is split on this recommendation with Paul Volcker, the former head of the Federal Reserve and the man charged with reform of the US investment markets through ‘the Volcker Rule’, saying that he doesn’t “believe in a firewall or Chinese wall, as you need a very high ring fence to stop the deer jumping over.”
True.
Regardless, the Vickers recommendations to ring fence banks are estimated to cost UK banks at least £10 billion a year in lost revenue, so that’s not good for London either.
Finally, you have the one thing that may be appropriate: the end of the FSA.
In June 2010, the UK government announced the end of the FSA. This will repeal the changes introduced by Tony Blair’s government, where the financial markets were run by a triumvirate of the FSA, the Bank of England and the Treasury.
The aim is to place more power into the hands of the Bank of England, with the regulatory part of the FSA becoming part of their operations.
From 2013, the FSA will therefore be split into two new regulatory bodies:
Will these changes succeed?
Will the City still be as strong as ever?
Will it maintain its #1 position as the financial hub of Europe and the World?
Who knows.
All we can say is that London has always been at the heart of the world’s trading activities from Roman and Viking times to the present day.
Through Empire and Industry, London has cemented its position as the leading centre for finance.
And by political and economic manoeuvring, has maintained that position throughout the last century, as the Empire disappeared and open borders created free trade.
It will be interesting to see where London’s position move over the next decade as reforms kick in to restructure London, to make it a safer place to trade once more.
This is the final part of a series about how the City of London developed its financial prowess and system. Previous entries include:
By the 1970s, the City had re-established its position of prominence thanks to trading in Eurocurrency and the increasing volume of trading in securities, but it lagged behind the rest of the world, particularly New York, due to its very traditional way of operating.
The markets were based upon a structure that was 150 years old, where gentlemen stockbrokers dealt with client needs and gave orders to jobbers who would make the trades.
The system started when many members of the Stock Exchange began to specialise in one of the leading types of securities during the nineteenth century.
These players were defined as ‘market-makers’ or jobbers, and the brokers who dealt with them on behalf of the public had a clear-cut separation.
This separation was made a formal one, when it was embodied in the Stock Exchange rules in 1909. The rules had been created to ensure that those taking orders were not creating dishonest trades, by inflating prices or concentrating investments through conflicting market making interests.
By 1914 there were over 600 jobbing firms as well as many one-man jobbing operations.
These numbers then steadily declined as the institutional investor supplanted the private one, which meant that the scale of capital required to be a jobber – as you had to cover your trading positions with collateral – increased dramatically.
Picture of the Stock Exchange Trading Floor, 1968, from the Museum of London
On the eve of 'Big Bang' there were five major jobbing firms on the floor of the Stock Exchange: Akroyd & Smithers, Wedd Durlacher, Pinchin Denny, Smith Brothers, Bisgood Bishop and Charles Pulley.
Meanwhile, the large stockbroking firms were Seligman Harris, Phillips & Drew, Capel Cure Myers and Quilter & Co. Their business was based upon schmoozing clients over long lunches, and the City was renowned for imbibing, massive entertainment bills and general high life activities.
Philip Augar tells the story well in his book The Death of Gentlemanly Capitalism, where a broker hears that his secretary lives on an estate in Romford, and replies: “How splendid. Do you keep horses there?”
No wonder the gentleman brokers were stereotyped as public school educated oafs from Harrow or Eton, whilst the jobbers were viewed as all being cheeky cockney boys who were loud and brash.
A very old world [to see the world of the old stock exchange, click here which links to a 47 minute BBC documentary from 1964 on the Stockbroker’s World].
Both the jobber and broker made money.
The jobbers made money by making markets, as every stock transaction had to be recorded in their books; the brokers made money through commissions from their clients, which were fixed; and both functions were firmly separated.
The real focus of the separation was made with the best of intentions: to avoid conflicts of interest, where a broker might falsely make trades in stocks where they had an interest themselves. This is important as some feel that today's issues are caused by the fact that such separation was removed
This is similar to the view that the repeal of Glass-Steagall by the Gramm-Leach-Bliley Act of 1999 in the USA, which removed the separation of investment banking from retail banking, was a mistake.
The separation of market maker and stockbroker caused issues for the City of London’s competitiveness, particularly by the 1980s when the volume of trading through London’s markets was just 1/13th of that being traded in Wall Street.
This was down to the innovations coming from across the Atlantic.
The New York Stock Exchange in the 1980s, courtesy of Flikr
In particular, the rise of technology had given way to new ideas about finance, and derivatives began to emerge as a way of creating futures markets.
The theories were based upon two professors, Fischer Black and Myron Scholes, who modelled risk equations and, in 1973, publish a paper: “The Pricing of Options and Corporate Liabilities”, which articulated a theory that any asset could be perfectly offset in risk terms by another investment.
A hedge, so to speak.
The markets embraced the concept immediately and this became known as the Black–Scholes equation, the mathematical theory that governs the price of an option over time.
The way the theory works it that you can create a derivation of an asset, and perfectly hedge the risks of that asset in a way that will “eliminate risk".
So I can take part of an investment in the stocks of General Electric, and hedge this with an option in oil commodities for example, in the belief that GE stock price will fall when oil prices rise and vice versa; or I can take an FX trade in Dollars and hedge this with an option in Yen for the same reason.
The pairing of risks on the basis of options for the future, using the Black-Scholes formula, combined with trading in parts of related assets and instruments - derivations - forms the basis for much of all market trading today.
It led to the rise of derivatives and OTC derivatives; the creation of new exchanges like the Chicago Mercantile Exchange, the London International Financial Futures and Options Exchange (LIFFE) and Eurex; and is a huge part of the volume of trading that goes through today’s high frequency trading automated systems.
The Rise of OTC Derivatives Contracts, from Zero Hedge
Wall Street adopted the derivatives markets rapidly, and also introduced automation for programming trades to allow more complicated mathematical models to operate as part of this new, more complex world.
These developments pushed London into a backwater.
It used to be “absolute hell with a wooden floor. You’d come back to the office at 3pm and blow your nose, and clumps of brown wood dust would come out.” Fred Carr, Partner at Capel-Cure Myers in the 1980s
By 1986, London trading volumes were a thirteenth of New York’s and a fifth of the size of Tokyo; Frankfurt and Paris were rising as serous European alternatives; and London appeared fusty and old.
It was time for change.
Margaret Thatcher’s Government and her Minister for Trade and Industry, Cecil Parkinson (a former guest speaker at the Financial Services Club) introduced the Financial Services Act of 1986.
This had a dramatic and profound effect upon City life.
The aim of the Act had many implications but, for the City, it was driven by four key principles:
In particular, the Act created competition between brokers - before Big Bang, commissions were fixed and so brokers did not compete on commission rates - and not only allowed brokers and jobbers to merge, but also abolished any oversight of the law courts on derivative contracts that might be considered speculative or contrary to the Gaming Act of 1845, e.g. ‘betting’.
A flurry of mergers and acquisitions followed, with the best deals going to those who jumped first.
For example, Security Pacific bought 30% of Hoare Govett, the top equity broker, in September 1983 at an implied value of £27 million. When they purchased a further 60% ten months later, the firm was worth £80 million.
By 1986, strategies had been chosen and implemented. Stockbrokers left their old premises, typically six-storey 1960s monstrosities, and moved into glass skyscrapers.
The actual day of change was 27th October 1986.
It was called the Big Bang because so much changes had to be implemented on one day: the elimination of fixed commissions; a marked increase in the number of market participants; a change in the structure and ownership of trading firms; and perhaps most importantly rapid movement of stock trading off the floor of the Exchange.
This remains the most rapid and complete regulatory reform of any market, and the most striking example to date of a regulatory event engineered to benefit the local financial industry.
A key impact was the introduction of a wave of new technologies.
The London Stock Exchange rapidly moved from open outcry – where the jobbers would shout “buy, buy, buy” and “sell, sell, sell” across the trading room – to a completely automated system, with program trading.
This led to algorithmic trading and now high frequency trading.
Today's "trading floor", from FinTechIsrael
The end of open outcry meant that trade times shortened from ten minutes to ten seconds back in 1986 (today, it’s nanoseconds).
Combined with the market opening two and half hours earlier and closing two hours later, this meant that trading volumes rocketed up 72% in 1986 and 56% in 1987.
London was rocking.
The Big Bang allowed London to follow Wall Street into automated trading of more and more complex instruments – the exotics as many derivatives products are termed – and, since the early 2000s, the City has been back on top of the Global Financial Centres Indices.
This is all down to the Big Bang of 1986.
The Big Bang made London a completely free and open trading location for all, with overseas firms welcome and all of the skills required to create liquidity based here – accountants, lawyers, technologists, auditors, advisors, consultants and more.
Over a million people work in the City today, and much of the Big Bang’s changes hailed the systems and structures that operate today, including those that allowed the credit crisis to occur.
This is because many of the theories around derivatives were wrong, and have proven to be wrong again and again.
Add technologies to turbo-charge these incorrect beliefs and markets fail faster and larger than ever before.
But the markets adopted these capabilities and practices as it creates liquidity.
Liquidity creates alpha, and alpha creates profits.
As can be seen, the effects of Big Bang were dramatic with London's place as a financial capital decisively strengthened to the point where it is arguably the world's most important financial centre.
An economic boom created a new class of nouveau riche – the Yuppie (young, upwardly mobile, professional) – that has persisted since the 1990s, and the boom expanded beyond the City into new developments in East London with the rise of Canary Wharf.
More on this tomorrow, but here are a few key events and dates that led up to the crisis:
1979 Margaret Thatcher and the new Conservative Government strive towards a ‘free market’
1982 Formation of LIFFE the London derivatives market
1986 ‘Big Bang’- the deregulation of the financial industry, and the movement from the Stock Exchange floor to screen and telephone based dealing mechanisms
1980’s Boom in privatisation issues (British Telecom, British Gas, British Airways,) as the British public share in the profits of the companies / services they use
1987 Black Monday - stock markets crash, compounded by traders taking speculative positions on the weakening sterling
1995 Barings bank ‘bankrupted’ by a rogue trader
1995 London Stock Exchange opens AIM the Alternative Investment Market (targeted at smaller developing companies)
1999 Stockmarkets reach record ‘highs’ – the effect of the momentum behind the dot.com boom
2003 The bottom of the ‘trough’ following the dot com bubble bursting and a deceleration in merger and acquisition activity
2004-2007 Company profits grow, takeover and merger activity increases, sophisticated financial products and gearing magnify gains and the market peaks at 6751
2008 Market falls on the back of a Global Banking Crisis as liquidity between major Global Investment Banks dries up
2009 The FTSE 100 reaches a low of 3460
2011 A New Act: the Government recommends new laws to separate Commercial and Investment Banking as a result of the Global Banking Crisis
The City of London by the Numbers (from the FT)
1986 2005
Domestic equities annual turnover LSE (£bn) 161 2,495
Foreign equities on LSE 0 2,703
UK government securities 424 3,231
Foreign exchange daily turnover ($bn) 50 1,210
Long-term annual premiums (£bn) 21 110
London exchange derivatives contracts traded (m) 17 (1987) 999
UK banking sector assets (£bn) 762 (1985) 5,526
Number of UK private equity funds 19 54
UK private equity amount raised ($m) 360 46,170
UK private equity (as a % of Europe) 3.9% 66.7%
Asset under management (£bn) 3 (1990) 89
Number of active firms 17 66
Capital raised by vinage year (£bn) 0 29
Much of this blog entry is based upon a number of essays about the Big Bang, so here’s a little more reading if this interests you:
This is the thirteenth in a series about how the City of London developed its financial prowess and system.
Previous entries include:
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