London is one the three largest financial markets in the world. While London originally grew as an international trading centre in parallel with the expansion of the British Commonwealth and then the establishment of its position at the centre of the international bills of exchange and gold markets. The bill of exchange and, in particular, the ‘bill on London’, became the most important form of payment in international trade and finance for almost three hundred years. The value of international currencies was also fixed against the price of gold for over two hundred years under the ‘gold standard’.
London remains a leading national and international financial centre. Rather than constitute any single market, London is, in fact, made up of a number of separate markets and sub-markets. The main domestic markets are the wholesale money markets with the commercial and retail banking and securities markets. The main international markets are the Eurodollar, the foreign exchange and the financial derivatives markets. London is also the centre of number of other commodity related markets (including the oil and metal markets) which trade product related financial instruments.
HISTORY OF BANKING
Banking began with the Italian merchant and financial families during the 13th and 14th centuries. The main financial centres were the Italian City states such as Lombardy and Florence, Venice and Genoa and other northern towns. The new Italian bankers quickly emerged as the leading money changers, lenders and dealers in early bills of exchange and coins within Europe. (The word bank is derived from the Italian ‘banco’ or bench on which the early bankers sat to conduct their business). Early coins were also referred to as ‘florins’ (after Florence) with the UK florin not being abolished until the decimalisation of English coinage in 1971. The close connection is still clear with one of the oldest banking streets ‘Lombard Street’ being named after Lombardy. The oldest bank in the world is claimed to be the Monte de Paschi in Sienna in 1472. Italian financiers had a close relationship with British royalty from an early stage. Money was often lent to the British crown generally to finance wars. Defaults were not uncommon such as when Edward III failed to repay outstanding debts to the Bardi and the Peruzzi in Florence in 1345.
International finance generally developed through the great trade fairs that were held in the main mediaeval towns across Europe from the 13th and 14th centuries. While these originated in the northern Italian towns, they subsequently spread to major European cities including Lyons and Geneva. They then moved north with the growing trade routes into Flanders and the Netherlands, Bruges and Antwerp. Important families included the Fuggers in Augsburg which developed from early wool trading to become the main financiers to the Hapsburg empire. The most common means of payment at such fairs was the ‘bill of exchange’ which was simply a transferable debt instrument drawn by a creditor on his or her debtor with the debt being directed to be paid to a third party (or the holder of the bill. The party may then further transfer the benefit of the debt before repayment by general or special endorsement.) The bill of exchange subsequently emerged as the dominant payment instruments in international finance until the early 20th century.
The most important type of finance instrument apart from the bill of exchange was the promissory note which was simply a written undertaking (promise) to pay an agreed fixed amount by one party to another. Although often used by merchants and tradesmen in their dealings with each other, promissory notes were also used as a form of receipt issued by early custodians or goldsmiths. Goldsmiths were often used as depository institutions for coins and other valuables due to the secure storage facilities maintained. Goldsmiths would then issue receipts which could be traded as early forms of money. Whether money then developed out of the goldsmith’s receipts directly or the promissory note is unclear and subject to dispute by historians. Some of the oldest banks in England are nevertheless derived from goldsmiths such as Coutts Bank which was set up as a goldsmith bank in 1692.
The first legal tender that was issued was by the Bank of Sweden in 1661. This had originally been set up as the Bank of Stockholm in 1657 although it had to be closed as a result of significant trading losses incurred which led to its founder being imprisoned. The bank was reopened and subsequently renamed the Riksbank. Other early banking institutions that subsequently developed into national central banks included the Bank of England which was set up by William Patterson, a Scottish merchant, in 1694.
The earliest type of banking that emerged from merchants and trade fair activities is still referred to as ‘merchant banking.’ This includes the financing of trade mainly through bills of exchange and then more recently letters of credit and other trade finance practices as well as raising finance for companies of governments through bond (securities) issues as well as providing other corporate advice and services. A number of the great British and European banking names developed out of such early merchant bank practices including Barings and Rothschild’s. The more modern form of banking that was solely based on deposit taking and the acceptance of funds from individual or corporate clients is generally referred to as ‘commercial banking.’ Such banks emerged during the late 18th and 19th centuries although it was not until the consolidation of the smaller regional banks that took place during the middle of the 19th century and the introduction of limited company liability that the large modern commercial banks emerged.
Other more specialised institutions include ‘acceptance houses’ and ‘discount houses’. These are specialist banks that add their credit by accepting (stamping) bills of exchange (trade bills) and other instruments which can then be sold (discounted) through a discount house with the fee being deducted equal to the interest due on the remaining term of the bill. The discount houses would also emerge as the specialist counter parties dealing directly with the Bank of England in the ‘primary money market’ in the United Kingdom. This is the main market through which the Bank manages monetary policy (essentially the amount and cost of liquidity within the financial system). This is distinct from the ‘secondary money markets’ that developed in the late 1950s and early 1960s dealing in other financial credits. The secondary markets now include the ‘local authority’ bill market, the ‘sterling certificate of deposit’ (essentially a security representing an underlying deposit) market, the general ‘certificate of deposit’, the ‘inter-company’ market and ‘inter-bank’ market.
The main markets in London remain the primary and secondary money markets as well as the foreign exchange market. Specialised international financial markets have also emerged since the late-1950s including, in particular, the international syndicated loan and international bond market. These are collectively referred to as the ‘Eurodollar’ markets. London remains the largest financial centre for international foreign exchange and Eurodollar dealings in the world.
LONDON MARKETS The main domestic markets are the money markets and the banking markets with the main international markets being the Eurodollar markets, the trade finance markets and foreign exchange markets.
(1) MONEY MARKETS The money markets consist of the primary and secondary markets:
(a) PRIMARY MONEY MARKET
The primary money market is the market in which the Bank of England intervenes as central bank to control the volume and cost of liquidity (money or credit) within the financial system. The Bank formerly only dealt with a limited number of the ‘discount houses’ (with the market also then being referred to as the discount market). The range of available counter parties with which the Bank can deal has since been extended and the range of instruments expanded, in particular, to include ‘repos’ (sale and repurchase agreements). The Bank generally either buys or sells paper (bills) in the market which will consequently either increase or reduce the amount of funds (liquidity) available in the financial system. The cost at which the bank Deals also creates a floor rate (base rate) against which other lending costs can then be calculated.
(b) SECONDARY MONEY MARKETS
The secondary money markets emerged during the late-1950s and the early-1960s for specialist dealing markets in alternative types of bills or finance paper. The first market was the ‘local authority’ bill market which arose with the closure of the former Public Works accounts which forced local authorities to borrow money directly from the markets for the first time. A market in local authority paper then quickly developed. This was followed by the sterling certificate of deposit, the general certificate of deposit as well as the inter-company and inter-bank markets. These represent specialist wholesale markets within which financial institutions deal in particular types of debt or paper.
(2) BANKING MARKETS
The two main types of bank are the merchant banks and the commercial banks. Merchant banks generally deal in trade finance related instruments and provide a range of corporate capital market advice and support services. Commercial banks have traditionally only accepted deposits (savings) from the public and advanced loans or credit on the deposit volumes generated. With the emergence of the secondary money markets, commercial banks have since borrowed funds directly to the wholesale markets which has allowed them to expand their loans and the asset side of their business. Commercial banking has then generally moved from being traditional ‘deposit (liability) based’ to ‘asset’ (loans) and ‘asset and liability’ management based. Commercial banks also now provide a range of other financial services for their customers including consumer finance, consumer credit, other payment cards and increasingly on-line internet based financial services.
(3) EURODOLLAR MARKETS
The main international markets are the Euro syndicated loan market and the Eurobond market. The syndicated loan market is an extension of the domestic commercial bank market and is consequently ‘term loan’ based. A number of additional information requirements and controls are nevertheless imposed on borrowers under the term loan agreements used while funds will often generally be advanced by a group (syndicate) rather than by a single bank due to the amount and exposure involved. The reference to ‘Eurodollar’ generally means that the currency in which the funds are advanced (historically US dollars but subsequently Japanese yen, Germany deutschmarks, Swiss franks and other currencies) is different from the currency of the country in which the debt is issued and traded (generally sterling in London).
The Eurobond market is a parallel security based market in which the borrowers (governments or large companies) issue debt instruments (bonds) into the market rather than borrow the money directly from a bank or group (syndicate) of banks. Once issued (in the primary market), the bonds will be traded (in an over-the-counter (OTC) secondary market). Eurobonds were originally issued for similar amounts and terms as syndicated loans although the advantage was that lower costs of funding are available depending upon the credit standing of the borrower. There has consequently been a general decline in the syndicated loan as against the Eurobond market although syndicated loans remain a highly useful and flexible credit device especially in more complex financing situations.
(4) FOREIGN EXCHANGE
One of the other main international market is the foreign currency market which involves the purchase and sale of the currencies of different countries either on an immediate (spot) or future (forward) basis. London remains the centre of the market which is conducted on an over the counter (OTC) basis.
(5) FINANCIAL DERIVATIVES
The other main types of financial instrument that may be traded are financial derivatives. These generally consist of futures, options and swaps which may either be dealt with on a formal exchange or OTC basis. The domestic derivatives market is based at the London International Financial Futures Exchange (LIFFE) although a number of financial derivatives are also traded through the OM Exchange and London Stock Exchange. International derivatives (including derivatives products attached to international syndicated loans or bond issues) are generally dealt with on an inter-bank or OTC basis. The international OTC derivatives market is the largest financial market in the world and is currently valued in excess of US $116 trillion on a nominal gross basis ($14 trillion net).
G A WALKER