International Finance Law
3. INTERNATIONAL FINANCIAL MARKETS
National and international financial systems are made up of a number of specific markets and sub-markets. These are generally divided into the money and capital markets each of which includes a number of separate sub-markets. These may either operate on a formal exchange or off market over-the-counter (OTC) basis. Almost all will be subject to some formal organisation and oversight.
Financial markets carry out a number of essential services including savings, credit, and funding or investment and loss cover or risk management. Risk can be managed either through insurance contracts (including life and non-life or contingent liability insurance) or through specialised instruments, including financial derivatives such as futures, options and swaps or other hybrid products. Organised markets or exchanges more specifically carry out a number of important functions including price discovery or disclosure which permits trading or dealing in relevant securities as well as supporting clearing and settlement and trade and transaction reporting.
One key feature of all of these markets and instruments is that they are based on legally enforceable contracts or claims. This can either be constituted by a debt obligation entered into between a bank (or group of banks) and the customer on a bilateral (or multilateral) basis or in a transferable form of with dedicated security instrument to evidence the debt. While these were traditionally issued in the form of a written security certificate, they have increasingly being issued in a purely electronic form and transferred or traded through electronic systems. This is referred to as the dematerialisation with immobilisation involving the holding of securities through central custodians.
The main types of financial markets that make up any modern economy are reviewed next. This is followed by an examination of the principal types of financial assets or instruments dealt with on these markets.
(1) Money Markets
An initial distinction has to be drawn between the money markets and capital or securities markets. These are the two main set of markets within any financial system.
The money markets generally refer to the wholesale markets in short term bills or paper of up to one year. Relevant instruments include treasury bills, local authority or corporate bills, bankers’ drafts (promissory notes issued by banks), certificates of deposit (transferable securities representing underlying deposit amounts) as well as commercial paper (short term marketable unsecured promissory notes) and bankers’ acceptances (accepted bills of exchange) or bank deposits. These are considered in further detail in the following section.
The UK money markets are made up of the primary (or discount) market, in which the Bank of England manages the amount of money (credit) in circulation within the financial system as the central bank, and the secondary money markets in which other types of wholesale credits are bought and sold. The Bank of England will generally only deal with a limited number of specialist dealers in the primary market. This is also referred to as the Discount Market as this group was originally restricted to Discount Houses in the City of London, the role and function of which has already discussed. The number of institutions eligible to participate in the primary money market has since been extended with the Bank of England also increasingly using sale and repurchase agreements (repos) to supply funds to banks without the use of the discount market. A repurchase agreement (RP or repo) provides for the sale and repurchase agreement which involves a cash or spot sale of a security or other asset with a forward repurchase at an agreed price. This effectively operates as a secured loan.
The parallel or secondary money markets consist of a number of separate wholesale markets for the issuance and trading of other types of short-term bills or money market instruments (MMIs). In the UK, these principally consist of the Local Authority market, Finance House market, Inter-Company market, Sterling Inter-bank market and Sterling Certificate of Deposit and Sterling Commercial Paper market. These markets generally emerged at the end of the 1950s following the closure of the earlier Public Works Account which required local authorities to issue bills into the market for the first time. Dealings are unsecured and not supported by the Bank of England and are generally conducted by telephone or on screen basis with no formal trading floor. A number of banks may operate in more than one of these secondary markets.
(2) Capital Markets
Securities or capital markets provide a range of alternative investment and funding mechanisms. The capital markets are made up of a mixture of primary (initial issuance) and secondary (dealing) markets. These principally allow for sovereign or corporate entities to obtain capital through the issuance of transferable debt instruments (principally involving bonds, bills or gilts) that can then be traded on active secondary markets. The investor will receive an interest payment during the term of the instrument with the nominal amount of the issue being repaid in maturity. This is economically the same as a loan except issued in a transferable form. Companies can also raise capital by issuing shares or equity instruments with the holder (shareholder) owning a proportionate interest in the entity and receiving a dividend payment instead of interest.
The issuer of debt or equity will receive funds on the first placement of the security in the primary market. These securities can then be bought or sold on the secondary markets with dealers or investors making a profit (or loss) on the rise and fall in the value of the security. Primary issues and secondary dealing can be carried out either on a formal stock exchange or market or on an off-exchange (OTC) basis. The capital markets more generally also include other direct sources of investment funds, such as through national or international development or industrial banks or investment vehicles or other venture capital providers.
The equity markets consist of the markets for the initial issuance and subsequent purchase and sale of shares in corporate bodies. Equity refers to the equity or share capital of a firm which represents the total value of the company and all of its assets on a going concern basis which corresponds with the total amount subscribed by its members. Warrants and depositary receipts may also be issued. Warrants are transferable certificates that allow the holder to acquire a specified number of shares or bonds at a future date. Depository receipts are certificates evidencing ownership of an underlying asset such as a share. The certificate acts as a receipt that becomes a fully transferable security independent from the underlying share. These are often used where domestic regulatory restrictions would otherwise prohibit or restrict the sale of the original shares. These include American Depository Receipts (ADRs), that are cleared through the US Depository Trust and Clearing Corporation (DTCC), as well as Global Depository Receipts (GDRs) and some European Depository Receipts (EDRs).
Capital markets generally then provide for the issuance and trading in debt instruments (bonds or gilts), equities, warrants and hybrids as well as depository receipts. Governments principally borrow through debt or bond instruments although these are also commonly issued by large and medium or smaller sized corporate bodies (in which case the instruments are often referred to as debentures). Bonds may either be issued in the local currency or in another currency. The international markets in which large loans or bond issues are denominated in a currency other than the currency of the country of issuance are referred to as the Eurodollar markets.
(3) Eurodollar Markets
The largest international financial markets include the Eurodollar markets which are made up of separate syndicated loan, bond and underlying Eurodeposit or inter-bank markets. These grew significantly with the expansion of cross-border banking and investment business following the restoration of currency convertibility after the Second World War beginning in 1958. Growth of the Eurodollar markets was boosted by the massive influx of ‘petro-dollars’ following the oil price increases in 1973 and 1979 as well as the more general demand for investment capital by countries and international corporations especially since the early 1970s. While borrowing through the Euroloan markets declined relatively during the 1970s and early 1980s, this was accompanied by a corresponding increase in Eurobond activity which has the advantages of inherent transferability and negotiability which increases liquidity and allows better quality issuers to raise funds at lower margins.
(4) Currency Markets
The currency markets are the wholesale markets for the purchase and sale of foreign exchange on either an immediate (cash) or future (forward) basis. Foreign currency is not strictly money, as it is not legal tender in a particular the local country, and is therefore treated in law as a commodity in the same way as gold or oil. The currency market is reputedly the single largest market in the world with over US$4 trillion being transferred daily. The market is screen based with around 350 participating banks although the majority of transactions are carried through a smaller number of around 50 banks and between 10-12 brokers. Dealer banks provide continuous bid (buy) and ask (sell) prices on minimum contract sizes of US$1m. Brokers act as intermediaries between corporate or retail customers and the main market. Most transactions are inter-bank with a third involving a dealer and another financial institution. The principal financial centres are London, New York and Tokyo with over one-third of the total business being conducted through the City of London.
(5) Financial Derivatives Markets
The financial derivatives markets provide for a number of risk management and investment facilities. These can either be used to hedge specific risks, such as currency and interest rates or increasingly credit risk, or be used for proprietary trading purposes as with other securities. The main instruments involved include exchange and off-exchange futures and options as well as swap contracts. While forwards trading has been available since early times, most of the new more sophisticated instruments only emerged during the early 1970s following the collapse of the Bretton Woods system of managed exchange arrangements between 1971 and 1973. This, in particular, led to the introduction of floating currencies for the first time during the post-War period with associated volatility in foreign exchange and interest rate risks in response to which new derivatives contracts were created and exchange traded products opened on various exchanges including the Chicago Mercantile Exchange (MERC originally opened in 1898) and Chicago Board of Trade (CBOT established in 1848) which later merged in July 2007 to create the CME Group. The largest derivatives exchange in London is the London International Financial Futures and Options Exchange (LIFFE), which was set up in 1982 and later acquired by Euronext in January2002 and merged with the New York Stock Exchange in April 2007. Eurex was created in 1998 with the merger of Deutsche Terminbörse (DTBe) and the Swiss Options and Financial Futures (SOFFEX).
(6) Gold Market
The gold market provides for the sale and purchase of gold bullion following a daily price ‘fixing’ in London with physical delivery being managed through other centres such as Zurich. The Gold Market has traditionally been based at Rothschild’s in London with the five main members meeting at 10.30am and 3pm to fix the daily price to cover outstanding purchase and sales orders. The market now includes around 11 market-makers and approximately 50 ordinary members of the London Bullion Market Association (LBMA) which was set up in 1987. Members represent the major gold centres including Zurich, Frankfurt, Sydney, Tokyo and New York with the Bank of China also a member.
(7) Commodity and Shipping Markets
Other commodities can be bought and sold on an open outcry or auction basis through various exchanges, salerooms or auctions. This includes oil and metals as well as consumables (such as sugar, cocoa, copper or coffee) and non-consumables (such as fibres and furs). Ships and shipping and airfreight and aircraft are sold through shipping and carriage markets such as the Baltic Exchange in London.[1] The exchange is in St Mary Axe, London beside Norman Foster’s Swiss Re Building (‘the Gherkin’) at 30 St Mary Axe.
(8) Insurance Markets
Insurance markets provide for a range of additional risk management services. These principally either include life (pension) assurance and non-life or other contingent liability cover (including property, business, fire, motor and personal injury insurance). Insurance intermediation allows for the payment of an agreed sum in the event of a contingent or unexpected event. The life or insurance companies receive a one-off, or annual premium, that is invested in the capital markets to create an appropriate capital base to produce an income stream from which payments can be made. This allows governments, businesses and individuals to manage their commercial and financial risks and operations more effectively.
Lloyds of London is the largest single insurance market in the world through which members operate in groups or syndicates.[2] Lloyds began in a coffee house set up Edward Lloyd in Tower Street around 1688 with a New Lloyd’s Coffee House being established in 1769. Lloyds operated out of the Royal Exchange building until it was destroyed by fire in 1838 and then moved to Leadenhall Street in 1928 and Lime Street in 1958. Its prestigious new Richard Rogers building at Number One Lime Street was opened in 1986.
Reinsurance allows issuers of insurance policies to take out separate cover either through Lloyds or through larger insurance companies the event that a claim is made on the underlying policy. This can ever be done on a specific contract (facultative) were general (treaty) basis. The largest reinsurance companies include Munich Re and Hanover Re in Germany, Swiss Re, SCOR in France, General Re and the Reinsurance Group of America in the US and Lloyd's in the UK.
[1] http://www.balticexchange.com.