Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
[An edited version of this article first appeared as "Financial Centres Futures: Small Ponds Or Big Pools?", SIBOS 2008, WorldBanking (September 2008) pages 64-68.]
Assessing Financial Centres
The City of London regularly commissions research on financial centre competitiveness. The Global Financial Centres Index (GFCI) was first published in March 2007 (GFCI 1) to produce an indicative rating of the competitiveness of major financial centres. GFCI 2 (September 2007), GFCI 3 (March 2008) and GFCI 4 (September 2008) have been completed. GFCI 5, 6 & 7 have been planned.
But why study financial centres? Financial centres funnel investment toward innovation and growth. Vibrant, competitive financial centres give cities economic advantages in information, knowledge and access to capital. While financial centres do compete with one another, the competition is not a ‘zero sum’ game. A strong financial centre, whether domestic, niche, regional, international or global, connects the wider financial centre to the global financial community. Being part of the global financial network with other financial centres ensures that cities gain from global trade and growth. Inward and outward investment opportunities increase the wealth of financial centres and their citizens.
The GFCI enables financial centres to be ranked against each other and identifies the changing priorities and concerns of finance professionals. A continuous index based on instrumental factor analysis moved beyond snapshot reports to the use of a wide range of instrumental factors, a shorter and more direct questionnaire with a greater response rate, and more frequent updates for comparisons over time.
The aim of the GFCI is to improve understanding of the most influential factors in financial centre competitiveness by providing an ongoing rating system. The GFCI factors fall into five groups - People; the Business Environment; Market Access; Infrastructure and General Competitiveness. Each of the key indicators covers several aspects of competitiveness:
People factors assess the availability of good personnel, the flexibility of the labour market, business education and the development of ‘human capital’;
Business Environment looks at regulation, tax rates, levels of corruption, economic freedom and the ease of doing business. Too onerous a regulatory environment directly affects the competitiveness of a financial centre, while too lax an environment reduces trust;
Market Access examines the levels of securitisation, volume and value of trading in equities and bonds, as well as the clustering effect of having many firms involved in the financial services sector together in one centre;
Infrastructure is mainly concerned with the cost and availability of buildings and office space, as well as transportation;
General Competitiveness compares more general economic factors such as price levels, economic sentiment and how centres are perceived as places to live.
Horses For Courses
Financial centres can fulfil one or more of five different roles:
Global financial centres – there are only two centres that can reasonably claim to fulfil this role, London and New York City. Global financial centres have sufficient critical mass of financial services institutions to act as an intermediary, connecting international, national and regional financial services participants directly. An asset manager in Munich, for example, can trade in financial instruments directly with a broker in New York City without having to go via an intermediary in, for example, Frankfurt.
International financial centres conduct a significant volume of cross-border transactions – those transactions that involve at least two locations in different jurisdictions. Hong Kong, for example, is an international financial centre that is involved in a significant proportion of Asian financial transactions.
Niche financial centres are worldwide leaders in one sector; several centres score highly on the basis of being strong in one particular niche of financial services, such as Zurich for private banking or Hamilton (Bermuda) for reinsurance. Whilst these niche financial centres will almost certainly never rival London or New York City as global financial centres, they are often as strong as London or New York City within their own specialist area.
National financial centres conduct a significant proportion of a particular country’s financial business. Toronto, for example, is the national financial centre of Canada. Where there are multiple financial centres in a country, e.g. Canada, Australia, Germany or the USA, the situation is complicated. In Canada, for instance, the GFCI covers Toronto (ranked 15th), Montreal (ranked 30th) and Vancouver (ranked 33rd). All three are sizeable financial centres, but Toronto is the national centre. In countries where there are multiple financial centres, the national centre is frequently tied with foreign exchange connections.
Regional financial centres are defined here as centres that conduct a large proportion of regional business within one country. Chicago, as well as being an international centre is also a regional centre for the mid-western USA.
Over the course of four indices (two years) a few trends have emerged:
regulation (within the Business Environment factors) is the principal competitive differentiator and is frequently evaluated with the words “trust” or “mistrust”;
Hong Kong and Singapore threaten New York City and London in the next decade as the gap between them narrows;
Gulf State centres have risen strongly in the ratings;
off-shore centres perform increasingly well;
the top three cities becoming “…significantly more important over the next two to three years…” are believed to be Dubai, Shanghai, and Singapore.
In With The New
New financial centres get their start because existing financial centres don’t care about smaller markets. While the larger, older financial exchanges talk about “global liquidity pools”, the newer exchanges focus on helping their customers get better prices with lower transaction costs, e.g. India’s Multi Commodity Exchange. New exchanges are also quite innovative at finding new customer needs, e.g. Betfair as an online betting exchange is worth more than the London Stock Exchange, and is nine years old, not over 200. In a related vein, there is a plethora of “prediction markets” hoping to capitalize on “The Wisdom of Crowds”. InnoCentive (www.innocentive.com) is a new stock exchange that connects scientists and engineers (“solvers”) with cash prizes for finding solutions to corporate (“seekers”) technology problems. There are new social exchanges that are social in two senses (1) they promote more direct social interaction, (2) they are often socially responsible. Aside from the rapid growth of the carbon markets in Europe there are more direct social exchange with potential such as Kiva (www.kiva.org) a social exchange that helps people lend to small entrepreneurs in the developing world in order to help them escape poverty. Intriguingly, in the developed world too there are several analogous exchanges for people who want to lend directly to other people, e.g. the UK’s Zopa (www.zopa.com – a P2P/peer-to-peer social money lending service) or the USA’s Prosper (www.prosper.com – an online auction site for borrowers and lenders). Zopa and Prosper are really just first-world micro-finance organizations, emulating Muhammad Yunus’ Grameen Bank and its third-world lending in the developed world.
People want to lend and invest within their communities. The problem is that “community” is many things, ranging from lending to people with similar ethnic, gender or religious biases, to investing locally. Sure, every market starts small, and the most successful rise stratospherically, but an interesting thing to note is the resurgence of ‘locality’. In the UK, a host of regional financial centres died by the 1980’s as trading centered on London. In the USA a century ago there were hundreds of stock exchanges, but things consolidated on a handful of national platforms. This national consolidation is not just competitive success, or “liquidity begets liquidity”, it is frequently driven by regulatory or legislative forces that believe centralization, consolidation or size are important to regional or national success.
Often unremarked is the scale and organization of local barter networks or exchanges (e.g. www.nationaltradebanc.com or www.itex.com), but equally there are significant moves to create local exchanges for investors. In the UK, the regional development agency for the west midlands (i.e. the Birmingham area), Advantage West Midlands, has fought regulatory battles to get permission for a pilot project to build a local investment exchange, the InvestBX project (www.investbx.com). The basic idea is to promote investment opportunities in the region by matching local investors with local companies. It may sound strange, but it is hard to find local investment opportunities in a national or international environment. You can google investment opportunities half-a-world away, but not realize that the same opportunity might exist locally, around the corner from your house or office.
So how can you grow a successful financial centre? To oversimplify it, SPIN:
structure: basic infrastructure of good quality is essential – roads, railways, schools, airports, housing. With such choice in financial centres, the lifestyle must be good;
people and regulation: skills are required, but in a balanced regulatory environment. People care about finding other quality people when markets are booming. People care about the quality of regulation when markets aren’t booming;
information: while a formal stock exchange isn’t required, a “buzz” is. All marketplaces need prices, from a jumble sale to a derivatives exchange. Part of the difficulty the insurance markets face in catching up with the growth in other financial services is that, traditionally, insurers are poor at providing semi-transparent prices;
networking: financial centres need to be nexus points for many activities. Deals are inherently unstructured, or they could be automated. A tourist visit leads to a chance meeting; a conference on geology leads to a green tech investment; a finance student finds a job on a local train. Moreover, financial centres are inherently rated by people in other financial centres.
It is increasingly clear that one key characteristic often overlooked in building a financial centre is trust. London has long spoken about the ‘Wimbledon’ effect, i.e. the competition is held in London and the native player probably won’t win, but everybody trusts the judges. In financial centres this fair treatment is crucial. London has taken quite a few knocks recently in non-domiciled tax changes, treatment of foreign income, changes to the effectiveness of trust structures, increasing capital gains tax, altering visas and introducing identity cards. In isolation, these changes may be sensible, but the combined effect is destabilizing the faith of foreigners in London treating all comers fairly. The USA has numerous domestic firm advantages. Some European centres have rules that favour domestic firms in any legal tussle. Some Asian centres have ‘fair’ rules, but unfair application in practice. The dominant financial centres have always been those that treat outsiders fairly. In a way, that is really what fair regulation is about.
Hindsight Is The New Foresight
So what can we anticipate? First, many of the so-called third-world or developing economy micro-finance models seem equally appropriate in the developed world. The developed world has its poverty too. Moreover, if necessity is the mother of invention, look to the third-world for inspiration. So, expect more application of third-world ideas in first-world contexts, e.g. mobile-telephony-based exchange applications developed in Africa moving to the streets of New York City or London. This interaction should lead in turn to the blurring of financial centres roles and geographic spread.
Second, financial centres need to promote more social interaction. Too many financial centres believe that globalization should reduce social interaction. Actually, the more social interaction financial centres can provide, the more likely they are to keep their customers. Technology can help here, using geo-referencing and networking tools to create micro-clubs, but the human aspect is real people meeting other real people, not just cyber-bots transacting with avatars. So, expect to see as much investment directed towards social networking and tools, e.g. interest group meetings, institutes and research centres, conferences or magazines, opening borders and work permits, as towards trading technology investment.
Finally, creative destruction shall continue, and existing financial centres need to think more like publishing firms. In publishing, large publishers accept that among the numerous small new titles there will be some major successes. A successful large publisher needs an excellent scouting process that identifies winners early on, approaches them and successfully consolidates them before the competition. The largest publishers follow a “portfolio” model, not a corporate delivery model. It’s clear that many financial centres are already following a portfolio acquisition model. There are far too many exchange opportunities left, wherever risk or opportunity can be exchanged, direct peer-to-peer insurance, peer-to-peer pensions, property exchanges … for any existing financial centre to try and develop them all in-house. Just as many exchanges have abandoned the “mutual” model for the corporate model, so too do many financial centres need to move on and swap a top-down corporate model for a bio-diverse portfolio model.
Some of the new small ponds will attract enough liquidity to become great lakes. In turn, they will attract the attention of the biggest financial centres. Looking forward to GFCIs to come, the challenge for financial centres will remain, as ever, “to think global, act local, be social”.
Professor Michael Mainelli FCCA FSI leads Z/Yen Group, the City of London’s leading commercial think tank promoting societal advance through better finance and technology. Michael co-founded Z/Yen in 1994 after a career as a research scientist in aerospace & cartography then accountancy-firm partner. Michael’s financial clients include banks, exchanges and insurers. Michael has won a Smart Award for prediction systems, a Foresight Challenge award for financial research, been named UK IT Director of the Year and served on the board of Europe’s largest R&D organisation. Michael is Professor of Commerce at Gresham College, created the Farsight Award for long-term investment research, created the $15M London Accord ‘open source’ research cooperative into climate change economics, and created the Global Financial Centres Index.
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