City and Business: Foreign innovators help the City to fat profits

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The Independent Online
MOST people view the City as something of an abstraction - not part of the real economy at all. If you do too, think again. According to a London Business School report commissioned as part of the City Research Project, the financial services industry now accounts for nearly a quarter of Britain's gross domestic product.

It's a characteristic Britain shares with Italy, where financial services are an equally high proportion of the national economy. The reasons, however, could hardly be more different. In Italy it is because the financial services industry is fat and inefficient; it employs huge numbers of paper- pushers and charges accordingly. In Britain it is because the City is internationally competitive, and highly innovative.

In the past 20 years, the percentage of GDP accounted for by financial services has grown from 13 per cent to more than 23 per cent, and in the past decade, growth in output from these services has accounted for half the total growth in GDP. Those who think the City isn't part of the real economy should wake up to the truth: it's become part of our lifeblood.

Despite the power of technology to switch business between financial centres, and the increasing globalisation of financial activity - factors that would tend to diminish the City's position - London has maintained and probably increased its share of the world market in recent years. The figures are inexact and difficult to quantify, but broadly speaking the City seems to have stayed ahead of the game. It's done so, however, not so much because of our own home- grown financial services industry but because of an influx of innovative foreign banks and securities houses.

In recent years much of the City's growth has come from derivative trading and here the likes of Bankers Trust, Swiss Bank Corporation and Goldman Sachs reign supreme. Our own investment banks barely get a look in.

I have to confess to being a great deal more ignorant of derivatives than I would like or ought to be. Some of these markets are little more than 10 years old, and yet the amounts of money being hedged, rehedged and hedged again in a seemingly never-ending spiral of computer-driven transactions have become almost beyond comprehension; in 1992 the foreign exchange options market alone was valued at dollars 5,000bn.

Even to those of us who believe we know a little about the City, the explosive growth of derivative trading has been hard to keep up with or understand. For many it represents a further decoupling of financial markets from underlying realities - a further stage in the City's abstraction from the real economy. These are markets that piggyback on other markets, that seem to have no underlying purpose other than to make their designers and masters vast amounts of money.

IN SEARCH of enlightenment, I asked Rodolfo Bogni, chief executive of Swiss Bank Corporation's London operation, to arrange a session for me with his derivatives people. SBC is a world leader in all the three main derivative product lines of interest rates, foreign exchange and equities.

Last year SBC's London operation is said by some City analysts to have made profits of pounds 600m, making it easily the most profitable investment bank in the City. When you ask Mr Bogni about such estimates he just smiles inscrutably. SBC is a global operation, he insists; it all depends on when and where the profits are recognised and booked. Whatever the truth, there's no doubt that SBC made staggering amounts of money out of derivative trading last year, and so did everyone else who's any good at it.

The first thing you notice about a Swiss Bank derivatives man is that generally speaking he doesn't wear a suit (except when giving the client the hard sell). It's all blue jeans and open-neck shirts, even the occasional ponytail and ear-ring. SBC inherited the tradition from O'Connor, a leading Chicago-based derivatives firm acquired three years ago, then imported it into Britain where it sticks out like a sore thumb in the City's stuffed-shirt environment; it's as clear a sign as any of the new taking over from the old.

In derivative markets, new products are created like confetti, and you have to move fast to stay ahead of the game. The shelf life of most derivatives is short; many of them are tailor-made to suit the customer's needs, and it's never long before they get superseded by something even cleverer.

A typical derivatives trader is generally young, well-paid, clever and unpretentious; he's bright, knows how to work computers, blinds with science and comes equipped with a mind-boggling array of bewildering terminology.

Just take the following drawn at random from SBC's Dictionary of Financial Risk Management, 255 pages of state-of-the-art phraseology for the late-20th century derivative trader. Floorlet: one of the interim period floors in a multiple period floor agreement. Delta hedge: a risk offsetting position that matches the market response of the base or underlying position over a narrow range of price or rate changes. Mambo combo: a combination of an in-the-money call and an in-the- money put, both long and both short. Nakadachi: see Saitori. Leptokurtosis: a property of a probability distribution that gives a higher peak, a thinner midrange, and fatter tails than a normal distribution (see also Kurtosis). And so on.

It's easy to mock. Most of these terms come from the US where they love that kind of thing; in Britain mumbo-jumbo of this sort only serves to enhance the impression of something that's done with mirrors, more illusion than reality.

SO WAS I convinced? Surprisingly I was - almost. A derivative market, the SBC people explained, is no different from any other market. For every company or portfolio manager that wants to get rid of a risk, there's someone else who wants to take it on, or that's the theory anyway. The function of derivative markets is to allow those two parties to come together and trade the risk. Thus with an equity option, the fastest-growing area of derivative trading, the portfolio manager will sell some of his upside in return for protection against the downside. That position will then be rehedged with counterparties who have different priorities. The same is true of a foreign exchange option. For every company that wants to sell pounds against the dollar in three months' time at the present exchange rate, there will be another wanting to buy them. Advanced computer systems are used to aggregate the risk. Clearly it would be impossible to match bargains exactly; the bank has some residual risk. But at any one time it can quantify that risk and stop it running out of control.

The danger is if the risk becomes unduly concentrated - if the intermediary bank takes too much of the risk on to its own books. Though it is vehemently denied, you half suspect the big derivative players must have risked a lot to make the profits they did last year - either that or they are charging clients through the nose.

Despite these lingering doubts, however, it's clear that derivative trading is going to carry on growing at a cracking pace; all it amounts to is a sophisticated way of managing risk, and commerce appears willing to pay a lot for this. The shame is that British players have been so slow on the uptake.

It's not just in derivative trading that the likes of SBC are breaking the mould. On Monday SBC is planning to hold an auction for the rump of the Trafalgar House rights issue, a move which has so infuriated the company's brokers, Cazenove and UBS Phillips & Drew, that they refused to have their names put at the bottom of the press release. Normally they would have expected to place the stock among favoured clients at a big discount. It's said that Cazenove has nicknamed Brian Keelan, the SBC man who dreamt up the auction idea, 'Barney Rubble', the character from the Flintstones. The way things are going, however, it's the British houses that are being left in the stone age.

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