Why the City should fear the single currency

How the Euro might damage the City's position as Europe's leading Financial centre
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The Independent Online
Can the City hope to survive as Europe's pre eminent financial centre after monetary union? The general view in the City, shared and articulated by Eddie George, Governor of the Bank of England, is that it can; that it is so far ahead in terms of infrastructure and critical mass of Frankfurt, Paris and Milan that none of them is capable of catching up. Furthermore, the argument goes, the City's position might actually be enhanced if Britain stays out of the single currency; it would positively thrive as an entrepot between Europe and the rest of the world.

Is this all just complacency, or is London's position in financial markets indeed an unassailable one? Until quite recently I would have argued the latter, but I'm now I'm not so sure. It won't happen overnight, it may even take several decades, but I'm beginning to think that the City might one day get overtaken and eventually trounced.

This needs some explaining, for at the moment all the evidence rather points in the other direction.

Nearly all the big continental players with investment banking and capital market pretensions have chosen London as their European base for these activities. Because of language and cultural ties, the City also makes an obvious choice of location for US investment and commercial bankers. This creates a snow ball effect. If the Americans and Europeans chose London, then the Japanese and other Asian economies must follow in their wake. And so on and so forth.

So attractive has the City's formula become that a number of US investment bankers have gone beyond merely using London as a base for European business, and begun quietly shifting international operations, where location is unimportant, away from their financial centre of domicile and into London.

At the World Economic Forum in Davos, Switzerland, this week, one leading US investment banker admitted privately that he had become so disillusioned with the byzantine capital and regulatory requirements of New York, that significant parts of his bank's derivatives book would be moved to London over the next year.

After an exhaustive study of more than 50 possible alternative locations, including a number of offshore centres, he had concluded that the City had the most attractive combination of regulatory requirements and trading infrastructure anywhere in the world.

Does that mean, then, that foreigners come to London because of its relative lack of regulation compared to rivals? Not at all, he insisted. This was not an attempt to escape regulation. But he did believe London was more in tune with and adapted to the needs of practitioners. He also liked the way City regulation was being consolidated into a single organisation, the Financial Services Authority, which he believed mirrored trends in the market place.

The decision, moreover, had been entirely uninfluenced by the approach of the single currency, or any kind of a judgement on whether Britain would be in or out. Trading financial instruments is a "virtual" activity which could as easily be located on the other side of the moon as London, Frankfurt or New York provided it had a phone line and a computer terminal.

All this would rather back the view that the City's position is safe. So long as London remains a groovy place to live, and as important, its tax regime relatively benign, the foreigner will continue to flock in. Others have compared its position to that of the Wimbledon tennis tournament. This is a good parallel if an inexact one. The event and place is quintessentially English, but virtually all the players are foreign and they love playing here. As a result, Wimbledon remains the most prestigious tournament in the world, despite our lack of players of international stature.

I suspect, however, that this is also where London's greatest weakness as a financial centre lies. At the moment the City prospers as an international market place almost wholly divorced from the rest of the UK economy. Most of what happens there in terms of securities and foreign exchange dealing is largely irrelevant to the rest of the country.

That's not to say the vast flows of international capital that run through the City don't have an effect on the UK economy. They do; because the City is pivotal to the way capital is allocated nationally and internationally, it is a far more powerful force in the land than Gordon Brown and the Government. But in the sense that this trading of capital could be conducted from almost anywhere in the world and still have the same effect, it is not relevant to the lives of most ordinary people. The same is obviously not true of a manufacturing plant or a street market.

All this makes the City quite unlike the world's other two main financial centres - New York and Tokyo. Both of these centres exist primarily for the purpose of servicing the vast domestic economies from which they spring. The City is different. Think of New York and the image that springs to mind is of a tiny head on top of the Arnold Schwarzenigger type body of the US domestic economy. Think of the City and what you have is a vast head on top of a puny and dispensable little body.

Lying just across the Channel, however is the Continent, soon to be united by the single currency. While the euro looked like being a currency confined to just France, Germany, Austria and the Benelux countries, the City could have carried on much as before thriving as an offshore centre for Anglo- Saxon speculators. But now it looks as if the single currency will be launched in January next year on a much wider basis, with 11 or more countries. An economic unit potentially far more powerful than Japan or even the US will come into existence and it will need a comparable capital markets infrastructure to service it.

It is possible that the City will somehow or other manage to graft itself onto this giant new single European body. That becomes less likely if Britain isn't in at the start of the single currency, but the exercise may be impossible anyway. All depends on the extent to which the euro establishes itself as a viable alternative reserve currency and store of value to the dollar. To do so it must create an integrated capital markets infrastructure with comparable liquidity to that of the US. That means primarily an integrated debt market capable of attracting Japanese and other international capital on the same scale as New York.

I hesitate to pontificate about a field I am no expert on, so I will let Howard Lutnick, chief executive of the specialist New York primary dealer, Cantor Fitzgerald, do the talking for me. According to Mr Lutnick, the creation of such a market depends vitally on establishing a benchmark instrument about which all others can trade.

In the US this instrument is the Treasury long bond. Whichever financial centre manages to lay claim to the benchmark, be it London, Frankfurt, Paris on Milan, will eventually inherit the crown jewels. Trading will naturally gravitate to this centre and banks will therefore want to locate there. Corporate finance, forex, equity, futures trading and all the other things you associate with a major financial centre would follow in their wake.

Since the issuer most likely to create this benchmark is either Germany or France, the City in this scenario is in a perilous position. What's to stop the City seizing this benchmark where ever it is created and using it to its own purposes? For the answer look no further than this week's news that Frankfurt has finally overtaken London in the most traded derivatives contract in Europe, the German 10 year Government bond future. Germany, in other words, has claimed back its inheritance and it will fight tooth and nail not to lose it again. The City's best hope of retaining its present position long term, then, is if the euro is a disaster or fails to create the benchmark instrument Mr Lutnick talks of. In those circumstances, London becomes the default centre. It would be foolish to count on that happening, however.