ALL YOU NEED TO KNOW ABOUT THE CITY

Think of a typical market selling, say, fruit & veg. It’s an exciting, noisy, messy place. It starts early. The people who work in it have a sense of purpose. They all seem to know their jobs. There are a few nefarious-looking people lurking round the fringes.

They may not actually be crooks, but you wouldn’t put it past them. The City is exactly the same.

The difference is that when you go to the City you don’t buy fruit & veg or meat. You buy money. Or, more accurately, the use of money. This may seem a bit weird. After all, when you go to a market or a shop, you use money to buy the goods you want. So how come you buy the use of money in the City? And what do you use to pay for it? (Answer: money.)

I have a very simple mental picture for explaining the City and whenever I come across someone in the City, I slot them into this framework. Here it is.

A SIMPLE FRAMEWORK

Companies are the City’s customers. They’re the ones who come to the City for advice on how to raise funds and (often) what to do with those funds.

More often than not they will go and see a bank. Now the term ‘bank’ is much wider than the bank in the high street where you keep an account, as I’ll explain. But, for the time being, imagine banks as the market’s stallholders. These banks can be commercial, investment or merchant banks.

Behind the banks are the wholesalers, the people who provide the market with its produce to sell. They turn up in vans and lorries loaded with the stuff; in the case of the City, with the money that companies want. These are institutional investors. They provide the money that companies need.

Finally, there are the barrow-boys with trolleys who go racing around, moving produce from the wholesalers’ vans to the stalls, transferring produce between stalls and putting some of it back in the vans. These are the brokers. So:

* Companies are the customers
* Banks are the stall-holders
* Institutional investors are the wholesalers
* Brokers are the barrow-boys

Now, this isn’t a very sophisticated picture and in some respects it’s a bit wrong, but it’s a good starting point and by the time you’ve worked out its shortcomings you’ll know enough about the City to be able to discard it if you want to. But I’m going to stick with it for now and in this book. It still works for me.

HOW MONEY STARTED

But before we go any further, let’s look at the idea of money itself. Imagine a primitive world without money. You have to barter for what you want. Let’s say you grow grain but what you want is salt (to preserve meat and fish over winter). Instead of getting on with farming your crop you have to spend time finding someone who not only has salt but who wants grain in return. This is what economists call a ‘double coincidence of wants’. And that’s not the end of it. Having found that person you will only conclude a successful exchange if you can agree a price (how much grain for how much salt). One other problem: most activities don’t allow the stockpiling of value. If you kill mammoths, those surplus to requirements would go off before they could be eaten. Even if you grow grain, you’ll not be able to grow enough to tide you over in retirement, so you won’t be able to stop working.

As society developed, people used popular commodities such as sheep to pay for whatever they wanted to buy. But sheep are difficult to carry, don’t last forever, can’t be divided (you can’t give a leg of mutton in change as you can three pounds for a fiver) and some are bigger and healthier than others. Salt was also used – Droitwich salt (from Birmingham) was a unit of currency and the word ‘salary’ comes from the Latin for ‘salt money’ – which had the merit of being transportable, durable, divisible and standard. But it can still get wet, not everyone wants it all the time and you still need to agree the exchange rate.

Then people switched to precious metals such as silver and gold as currency. Currency provides a medium of exchange (in place of barter), a liquid store of value (it doesn’t go off so you can stockpile it for the future), a unit of account (whereas sheep don’t come in a standard size) and stability (it doesn’t go out of fashion). It provides, therefore, a standard of deferred payments (you can buy now and promise to pay later). But gold isn’t that portable and it isn’t so divisible. People entrusted their gold to goldsmiths who gave them a receipt. When a depositor wanted to pay someone else, he wouldn’t bother to go and get the gold: he’d simply hand over his receipt to the other for that person to claim the gold off the goldsmith. In practice it was much easier to leave the gold where it was and just exchange receipts. This is how money (paper notes) started. And the goldsmiths, knowing the gold would stay where it was could ‘lend it out’ by issuing further notes in respect of it, which is how banking started. (Incidentally, in some parts of Africa salt was worth more than gold.)

Nowadays we use coins and notes over gold because they are portable, uniform (which means that money is fungible – when you lend a friend a fiver, you don’t expect that identical note back), divisible, acceptable (in the old days, some people didn’t want sheep or salt) and durable (you can replace old coins and notes).

In fact the old idea that paper money should be backed by reserves of gold has disappeared. So, when you think about it, we use coins and notes because we have confidence in their value, not because they are a substitute for gold. Confidence (the sense that your money has value and you will get it back if you stick it in a bank) is critical to financial markets. Money is a funny thing when you think about it: a confidence trick.

FOREIGN EXCHANGE MARKET

I started by talking about the City as a market. In one very real sense the City really is a market where people buy and sell money. And that’s in something called the foreign exchange market or forex for short.

The forex market is where currencies are bought and sold. When you go on holiday you need to change pounds (sterling) into the currency of the place where you are going. When you come back you change back whatever is left over. Usually you do this by going to a bank or a currency changer like Thomas Cook. In exactly the same way, companies, banks and institutional investors need to change currencies.

Direct investment

Companies need to change currencies when they do business overseas. For instance, if a company has a customer in another country who pays in his local currency, the company needs to change that money back into its home currency. It might go further and set up a subsidiary in another country (or, for example, build a factory there). To do that it needs the local currency in order to pay the local builders to put up the factory. So it needs to change its money into the local currency. Then, when that local business starts to generate profit for it (in local currency), that profit needs to be changed back into the company’s home currency (called its currency of account) so that it can tot up its profit and loss at the end of the year. This sort of investment in another country by a company is called direct investment.

Indirect or portfolio investment

The other big users of the forex market are institutional investors (insurance companies, pension funds and asset managers – discussed in more detail in chapter 9). One of the things they do is invest in companies all over the world, by buying their shares on a stock exchange. This is called indirect investment (also known as portfolio investment). So when a UK institutional investor buys, say, shares in a Chinese company, this is called indirect investment in China. The Chinese company’s shares are likely to be listed in Shanghai or Hong Kong, so the UK institutional investor needs to change sterling into the Chinese or Hong Kong currency in order to buy those shares locally. And when it sells those shares, it needs to change the money back.

So, companies that go in for direct investment abroad and institutional investors that go in for indirect investment abroad use the forex market.

Virtual or OTC market

But the biggest users of the forex market – in fact they are the forex market – are banks, because they operate all over the world and make loans in many different currencies. The reason I say they are the forex market is because – and this may seem a bit strange at first – there is no actual forex market as such. There is no single place where currencies are traded. All forex trading is done over the phone and on computer screens. Forex traders in companies, banks and institutional investors call each other up to trade. Most trades are between banks, or between companies and banks, or institutional investors and banks. In other words, banks act as intermediaries – they stand in the middle of most transactions. This sort of market that does not have a central exchange or market place is often called an over-the-counter (OTC) market because those in it trade directly with each other, often using what are called ‘online trading platforms’ which are like websites.

Central banks

Governments are also big users of the forex market. Each country through its central bank (the state-owned bank that acts as regulator of that country’s interest rates) amasses reserves which it will hold in a combination of currencies including its own and those of the leading economies: the US dollar, for example, is the most widely held currency in the world. Governments may use those reserves, for instance, to buy their own currency in the market if it weakens. When they do this they are said to intervene in the forex market or to make an intervention. For more on this see chapter 12. It was in trying (and failing) to prop up sterling in 1992 that the Bank of England spent over £3 billion of its reserves buying pounds – see box below.

You may be thinking, but who says whether someone can trade forex or not? The answer is: anyone can trade forex provided someone else is prepared to trade with them. No bank, company or institutional investor is going to trade with anyone else unless they think they are creditworthy, in other words, unless they consider them big enough and safe enough to keep their side of the deal and pay over the money they’ve agreed to exchange. So if I claim to be a bank, no one is going to trade with me until they have heard of me and checked me out. And if they do that, they’ll discover I’m not a bank and won’t deal with me. In this way, the forex market is said to be self-regulating because no single government or regulatory body is in control of it.

Banks are sensitive to the risk of other banks defaulting ever since a German bank called Herstatt defaulted in 1974 owing over half a billion dollars in incomplete forex trades. Since other banks had entered into forex deals on the basis of those with Herstatt, the forex market came to a standstill and it took weeks to unravel banks’ positions.

This counterparty risk is known in the forex market, not unreasonably, as Herstatt risk. Over 150,000 forex trades take place around the world

George Soros and the ERM

The most famous forex trade in recent times was by George Soros in September 1992 when he sold sterling at a time when the UK government was trying to maintain its value in order to keep the UK within the European ERM (Exchange Rate Mechanism), a precursor to the euro as the single currency.

As the Bank of England used its reserves to buy sterling in the market, so Soros sold more and more. Eventually, the Bank of England called it a day, George Soros banked a profit rumoured to be around $1 billion, and the UK dropped out of the ERM. This date has gone down in the annals of the forex markets as Black Wednesday.