INTRODUCTION TO FINANCIAL MARKETS

An Overview of Financial Institutions

Shani ShamahAugust 2005

Some Definitions

What is a Financial Market?

• A financial market is an environment where various types of financial entities are bought and sold, such as equities, currencies, money, bonds, commodities and energy according to a set of rules

• Various derivatives of these base entities are also traded, for example, futures, options and swaps

• A market for a particular entity exists when there are enough buyers and sellers to influence its liquidity

• The more buyers and sellers, the more liquidity the market is likely to be

What is a Financial Security?

• Historically, markets have been physical places, for example a trading floor• Increasingly they are becoming electronic ‘places’ • Financial securities of all types including foreign exchange and money are

traded in the financial markets• A financial security is a contract between the buyer and seller of the security• This contract specifies future cash flows of the security, in terms of the

amount (fixed or variable), timing, how long the contract lasts (maturity) and the price the buyer pays the seller

OTC and Exchange Traded Markets

• There are two main types of financial market:

Exchanges – where standard products are traded and where the exchange is responsible for administration, clearing, settlement, some regulation and price distribution

Over-the-counter – where products traded tend to be non-standard and are designed to satisfy a particular financial need of one of the counterparties, for example a client who requests a broken date FRA.

Institutions

Types of Institutions - 1

• The term financial institution describes an organisation involved in some capacity in the financial markets

• Care is needed in the use of this term since “institution” is sometimes reserved for the “buy-side” of the market with the term “securities house” generally implying the “sell side”

• Their business goals and the instruments they trade determine to a large extent the roles of employees of that institution

• The financial market consists international and domestic institutions• International institutions deal with international loans, import/export finance,

and foreign exchange dealing• Domestic institutions deal with banking and monetary issues in their

respective countries (although some domestic institutions are becoming increasingly global)

Types of Institutions - 2

• A financial institution such as a bank, uses investors, depositors or its own funds to invest in financial assets such as equities or bonds to make profit

• Examples of institutions are:

Banks Building societies Broking firms Corporations Local authorities Fund management and insurance companies

Attributes of Institutions - 1• It is important to recognise the differences between institutions because the

objectives of the institutions will be a large factor in determining the goals and how they go about achieving them

• Institutions can differ greatly but they have common attributes• Revenues – earn revenues and can thus generate profits in a number of

different ways:

Market makers make a profit through the “turn” or “spread”, that is the difference between their bid and ask prices on any instrument

Traders make a profit through their skill in determining when and at what price to buy and sell

Brokers earn their revenues by charging commission on trades they complete for the clients – the “fills”

Fund managers earn fees, which in most cases are based on return or risk performance

Investment banks earn fees for underwriting new issues

Attributes of Institutions - 2

• Business Objectives – all organisations or institutions develop and try to meet business objectives that steer the activities of the organisation towards the achievement of certain goals. Some common objectives are to:

Satisfy clients and develop a good business relationship with them Increase earnings per share Increase market share Reduce costs Expand into new developments

• Trading – involves taking a position which is held when there is an imbalance between the sales and the purchases of an instrument

• Sales Activities – the sales role is the client-facing one in most security houses and is to drum up business with all clients, whether private, corporate or fund management companies

Attributes of Institutions - 3

• Cash Flow Management – most organisations often have temporary cash surpluses or deficits in their domestic currency or foreign currency which need to be managed

• Asset Management – asset allocation accounts for a significant number of the tasks of many players, especially portfolio and fund managers. The aim is to select the assets in which to invest, for a stipulated risk and return

• Risk Management – most financial institutions hold positions in the financial markets and are therefore exposed to a number of different types of risk. Risk is the probability that a loss may occur due to an unforeseen development in the market. It is a term used to cover all the tools and strategies managers use to minimise risk and avoid a possible financial loss on a position

• Limits – are net amounts which define the range within which an institution or trader can trade. These are set by the management in order to manage risk

Attributes of Institutions - 4

• Credit Risk / Counter Party Risk – the exposure to counterparties defaulting on a payment due, such as a bank becoming insolvent

• Country Risk / Sovereign Risk – the total exposure of investments in a particular country. Possible problems could include economic collapse, change to local regulations or government seizing or freezing assets

• Currency Risk – the potential losses due to adverse movements in exchange rates

• Inflation Risk – associated with the return on an investment being eroded by the loss of purchasing power

• Market Risk – the risk associated with losses due to the reduced value of investments, reduced income or increased costs due to interest rate movements

• Liquidity Risk – the risk of not being able to purchase or sell an instrument at the times desired

• Settlement Risk – the risk of a counterparty not settling on time. If the counterparty settles late, this means you either have a long or short position until the deal is settled

• Set counterparty limits

• Set country limits

• Setting limits on traders

• Investing in inflation-linked investments

• Hedge plus limits plus capital adequacy constraints

• Only participate in liquid markets

• Dealing with reputable market participants and using efficient settlement procedures

Banks

Definition of a Bank

• Amazingly, despite London being regarded as a major banking centre, no definition existed of a bank prior to 1979

• At that time a Banking Act was passed resulting from the secondary banking collapse of the 1970s

• The Act defined a bank and established a two-tier status• The largest banks, providing a comprehensive range of services were

known as “recognised” banks, whilst smaller and more specialised institutions were known as “licensed deposit takers”

• The 1979 Banking Act made it illegal for anybody not authorised to accept deposits form the general public

• The two-tier system was abolished by the Banking Act 1987 and now there is a single category of “authorised institutions” which can vary from Barclays Bank to the financial subsidiary of Marks and Spencer

What is a Bank?

• The term “bank” is incredibly misleading• Technically, a bank is any company that has a ‘banking licence’• Most countries have regulations governing the operation of banks• If a company is to operate as a bank, it must have a licence granted by the

government and conform to the regulations which apply to banks in that country

• Usually a banking licence is granted by a country’s central bank• For an institution to operate as a bank in the UK, originally, the Bank of

England supervised banks in the City, but that role is now carried out by the Financial Services Authority (FSA)

• There are three types of bank:

Commercial banks Investment banks Integrated (conglomerate, universal or bundled) banks which are the

first two together

Which Banks do What?

• 20 or 30 years ago the categories would have been different from those we have today – what may be accurate today may no longer seem so tomorrow

• The large commercial banking groups (including former building societies) such as Barclays, Lloyds TSB, HSBC (including Midland bank), RBS (including National Westminster), Halifax/Bank of Scotland

• Investment banks, with such well known names as Morgan Stanley, Goldman Sachs, Merrill Lynch, CFSB, Deutsche Bank (many former merchant banks, such as Schroders, Kleinwort Benson and S G Warburg)

• The original British overseas banks - such as Standard Chartered (now including former Grindlays Bank), HSBC all had large numbers of branches in overseas (mainly British, though not entirely British) territories

• Foreign banks operating in London through subsidiaries, branches or representative office – there are now about 447 in London

• Nationwide retail banks offering limited services such as savings, money transfer and other facilities, such as the supermarkets, the National Savings Bank and the National Girobank

Commercial Banks

• Are often called retail, clearing or commercial banks• Banks whose principle activities are taking deposits and lending money to

individuals and businesses• These banks have large cash flows and they aim to maximise their profits

by getting the largest possible spread between the rate at which they acquire money via deposits or through loans from other institutions, and the rate at which they lend money

• A commercial bank participates in the financial markets to manage the flow of cash in and out of the bank and to get the best return on the financial assets of the bank

• Lending to people is retail banking while lending to businesses and governments is wholesale banking

The British Banking Habit• Banking habits continue to change – though well over 90% of the adult population

now have a current account, the banks involved and the way in which payments are made are still developing

• The original “High Street” banks, with the familiar bank branches on street corners, have faced stiff competition from the building societies, supermarkets and retail chains offering banking services

• The number of High Street bank branches has dropped from close on 20,000 in 1990 to around 11,000 today

• Methods of payment have been changing rapidly too• While the cheque book both replaced cash and complemented it, cash dispensers,

especially the 25,000 plus now installed away from bank branches, have increasingly provided cash convenience

• By 2012 it is forecast that nearly three-quarters of the cash withdrawn by the public will be provided by cash machines

• Also, the use of plastic cards has been rising sharply and total plastic card spending per annum is now put at over £200 billion and is forecast to double by 2012

Investment Banks - 1

• An investment bank, or merchant bank as it is sometimes known in the UK, DO NOT invest – they do two things:

The underwriting and distribution of bond and share issues (primary market activity) and

The buying and selling of securities once they have been issued (secondary market activity)

• Fees charged for this service provide income for the investment bank• They also take trading positions using the assets of the company – this is

known as proprietary trading• The activities of underwriting and proprietary trading involve some risk

which must be managed by the investment bank

Distribution and Underwriting

• Investment banks help businesses that want to raise money• But their key role is distribution and underwriting the issue of securities

(meaning bonds and shares) by businesses• Distribution is the activity of finding buyers for securities – usually

institutional investors and other banks• All of this primary market activity is designed to get brand new securities

issued• It is also called “origination”• Underwriting – for a fee the bank will agree to buy any shares that no one

else wants • This way the business can rest assured that the floatation will be a success

and all the shares will be taken up (underwritten)

Secondary Market Activity

• Focuses on trading securities already in issue. It embraces:

Market making – which is the activity of being prepared to buy and sell a particular security, whereby the investment bank may promise as issuer that, in return for getting the mandate to underwrite and distribute its bonds, the bank will make a market in them, that is buy and sell them

This way, anyone who buys the bonds knows they can sell them again and anyone who may want to buy them knows where to get them from

Proprietary trading – which is where the bank buys and sell bonds for its own account, putting its own capital at risk to do so.

Trading – which is the generic term for secondary market activity and covers proprietary trading, market making and dealing in bonds on behalf of others (acting as a broker or intermediary)

Principal Investment and Private Equity

• There is one other activity that investment banks are increasingly involved in• This is where they use their own capital to buy long-term stakes in

businesses• For example – Nomura – whose principle investment unit was headed by

Guy Hands who then left to set-up Terra Firma, his own vehicle• It is similar to private equity where an investment bank will raise funds from

institutional investors to buy businesses• Where these businesses are public companies, these deals are called

public-to-private

Investment Banks - 2

• Investment banks are generally American in origin• Many of them developed their underwriting, distribution and trading

expertise from acting as brokers• This activity dates back to the 1850’s when there was massive need for

capital as companies expanded across the States• Every major city had its own stock exchange and brokers had branch offices

all over the country to reach and serve investors• This provided them with the ability to underwrite and distribute by having

close contact with a wide spread of investors• But those investors would only buy securities if they knew they could sell

them in the future• The most famous exception is Goldman Sachs, which used its knowledge of

markets and its skill at corporate finance / M&A to make its name

Why Investment Banks Developed

• The distinction between commercial and investment banks stems from the great Crash in America in 1929

• Banks used deposits to buy shares• When the stock market collapsed they were unable to pay back these

deposits and there was a massive run on the banking system• The Great Crash heralded the Depression of the 1930’s• To prevent this happening again, the US passed a piece of law known as

Glass-Steagall, which separated commercial banking from investment banking

• Banks could be one or the other but not both• Glass-Steagall was eventually cancelled in 1999 after lobbying by banks on

both sides of the divide but this has prompted greater regulation to prevent conflict of interest and more supervising of bank risk-taking

Universal Banks

• Universal, integrated or conglomerate banks in the world do everything• They are commercial banks, merchant banks and investment banks all

rolled into one• They have emerged over the last ten years or so, prompted by consolidation

in the banking industry – banks have taken over each other, leading to a smaller number of bigger banks

• This has been brought about by the need for more and more capital• The more capital a bank has to lend and underwrite, distribute and trade

securities, the more dominant its market position will be• That in turn is a reflection of the need for greater investment in technology,

itself driven by the need to use computers to track and model increasingly complex markets and to assist with risk management

Bancassurance

• Some banks also offer fund management, insurance and pension provision • Activities usually associated with institutional investors• The combination of banking and insurance is called Bancassurance• Leading European banks have been at the forefront of this• Possibly the best known was the merger in 1998 between Citibank and

Travelers – one a bank while the other an insurance company• They formed Citigroup - although the bulk of the Travelers insurance

business has now been sold off

Merchant Banks - 1

• Merchant banks were the old UK equivalent of US investment banks• They have all largely disappeared except for Lazard and Rothschild, which

are essentially small (boutique) investment banks• The term “merchant banking”, where an investment bank will use its own

money / capital to take a major stake on its own account in a deal, for example M&A deal

• Historically, UK merchant banks advised companies on how to raise money, what to use it for and on their finance strategy

• All of this used to be called Corporate Finance which is why in investment banks there are still corporate finance departments, which advise companies on M&A deals

• They were called merchant banks because they helped companies export overseas in the days of the British empire, an activity which is now called Trade Finance and is carried out by commercial banks

Merchant Banks - 2

• Their role in financing trade developed further• In due course they became financial advisers to companies, guiding them in

the raising of finance and in using that money to buy or merge with other companies

• They also developed a profitable niche in managing / investing customers’ money, an activity known as fund management or asset management

• However, over the past 20 years, they have lacked capital and have been bought up by commercial banks and merged with investment banks to form conglomerates

• Famous names that have disappeared include Kleinwort Benson, Morgan Grenfell, Hill Samuel and Barings

Citigroup

• At its heart is Citibank – a major American commercial bank• Which bought Salmon Brothers, an American investment bank• And bought Smith Barney, an American broker• As well as the corporate finance arm of British merchant bank Schroders• Then, Citigroup merged with US insurance group Travelers

JPMorgan Chase

• JPMorgan and Chase Manhattan were both leading US commercial banks which merged

• Chase had previously been taken over by Manufacturers Hanover• Which in turn previously merged with Chemical Bank• Chase had also bought British merchant bank and fund manager Robert

Fleming• And JP Morgan Chase also has within it the fund management arm of UK

merchant bank Schroders• It has also a joint venture with UK broker Cazenove

Union Bank of Switzerland

• Union Bank of Switzerland, a universal bank, has within it fellow Swiss commercial bank Swiss Bank Corp

• The UK merchant bank SG Warburg• An American broker and asset manger PaineWebber, which itself bought

Kidder Peabody• Plus Dillon Read, another American broker• Plus Phillips and Drew, a British broker and fund manager

Other Names

• Deutsche bank which bought Bankers Trust – US commercial bank, investment bank and fund manager

• Alex Brown (US broker) and Morgan Grenfell – UK merchant bank and fund manager

• Dresdner – German universal bank that includes UK merchant bank Kleinwort Benson which it merged with US boutique M&A specialist Wasserstein Perella

• Swiss commercial bank Credit Suisse, which bought Donaldson Lufkin & Jenrette and is referred to as CSFB

• Lazard and Rothschild both have significant French roots• UK universal banks HSBC – includes clearing bank Midland and merchant

bank Samuel Montagu • Barclays – includes Barclays Capital, an investment bank originally called

BZW and created out of de Zoete & Bevan and Durlacher (both London Stock Exchange members)

Making Sense of a Bank

• In order to make sense of a bank – given that they now do everything – find out:

Its principle or core activity - sometimes this may be geographic. For example, Standard Chartered is famous for its operations in East Asia

Its recent history, for instance commercial and retail bank Royal Bank of Scotland now owns UK clearer Natwest. HBOS is a merger between the former UK building society Halifax and the commercial and retail Bank of Scotland

Summary

Summary of Commercial Banking - 1

• The basis of commercial bank lending is matched funding – lending banks fund themselves in the inter-bank market and charge the borrower on a cost-plus basis

• The typical terms found in a bank loan are common to many types of funding

• A syndicated loan is one made to the same borrower on the same terms but by more than one back – coordinated by an arranger and a book runner – with syndicate members agreeing to share payments made by the borrower

Summary of Commercial Banking - 2

• Acquisition finance may be used by a company undertaking a massive takeover where it needs funds at short notice to complete the acquisition, with a view to refinancing subsequently

• Asset finance is a tax-efficient way of funding major pieces of kit used in a business where the bank buys and owns the equipment but as lessor leases it to a lessee for the equipment’s useful economic life in return for rental

• Project finance is limited or non-recourse finance where the banks look to the project’s eventual income stream to be repaid – it is used to fund complex infrastructure development in developing countries

Summary of Investment Banking - 1

• Investment banks originally underwrote and distributed bond issues (primary market activity) and then traded them in the secondary markets - as broker, market maker or for their own account

• Now investment banks do much more – most involving their own capital, such as proprietary trading and principal investment

• Consolidation – driven by the demands of capital, technology and compliance – has led to a small number of massive banks

• An investment bank acts as lead manager of a bond issue, assembles a syndicate of co-managers, is responsible for due diligence of the issuer and for documenting the issue and may also act as fiscal agent

Summary of Investment Banking - 2

• Privatisations through IPO’s have led to a convergence between the underwriting and distribution of bond and share issues

• The legal terms are similar to those found in loans• Bond issues are now dematerialised• Placings are a cost-effective way of distributing securities to a small number

of institutional investors• Vendor placings are used to provide the target's shareholders with a cash

alternative in an M&A deal

Central Banks

Central Banks - 1• Governments are involved in financial markets to implement their monetary

policy and to raise funds to finance the government's activities• Most governments participate in the financial markets via a central bank• These banks fulfil a number of functions such as:

Issuing bank notes Supervision of banks Management of exchange reserves Issuing Government debt

• The central bank in different countries has various names, for exmaple: The United State Federal Reserve System The Deutsche Bundesbank The Bank of England

Central Banks - 2

• The specific responsibilities of the bank of England as stated in the 1995 Report and Accounts:

• “…maintaining the stability of the financial system, both domestic and international; and seeking to ensure the effectiveness of the UK’s financial services sector”

• When central banks get involved in financial markets, it is usually to intervene either in the currency market to implement monetary policy by setting long or short-term interest rates

• Arguable, the central banks of the major economic powers have the most important influences on world interest rates

Bank of England

The Bank of England (BoE)

• The BoE remains at the centre of the City, physically and functionally• Its original Royal Charter, granted by King William and Queen Mary in 1694,

indicated that it should “ promote the public good and benefit our people”• The Bank now interprets this as maintaining the value of money, ensuring

the soundness of the financial system and promoting the efficiency and competitiveness of financial markets

• In 1694, when the BoE was established, its governing body, the Court of Directors, comprised a Governor, Deputy Governor and 24 directors

• When its was nationalised in 1946, the number of directors was reduced to 16

• The Bank was apparently under Treasury control between 1946 and 1998, since the Treasury could give the Bank such directions as it though necessary “in the public interest”

• The 1998 Act made the Bank responsible for maintaining price stability

Others Involved

Building Societies

• Building societies (known as Savings and Loans in America) are organisations which are set up to pool depositors funds so that they may be lent to other members to purchase property (real estate)

• In general they have a far smaller asset base than commercial banks, but they operate in a similar way, that is, they take deposits and make loans

• Traditionally they have restricted their lending to mortgages against a property

• Recently there has been a trend for building societies to merge and / or gain licences to become banks

Institutional Investors - 1

• If banks dominate the financial markets, it is institutional investors that make the financial markets possible

• The banks and the issuers they assist are the “sell side”• Institutional investors are the “buy side”• If banks attract attention, making a noise, showing off then….• Institutional investors tend to remain invisible• However, without them there would be no stock markets or bond markets

and much less activity in the foreign exchange market

Institutional Investors - 2

• That’s because it is institutional investors who:

Buy the bulk of all the bonds and shares that are issued Decide the fate of targets in M&A’s by accepting the bidder’s offer for

their share Invest in private equity funds for buyouts

• Institutional investors glide in and out of markets without anyone noticing because they don’ t want their act of buying or selling to move the price against them

• For this reason they are also big users of derivatives

Institutional Investors - 3

• Institutional investors are mountains of money• They are investment machines• And they get their money from us• We provide then with the money to invest through:

Insurance Pensions Savings

• Our insurance premiums go to insurance companies, while our pension contributions go to pension funds and our savings go to fund managers

Insurance

Insurance• Insurance is one of the City’s oldest activities and is about the sharing of

risks• Whether it’s the risk of losing your car, you house or your life, super tanker

or even an earth satellite, insurance provides a method of protection• Insurance works on the principle that not everyone will suffer the same

calamity at the same time • And that if we all make a contribution to a communal pool, there will be

adequate funds to pay out the main sufferer in full• Traces of maritime insurance in use in classical Greece and Rome give the

industry as lengthy an ancestry as money lending• But the real fundamentals of commercial insurance as we know it emerged

much later – marine in the 11th or 12th century, fire in the 17th century, life assurance in the 18th and 19th centuries and aviation and credit insurance in the 20th century

Insurance Companies - 1

• There are 2 types of insurance company:

Casualty (accident) insurers and Life assurers

• As with banking, there has been much consolidation in the insurance world and the divide between the 2 is cloudier than it was

• There have been mergers between the 2 types – creating what are known as composites – and there are insurers that do both

• Typical names include American International Group (AIG) and Aviva, which is one of the UK’s largest life assurer which is a merger of Commercial Union, General Accident and Norwich Union

Insurance Companies - 2

• Casualty (accident) insurers provide cover against accidents or loss of assets such as household insurance, car insurance, holiday insurance

• These are what people mean when talking about insurance companies• Life assurers are different• They provide insurance against long-term illness and death and thus

providing a lump sum for the dead person’s family• Since death is assured – it is a certain eventuality – these policies are

basically savings products• They allow individuals to set aside regular amounts of money on an ongoing

basis to build up a pot out of which the lump sum or regular support payments will be paid

Insurance Companies - 3

• The way both these types of insurer make their money is by investing the “premium income” – the contributions

• It is ongoing investment process that provides the reserves out of which they are able to pay claims

• Outside the world’s main financial centres there are cities where insurance companies are concentrated – Hartford Connecticut and Zurich are but 2

• Pension provision works on the same basis – you set aside money during your working life to pay for your retirement

• Some life insurers, such as Equitable Life, provide both life assurance and pensions

Lloyd’s of London

Lloyd’s of London - 1• Lloyds is unique - it is not an insurance company - it is a market• There is no equivalent to be found anywhere else in the world• The growing importance of London as a centre of trade after the English

Civil war led to a steady increase in the demand for insurance for ships and cargoes

• This coincided with the rise in popularity of coffee drinking – the first coffee house opened in 1652 and the number grew to hundreds by the end of the century

• The first known reference to Lloyd’s Coffee House was in 1688 when Edward Lloyd opened his coffee house in Tower Street for merchants to conduct their business

• His successors have fulfilled a similar function – the provision of a market place for insurance

• In 1871 the members of the Lloyd's underwriting community were incorporated by an Act of Parliament

Lloyd’s of London - 2• At the present time, Lloyd’s has a diverse range of capital providers –

investment institutions, specialist capital providers, international companies with limited liability and a limited number of individual “Names” who trade on an unlimited liability basis

• The capital provided in this way supports 66 syndicates, which vary is size

• In view of the losses suffered by Lloyd's (over £7 billion) in the 1980’s and early 1990’s it is important to realise what comprises Lloyd's basic security

• There are 4 links in the chain:

1. All premiums received are placed in trust 2. All members are required to hold additional capital at Lloyd’s 3. All other assets of unlimited liability members are available to meet

claims4. Lloyds itself operates a Central Fund

Pension Funds

Pension Funds - 1

• There’s a British custom that companies provide pensions for their employees after they retire

• It was 1 of the perks of employment and date from the days when people would spend their lives working for a single employer

• With some schemes, the employee made a contribution and the employer would match it

• With others, the employee might not have to make any contribution at all• Then when you retired you would receive, for as long as you lived, say two-

thirds of your final salary• Such schemes are called “defined benefits” schemes because you know

what sort of pension you will be getting• It’s specified or “defined”

Pension Funds - 2

• NOT ANY MORE!• Most of these schemes have closed to new members or converted to what’s

called “defined contributions” where what you get isn’t defined by reference to your final salary but it’s what you have to contribute that’s specified

• What you get when you retire will depend on how well those contributions have been invested in the meantime and how they have performed

• Pension funds rarely become household names• In fact, the largest pension funds are either in the public sector or are linked

to state-owned enterprises that have since been privatised• Examples in Britain include the pension funds of what were British Rail and

the Post Office – the latter was split when British Telecoms was privatised and its in-house fund manager, PosTel, was renamed Hermes and now manages money for other pension funds as well

Pension Funds - 3

• In Europe, one of the largest pension funds is that of the Dutch post office• One of the largest in the world is CalPERS – the California Public

Employees’ Retirement System – with assets of approximately $200 billion• Funds of this size invest in virtually everything, all over the world

Pension Funds - 4

• Over the past few years, the UK pension fund industry has become a mess for a number of reasons:

Poor investment returns over much of the 1990s, making it hard for pension funds to keep their promises to pensioners. This was made worse by companies taking pension contribution holidays in the 1980s when stock markets were doing well, meaning they didn’t put any money in because stock market returns were generating sufficient funds to meet pension liabilities

Changes in accounting standards which now require pension funds to account for future liabilities on a current basis – this means a fund must have assets now to meet pension liabilities in the future, no matter how far in the future those liabilities may be and notwithstanding the investment return the fund expects to generate in the meantime

Pension Funds - 5 This has led to pension fund deficits – to the extent that some M&A

deals have been called off when bidders have discovered the extent of a target’s pension fund deficit. For example Permira’s bid for WH Smith and Philip Green’s attempted takeover of Marks and Spencer

Action by the Government – in particular Gordon Brown’s imposition of a stealth tax on pension funds by removing a tax credit they received in respect of dividends from their investments in companies. The fact that the money last can’t be reinvested – that has been the real cost

Loss of confidence – principally through the Equitable Life debacle and the suggestion of regulatory incompetence. Equitable Life had for years advertised some of the best investment returns in the business, so attracting more premium income. But to achieve these it had been running down its reserves ad paying those out.

Other examples include the Maxwell scandal where newspaper owner Robert Maxwell pillaged the Mirror Group’s pension funds of £400 million to prop up the group’s financial position

The Stock Exchange

The Stock Exchange - 1

• The London Stock Exchange remains at the centre of the City and a stock market is at the heart of capitalism

• Over the 2 centuries since its beginning, the Stock exchange has had to adapt itself to the needs of investors and borrowers alike

• Its constitution has also had to reflect these changes• The original Deed of Settlement, which established the Stock Exchange in

1802, was revised in 1875 and following fundamental changes (so-called Big Bang) in 1986, under the Financial Services Act, was eventually exchanged for a new Memorandum and Articles of Association

• This was when the Stock Exchange became a private, limited company• 5 years later the Court of the Stock Exchange was replaced by a Board of

Directors and in July 2001, the Exchange itself became a plc and was listed on the main market

The Stock Exchange - 2

• The present London Stock Exchange can now be said to be offering these services:

It provides a market place for shares to be bought and sold and for new share issues to be offered

It ensures that the Exchange works efficiently fairly by policing the market’s mechanism

It vets new applicants for membership and ensures that existing members comply with its rules

• The worldwide role of the London Stock Exchange is not in dispute – more than 500 non-UK domiciled companies have been admitted to trading on its market from over 60 countries

• It has some £260 billion in investment assets under management

Big Bang – London 1986

• The UK government forced the London Stock Exchange to change• They had 3 concerns:

It said the Exchange was uncompetitive – charged the same commission

It said the Exchange was a club – no outsiders allowed They were concerned that the Exchange was undercapitalised

• So – the Exchange did a deal – it dismantled fixed commissions – large investors could negotiate smaller commissions for trades in large blocks

• It also opened up its member firms to external membership• Finally, the old distinction between jobber and broker was removed • ALL of this happened in one fell swoop – hence the term Big Bang

Fund Management

Fund Management in the City - 1

• Investors, large and small, domestic and foreign seek advice in the City• They have been doing so for centuries• But the scale of such advice and investment has only recently become fully

realised• Funds worth around £2,600 billion are now actively managed in the UK• About 60% of the funds are managed on behalf of UK institutional clients

such as insurance companies and pension funds• Of the total, nearly £700 billion is on behalf of overseas clients, of which

institutional clients make up a large majority• Funds under management in the UK are part of a worldwide industry

Fund Management in the City - 2

• Several features of these international funds stand out:

The world total is estimated at around $35 trillion – in terms of the source of these assets, the USA accounts for over 50%, followed by Japan with 10% and the UK 9%

In view of the UK’s high proportion of foreign assets under management, its international position is second only to the USA

Funds managed in the UK are larger than those managed in France and Germany combined

• Assets invested in insurance and pension funds account for the bulk of the UK institutional funds, followed by unit trust funds

Fund Managers

• Fund managers (also known as money managers, asset managers, wealth managers, investment managers and portfolio managers) specialise in investing money principally in securities (shares and bonds)

• They occur in 3 appearances:

Independent investment firms – such as Fidelity, Invesco, Henderson Global Investors

Banks – many of which have investment management arms – such as Citigroup Asset Management, Credit Suisse Asset Management and Merrill Lynch Investment Managers

Or which have bought independent boutiques, such as Newton (owned by Mellon Bank), Jupiter (owned by Commerzbank) and Framlington (51% owned by HSBC)

Hedge Funds

Hedge Funds

• One type of fund that has experienced an explosion in popularity is the hedge fund

• The term “hedge” is used in financial markets to mean to reduce a risk and it is usually achieved using derivatives

• For example – if I am going on holiday to America in 6 months time and I’m worried that the dollar many have gone up against sterling by then, I might buy the dollars now to hedge my position

• But that means I’ve tied my money up in dollars• Instead I could buy those dollars forward using a future, options or forward

contract so I only actually buy them in 6 months• The point is that I am doing something sensible to reduce a possible risk• Of course, companies do this the whole time

Use of Derivatives

• Hedge funds use derivatives but not to hedge• Instead they use derivatives to command much larger positions than they

could simply by investing in bonds or shares• In other words, to make large bets on market movements – for example in

the forex markets• The example of George Soros and his Quantum hedge fund that led the

attack on sterling by shorting it.• Hedge funds are reportedly behind the huge growth in forex volumes with

daily turnover of almost $2 trillion• They also account for as much as half of daily trading activity on the New

York Stock Exchange

Different from other Funds• Hedge funds differ from other types of funds in that they are relatively

unregulated, which means that they cannot be marketed to individuals (in fact they are targeted at wealthy individuals and institutional investors)

• They tend to be structured as partnerships and do not allow investors to move in and out – instead they tend to impose a lock-up of up to 5 years

• Hedge funds depend on the cult of the personality – a fund’s success or failure is down to the individual managing it

• Nor do they pursue conventional investment strategies – shorting is a favourite hedge fund activity

• Long-short hedge funds, for example, buy shares they consider undervalued and short those they consider overvalued

• Hedge funds often borrow shares or bonds from banks to cover their positions (stock lending) and they tend also to be highly leveraged (borrow heavily)

LTCM – a Hedge Fund Gone Wrong

• The combination of high leverage and the use of derivatives to increase market positions can be an explosive mixture in the hands of hedge fund managers

• Long-Term Capital Management went spectacularly bust in 1998• Its total losses were more than $4.5 billion• When it blew-up it had equity of just under $5 billion, borrowings of $125

billion and a derivative position of over $1 trillion• Unfortunately, LTCM had a large position in bonds when Russia defaulted –

its bond holdings collapsed in value• The risk to the markets was so great that the American Central Bank had to

step in and arrange a $3 billion plus bail-out to prevent a systemic market failure

• Yet between 1994 (when it started) and 1998, they had generated returns of 40% and it was led by some of the cleverest people on Wall Street

Brokers

Brokers

• Broking firms provide an intermediary service between buyers and sellers in the financial market

• For this service, they charge the buyer and the seller a commission on any deal they broke

• The more deals they broke, the greater the profit they make• Brokers are agents working within a broking firm who do not hold a position

in the market• They are not principals as they simply provide a matching service between

buyers and sellers

Others Involved

• Corporations – a company may have large and variable cash flows because of the nature of its business and they may need to buy or sell goods and services overseas or raise capital for large projects

• The management of the cash flow, assets and liabilities of a company is usually performed by the corporate treasury department

• Local Authorities – form part of the government structure, although they often participate in the financial markets independently of central banks

• They have large cash flows and often require short term funding or have a temporary surplus of funds