DECEMBER/JANUARY 1986-1987 - VOLUME 7 - NUMBER 15 / VOLUME 8 - NUMBER 1
B R I T A I N ' S T W I L I G H T
Britain's Big Bang
by Jonathan Brown
LONDON, England - In 1986 deregulation swept through the London Stock Exchange - the market place for trading corporate equity shares and U.K. government securities. Deregulation culminated in the the Big Bang of October 27, which has dramatically changed both the exchange and its members.
During the past year the London stock exchange abolished a number of rules that had long restricted competition.
Prior to deregulation, membership on the stock exchange had been limited to relatively small partnerships engaged either in stock brokering - buying and selling securities on an agency basis for clients - or jobbing - making a market for stockbrokers in securities listed on the stock exchange.
In March 1986 the stock exchange eliminated its restrictions on ownership and management of its members by outside corporations, especially financial conglomerates. As 1986 draws to a close almost all of the larger members have been taken over by financial firms both domestic and foreign seeking to diversify. The Big Bang in October abolished fixed minimum commissions for buying and selling securilics and eliminated the prohibition against members functioning as both stockbrokers and jobbers.
The stock exchange had agreed to deregulation back in 1983 in order to end the threat of government anti-trust prosecution under the Restrictive Practices Act of 1956. A seven-year investigation of the stock exchange by the government's Office of Fair Trading had identified 173 anticompetitive practices.
The Thatcher Government's push to deregulate the stock exchange, however, reflects more than just a commitment to free markets. More important, it is part of a strategy to bolster London's position as the premier international financial center. London is the world's leading center for Eurocurrency deposits - bank deposits denominated in a currency other than that of the host country. Eurocurrency deposits, which generally escape the monetary policy regulations imposed on domestic deposits, are in reality a form of off-shore banking. London is the financial center that originates the largest share of international loans made by commercial banks. London is also recognized as the leader in one of the fastest growing sectors of international finance, the underwriting and trading of Eurobonds - bonds denominated in a currency other than that of the issuing corporation or currency. Finally, London is a major market for foreign exchange transactions and international insurance activities. All in all, a tremendous volume of cross-border financial transactions involving corporations, government, and wealthy individuals are routed through London.
London's role as a financial center does not depend on the strength of the U.K. economy or even the market share of U.K. financial institutions. For example, roughly 80 percent of international banking in London is conducted by non-British banks. The keys to London's success are the aggregation of financial expertise in the City, London's financial district, and the presence of a large number of foreign financial institutions.
Somewhat ironically, in view of all the fanfare associated with the Big Bang, the London Stock Exchange is relatively small by New York or Tokyo standards. In 1985 it had only 29 percent of the trading volume of the New York Stock Exchange and 38 percent of the trading volume of the Tokyo stock exchange. This is not surprising, however, since most equity securities traded on stock exchanges are securities issued by domestic corporations and the equity base of U.S. and Japanese industry far outweighs that of British industry.
What the Thatcher government hopes is that the Big Bang will enable London to capture the relatively small but rapidly growing market of internationally traded securities - equity securities of the world's largest corporations and debt securities of the world's more credit-worthy governments. By allowing the full integration of securities brokerage and market making with other financial activities, such as securities underwriting or commercial banking, the Thatcher government expects to make British financial institutions more powerful international competitors. More importantly, it hopes to encourage the world's most powerful financial conglomerates to conduct their international securities business in London.
Equally important - in regard to the current changes in London's securities markets - is the push by the Thatcher government for an across-the-board strengthening of investor protection laws. For many years, securities and investment activities have been less regulated from an investor protection perspective in the United Kingdom than in the United States. Beginning around 1980 London began to experience a substantial increase in investment and other financial scandals. In 1982 the London Police Commissioner reported that 96 major investment fraud cases with a combined loss of 100 million pounds were under investigation and observed that "the problem is likely to remain with us until legislation, regulation, and control is made more effective."
The case for stronger investor protections received an additional boost from the pending integration of securities brokerage and market making with other financial activities. Financial conglomeration is likely to increase conflicts of interest and consequently the need for investor protection.
After several years of debate Parliament in late 1986 enacted a major overhaul of investor protection laws. The Financial Services Act is intended to: (1) close loopholes in the coverage of investor protection laws; (2) establish a more comprehensive regulatory structure with enhanced enforcement powers; and (3) apply the same investor protection standards to a broad range of securities and investment activities, i.e., create a level playing field.
From a U.S. perspective, the Financial Services Act will provide a regulatory structure that involves a curious mix of statutory principles, agency discretion, and self-regulation. A new agency, the Securities and Investments Board (SIB), has been established to oversee investor protection regulation. The SIB will issue general conduct-of-business rules, authorize a variety of self-regulatory organizations (SRO's) for different
sectors of the securities and investment industry, and review rules issued by the SRO's. Separate SRO's will be authorized for: members of the stock exchange and Eurobond dealers; financial and commodity futures brokers and dealers; and brokers of pooled investment funds and life insurance policies.
The SIB is currently in the process of drafting conduct-ofbusiness rules which will address important issues including disclosure to investors, restrictions on marketing practices, the scope of duty to a client, and various safeguards against conflicts of interest. Although it is too early to tell how strong these rules will be or how vigorously they will be enforced, powerful financial industry sectors have already begun to lobby hard for exemptions or at least a watering down of the proposed rules. Eurobond dealers have warned that London could lose much of its share of the Eurobond market if the SIB does not relax some of its proposed rules.
The SIB has already backpedaled on its proposed rules for the marketing of pooled investment funds, such as unit trusts. The SIB has been sympathetic to an investor protection concept known as polarization under which a firm would have to choose between selling the investment products of a single company or acting as a genuinely independent broker who scans the market for the best possible investment product. The SIB had proposed that banks which offer investment advice to their customers - and thus have a duty to scan the market - could invest customer funds in an in-house unit trust only if it was "clearly better than" competitor unit trusts. After strong protest from the banking industry, the SIB changed the proposed standard from "clearly better than" to "at least as good as" competitor unit trusts.
The concurrence of the Big Bang and the Financial Services Act indicate that London is trying to walk a tightrope between financial permissiveness that will draw international financial business to London and investor protections that are adequate to maintain confidence in the integrity of London's financial market and also protect U.K. residents from investment abuses. Notwithstanding the Financial Services Act's call for a level playing field, a tiered system of investor protection is likely to emerge. Those with the greatest capacity to relocate to other financial centers, such as the Eurobond market traders, have more bargaining power to weaken investor protection regulations than those who have a domestic clientele, such as life insurance brokers. Clearly, the more internationally mobile traders are likely to whittle investor protection regulations down to the level minimally necessary to protect both market reputation and themselves in their dealings with each other. p
Jonathan Brown is the director of the Financial Institutions Accountability Project.