i HOW THE GLOBAL FINANCIAL MARKETS REALLY WORK ii Praise for How the Global Financial Markets Really Work “An essential handbook for anyone hoping to understand the financial world of the 21st century.” William Kay, The Sunday Times ‘Money’ columnist, London “This book provides an easy-to-read and up–to-date overview of the players and products of the capital markets, explaining how and why things went so spectacularly wrong in the credit crunch.” Janette Rutterford, Professor of Financial Management, Open University Business School “An excellent introduction to financial markets. Wide-ranging, easy to read, and with a wealth of information for investors.” John Calverley, Head of Research, North America, Standard Chartered Bank, and author of When Bubbles Burst: Surviving the financial fallout “Alexander Davidson has provided a very useful overview of the structure and operation of the broad range of financial markets. This provides a frame- work in which the challenges and implications of the credit crunch can be explained.” Duncan McKenzie, Director of Economics, International Financial Services, London “A concise and readable commentary, particularly focused on making sense of recent events. Its scope is remarkably wide and the descriptions are well complemented by the glossary and other appendix materials.” Professor Stewart Hodges, Faculty of Finance, Cass Business School, London “Never has it been more important for all of us to understand how financial services work and this superb general guide deserves to be widely read. Alexander Davidson has done an excellent job in explaining how it all fits together and how the ‘City’ impacts the rest of society, and the world.” Lord Mayor of London, Alderman Ian Luder “The author provides a thorough analysis of the global financial markets and sets out in clear terms the interdependence of markets in the modern era. The book is a valuable aid for policymakers, campaigners with an interest in global financial markets, and students alike.” Mick McAteer, Director, The Financial Inclusion Centre, London iii HOW THE GLOBAL FINANCIAL MARKETS REALLY WORK The definitive guide to understanding international investment and money flows Alexander Davidson London and Philadelphia iv Publisher’s note Every possible effort has been made to ensure that the information contained in this book is accu- rate at the time of going to press, and the publishers and author cannot accept responsibility for any errors or omissions, however caused. No responsibility for loss or damage occasioned to any person acting, or refraining from action, as a result of the material in this publication can be accepted by the editor, the publisher or the author. First published in Great Britain and the United States in 2009 by Kogan Page Limited Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the prior permission in writ- ing of the publishers, or in the case of reprographic reproduction in accordance with the terms and licences issued by the CLA. Enquiries concerning reproduction outside these terms should be sent to the publishers at the undermentioned addresses: 120 Pentonville Road 525 South 4th Street, #241 London N1 9JN Philadelphia PA 19147 United Kingdom USA www.koganpage.com © Alexander Davidson, 2009 The right of Alexander Davidson to be identified as the author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN 978 0 7494 5393 0 The views expressed in this book are those of the author, and are not necessarily the same as those of Times Newspapers Ltd. British Library Cataloguing-in-Publication Data A CIP record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Davidson, Alexander. How the global financial markets really work : the definitive guide to understanding interna- tional investment and money flows / Alexander Davidson. p. cm. Includes index. ISBN 978-0-7494-5393-0 1. International finance. 2. Investments, Foreign. 3. Money market. 4. Capital market. I. Title. HG3881.D3287 2009 3329.042—dc22 2009014889 Typeset by Saxon Graphics Ltd, Derby Printed and bound in Great Britain by Thanet Press Ltd, Margate v LONDON PARIS BERLIN MADRID TURIN FIVE CAMPUSES - ONE ROUTE TO YOUR SUCCESS At ESCP Europe we understand how competitive the job market has become and how it’s never been more important to lead the race With our finely-tuned programmes taught across five European campuses, we offer a metropolitan and truly international education. Our London-based programmes: Master in European Business Master in Management (ranked 1st in the UK and 2nd worldwide*) Master in Marketing** Specialised Master in Finance Executive Education (EMBA ranked 19th worldwide*) A hands-on approach combining the latest thinking in management education, internships, and consultancies has made us one of the leading business schools in Europe. 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SaySay waswas oneone ofof thethe firstfirst greatgreat economists,economists, andand hishis understandingunderstanding ofof howhow individuals coordinate coordinate their planning through through the thhe institution of market exchangeexchange helpedhelped toto definedefine thethe discipline.discipline. ThisThis “Classical“Classical School”School” ofof economicseconomics andannd accompanyingaccompanying modelmodel ooff llaissez-faireaissez-faire has sincesince lostlost fafavourvour amongstamongst somesome commentators and intellectuals,intellectuals, but is little understoodunderstood.. However,However, if youyou talk to the entrepreneursentrepreneurs and investorsinnvestors that anticipated the currentcurrent financialfinancial crisiscrisis andand areare criticalcritical ofof thethe governmentgovernment interventionintervention thatthat has followed, you will find threethree important lessonslessons about freefree markets. Firstly,Firstly, marketsmarketts revealreveal newnew infinformationormation. It waswas the short sellers trading on theirtheir concernsconcerns aboutabout banksbanks thatthat wwereere provenproven right, and the regulatorsregulators who failed. failed. A holistic approach approach to financial regulation reggulation would realise realise that no public agencyagency can ever accumulate and act uuponpon the local and tacit knowledgeknowledge acrossaccross anan entireentire economy,economy, andand wouldwould appreciateappreciate thethe rolerole thatthat markets can play in bringing this information tto light. WWee could very quickly discoverdiscover the extent of a bank’sbank’s toxic assetsassets by allowing anyone withwith relevantrelevant informationinformation to tradetrade on it.it. ThisThis wwouldould ggiveive potentpotentialial whistleblowerswhistleblowers a voice that would actually be heaheard.rd. Companies such as Koch IndustriesIndustries and GoogleGoogle have pioneeredpioneered thet use of internalinternal predictionprediction markets to allow alllow executives to utilise the combined commbined wisdom of their employees.employees. One O of the key lessons is that the e people with private informationinformation arearre the ones who improveimprove marketmarket efficiency.efficiency. Secondly,Secondly, valuevalue comes throughthrough exchangeexchange..Th Thehe reason reason that socialism has ledled to economiceconommic chaoschaos whereverwherever itit hashas beenbeen triedt is because the market- advertisementadvertisement featurefeature vii clearing price of a good is not merely a technical problem that can be solved through statistical modelling. Prices can only be established when subjective valuations combine and two parties actually trade. The quantitative analysts on Wall Street failed to realise this, since their models used current market prices as estimates of the value of an asset. However, we only find out the real value when that asset is sold, and if there is a systemic event that compels many banks to sell at the same time, this model will have been hopelessly optimistic. Thirdly, central banks are not market institutions. In the UK, our monetary system is centrally planned by a nationalised bank which holds a monopoly over the issuance of currency. Each month, a committee meets to set the Bank rate of interest; if they cannot set it any lower, they resort to directly expanding the supply through quantitative easing. If this were any other industry, it would be viewed as the Soviet-style planning board that it is, and we would be duly sceptical about its ability to