Regulation and Regulators, 1993–2006

By the 1990s the combination of internal deregulation and globalization led to a spectacular growth in the value of financial transactions both inside countries and across borders. There was a commensurate increase in pressure on payment and settlement systems to cope with the huge volume and variety of transactions. All this was of concern to those who regulated financial systems around the world. The speed and extent of the changes taking place, assisted by the advances made in the technology of communication and data handling, forced regulators to search for new ways of coping with the consequences, as the methods of the past were becoming inadequate. Globalization meant that national boundaries could no longer define the parameters within which financial systems operated, as all became integrated into international flows of short-term money and long-term finance. The complexities arose not only from the process of globalization and technological change but also from the disappearance of the barriers that had long separated different components within national financial systems. Rather than serving separate communities banks and financial markets increasingly competed with each other. In the face of these enormous changes regulators turned to the megabanks as a safe and secure way of monitoring and policing global financial markets. There was an implicit belief that the size and sophistication of these megabanks had made them to big to fail or even require the central banks to play a role as lenders of last resort.

Trends, Events, and Centres, 1993–2006

At the beginning of the 1990s banks, exchanges, and regulators were all in a state of flux, facing a very uncertain future. The certainties of the past had been removed as internal and external barriers crumbled, destroying the world within which they had operated since the end of the Second World War. In its place the world was moving towards global 24-hour financial markets and an elite grouping of megabanks. These developments were driven by global economic integration, developments in technology, the retreat of government from policies favouring ownership and control, and the search by regulators for strategies that could cope with the end of compartmentalization. Though these trends continued in the 1990s and into the twenty-first century they faced numerous obstacles and experienced significant twists and turns that were instrumental in shaping the outcome. Even though barriers to international financial flows were reduced or removed the result was not a seamless global market, as major differences in language, cultures, laws, and taxes remained. These all contributed to the segregation of markets. Though many prophesied that the revolution in communications spelt the death of distance or the end of geography, when it came to the location of financial markets that ignored the fact that time was not absolute but relative. The effect was to generate a continued clustering of financial markets

Banks, Brokers, Bonds, and Currencies, 1970–92

After the Second World War governments prioritized banks over markets within both national and international financial systems. The result altered the balance between banks and financial markets firmly in the direction of the former. Banks responded by expanding, reaching a size and scale that allowed them to internalize financial transactions within a single organization. That position then changed from 1970 onwards with an end to the era of control and compartmentalization. The process of change involved the gradual removal of the national boundaries and segregated activities that had protected banks from competition. In this new world financial markets began to prosper. These included markets for stocks and bonds as well as the exponential growth of trading in foreign exchange as the regime of fixed exchange rates collapsed. This era saw the emergence of a new breed of megabanks that spanned the globe and engaged in all manner of financial activity. Serving their needs was a group of interdealer brokers who acted as intermediaries between these banks. The combination of the megabanks and the interdealer brokers undermined the ability of regulators to police both banks and financial markets through a policy of divide and rule.

Regulation and Regulators, 1970–92

Before 1970 regulators had relied on the principle of divide and rule as a way of keeping financial systems in order. What this meant in practice was that even in market-based economies authority was exercised behind national boundaries, aided by controls on international financial flows, and by insisting upon a degree of internal compartmentalization not only between banks and markets but also within the banking sector. By the 1970s it was becoming apparent that a growing proportion of financial activity was taking place away from those centres, markets, and institutions over which regulators could exercise some control. The result led governments to abandon formal controls and regulators to search for ways of supervising financial markets. Increasingly the solution was seen to lie with the megabanks as they had the capacity to monitor and police their own behaviour, and were closely supervised by central banks.

Commodities, Futures, Options, and Swaps, 1970–92

One of the most dynamic financial markets to appear after 1970 was the trading of derivatives. Prior to 1970 the fixed nature of both interest rates and exchange rates, because of government controls and central bank intervention, limited the need to cover risks in these areas. With the breakdown of the Bretton Woods system in the early 1970s both interest rates and exchange rates experienced rising volatility, forcing banks to turn to derivatives as one way to coping. Governments of countries also began relaxing the prohibition on the trading of futures contracts that had been introduced in the past as a way of coping with destabilizing speculation. The commodity exchanges responded to these opportunities by devising contracts that allowed users to cover risks in financial markets as had already been done for such products as wheat, copper, and, later, oil. Leading these developments were the Chicago commodity exchanges such as the Chicago Mercantile Exchange but numerous contracts were also traded in the Over-the-Counter (OTC) market, directly between banks or through interdealer brokers.

Afterword

The shock to the global financial system in 2020, caused by the coronavirus, provides is a test for the measures taken since the Global Financial Crisis of 2008. The coronavirus has caused a shock to the global economic system, disrupting both supply and demand, and this demands more direct government intervention than central banks are able to provide. Whereas the 2008 crisis was one centred on the global banking system that of 2020 was an event akin to a war, natural disaster, or a political revolution. In turn that had implications for the global financial system as it contained the potential to destabilize banks by threatening the solvency of those to whom they had made loans and extended credit. To forestall such an event central banks are called upon to act as lenders of last resort, particularly the Federal Reserve, as it was the only one capable of supplying the US$s on which all banks relied when making and receiving payments, and borrowing and lending, among themselves. From the outset that response appears to have learned lessons from the mistakes of the 2008 crisis, in terms of speed, scale, and co-ordination, while the global banking system is far more resilient.

Commodities and Derivatives, 1993–2006

Derivatives blossomed in volume and variety during the 1990s. Derivatives provided a means of insuring against fluctuations in prices, exchange rates, and interest rates, the default of borrowers, the collapse of issuers of securities, and the miscalculation of investors. In a world of uncertainty a derivatives contract could be used to guarantee a particular outcome regardless of the turn of events. Those guarantees underpinned countless decisions as they generated confidence that the risks being taken were predictable and manageable. Through the use of derivatives, buyers and sellers, borrowers and investors, savers and lenders, could experience the flexibility derived from liquid markets, combined with the returns generated by a long term commitment, without the rigidity imposed by government controls, business collusion, and the suppression of competition produced by division and compartmentalization. Derivatives offered a means of coping with the risks and volatility produced by open and competitive markets, where prices, exchange rates, and interest rates experienced wild fluctuations and counterparties defaulted on deals. For that reason derivatives were embraced by all ranging from regulators to speculators.

Bonds and Currencies, 2007–20

Though markets are normally associated with regulated institutions such as exchanges of far greater importance was that trading which took place outside them. Ranked among the largest and most active financial markets in the world were those involving fixed income financial instruments and currencies, where trading took place through direct contact between buyers and sellers, the intermediation of inter-dealer brokers and, increasingly, the use of electronic platforms that matched sales and purchases. These markets were essential tools used by banks in their constant adjustment of assets and liabilities across time and space, as well as type, or the lending and borrowing they did between each other so as to profitably employ the resources at their command. This was a world in flux that was pushing traditional exchanges and the voice brokers towards oblivion, though leaving a role for those who negotiated bespoke deals or handled complex products. That was the position on the eve of the Global Financial Crisis, and then resumed thereafter. The advance of the electronic trading platforms proved unstoppable, sweeping away all rivals that failed to embrace the revolution taking place.

Banks and Brokers, 2007–20

Before the crisis the megabanks had established themselves at the centre of the world’s financial system, transcending national boundaries and time zones as they extended their operations around the globe. These banks also spread themselves over a growing diversity of activities that destroyed the compartmentalized structures of the past.Such was their size, scale, and spread, and the structure of the business they conducted, that these banks were regarded as too-big-to-fail not only by those who worked for them, used them, and traded with them but also by the regulators responsible for supervising financial systems and the central banks tasked with preserving financial and monetary stability. It was this world that appeared to evaporate with the Global Financial Crisis. That turned out not to be the case. Though curbs were placed on the megabanks they turned out to be indispensible in an age of globalization and the only available mechanism through which regulators and central banks could exercise a degree of control over the financial system. What remained after the crisis was a small number of even more powerful US-based megabanks along with an equivalent group of US-based megafunds.

Equities and Exchanges, 1993–2006

By the 1990s the pressures on traditional stock exchanges were so intense that inertia was no longer an option. These pressures included the globalization of investment, deregulation, dismantling of capital controls, cheap and rapid communication, and powerful computing, The effect was to undermine the grip that exchanges had once exerted over national stock markets. No longer were the members of exchanges the filter through which buying and selling passed because of the control they exercised over access to both information and the market. Alternative means of trading stocks were proliferating, undermining and then destroying the exclusive privileges long enjoyed by those belonging to stock exchanges. Leading this attack on the power of stock exchanges were the megabanks. As these banks grew in scale and scope, extending their activities around the globe, they were either able to internalize many transactions or trade between themselves. In the process they cut out the exchanges, bypassing, and the charges and restrictions they imposed. There had long been an ambiguous relationship between banks and exchanges, as they were both rivals and heavy users. The combination of the megabanks, interdealer brokers, and electronic markets was rendering exchanges redundant in the 1990s, forcing them to respond through diversification and mergers.