T h e TABS Journal
British Financial Markets
By: Marian Klein
A
lthough much is known and published about financial markets in the United
States, investors know and understand less about overseas markets.
Numerous financial markets, similar to those in the United States, exist in foreign
countries. Although many of these markets tend to be relatively small and insignificant,
some markets, like those in the United Kingdom, are perhaps as influential as their
equivalent American markets.
For centuries, London has been celebrated as an international financial center.
Despite Britain’s weakened economic and political strength since the 1940’s (Baughn 4),
it still continues to be an influential and powerful financial market. This is mostly due to
its unrivaled variety of services and degree of financial expertise. In this article, I will
present four financial markets in the United Kingdom and will explain the framework,
procedures, and regulations in those markets as well as the similarities and differences
between these markets and those in the United States.
Equity Market
There are two main kinds of equity: preference shares and ordinary shares.
Preference shares bear a fixed rate of interest, and some, called participating preference
shares, also receive a fluctuating amount of the profits of the company. The shares have a
preference over the ordinary shares in that the interest on them must be distributed first
before any dividends are distributed to the ordinary shareholders. Unlike the preference
shares, the income from the ordinary shares is not fixed in any way. Instead, the
shareholders are entitled to whatever share of the profits the directors of the company
decide to distribute. (Revel 43, 44)
In addition to traditional equity, gilt-edged securities, those backed by the British
government, are also listed on the London Stock Exchange. Likewise, securities backed
by local U.K. authorities and securities issued by international organizations like the
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World Bank are also listed. However, these securities make up less than 20% of the stock
market, while it is the company securities that make up the greater part of the market
(Revel 58). As of 1995, the London Stock Exchange listed 2,078 domestic companies and
462 foreign companies (Levich 528). London is the center for trading foreign stocks, and
until recently, more foreign stocks were listed in London than in the United States
(Levich 528).
The London International Stock Exchange (ISE) is similar to all other stock
markets in that it can be divided into two main sections: the primary market and the
secondary market. The former raises new financial claims while the latter is involved in
the buying and selling of the “second hand” – or already existing – financial claims. The
secondary market is the largest market in the United Kingdom. One of its functions is to
help the primary market in pricing the new issues. An active secondary market with semi-
strong efficient markets will lead to the accurate pricing of new securities where share
prices correctly reflect the company’s prospects. (Pawley 203, 204)
The ISE has three tiers: the main market (the Official List) with over 200
domestic companies; the Unlisted Securities Market (USM) that allows for the entrance
of smaller companies into the market; and the OTC – the over-the-counter market. The
OTC market is an informal market that consists of trading in small business shares by a
group of brokers and licensed dealers to the public. (Pawley 205)
The London Stock Exchange differs from all other stock exchanges in one main
feature – the jobber system. A jobber is a dealer who acts as a chief in all dealings and is
instrumental in evening out dramatic fluctuations in price. London is unique in enforcing
an adamant separation between jobbers and brokers and in forbidding direct dealings
between brokers. (Revel 62)
In 1989, the ISE accounted for approximately thirty percent of European domestic
equity capitalization, the largest proportion of any European country. The ISE has also
shown a tremendous amount of growth in terms of market capitalization. In 1984, U.S.
markets had 54% of the total equity market capitalization, while the United Kingdom had
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only 15%. This spread however has significantly decreased, and by 1995 the U.K. had
22% of the market, while the U.S. had 39% (Levich 526).
Most major equity markets allow foreign companies to trade their stocks locally.
Nevertheless, each company must satisfy some sort of requirement that is demanded from
them by the domestic government. In the United States, each listed company, whether
domestic or foreign, must satisfy the demands of the Securities and Exchange
Commission (SEC). Because SEC rules are much stricter than those demanded in foreign
markets, foreign companies wishing to be listed in the United States must often release
more information than they are accustomed to doing at home.
The Securities and Investments Board (SIB) regulates international stock
exchanges. The SIB must recognize the exchange in order to allow the transfer of
securities. If an exchange is accredited, it becomes known as a Recognized Investment
Exchange (RIE). The Securities Association (TSA) allows firms to deal in gilts, domestic
and foreign equities, fixed interest stocks, options, and international bonds. (Pawley 226)
The Financial Services Act of 1986 prohibited market manipulation, insider
trading, and investment fraud. The act protects investors from these problems and assists
in bolstering investor confidence. Insider trading has been illegal in the United Kingdom
since 1980 when the Companies Act was passed. (Pawley 227) Similar to the United
States, investors are required to maintain an adequate amount of margin to protect against
large falls in share prices. The greater the risk and the more volatile the shares, the larger
the capital requirement.
Most of Europe permits open markets by practicing reciprocity. This means that
foreign companies do not have to restate their accounting reports into local GAAP
(Generally Accepted Accounting Principles) before their shares may be listed on their
markets. The London Stock Exchange practices a modified form of reciprocity where it
reserves the right to request additional accounting information in individual cases.
(Levich 558) Although London is stricter in this sense than other European markets, it is
still not as strict as the United States that requires all firms to report their accounting
statements in U.S. GAAP. This policy, mandated by the SEC, protects investors from
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potentially misleading and confusing foreign accounting statements, hence decreasing
investor risk. Furthermore, companies whose securities are quoted on the stock exchange
are expected to create a prospectus that complies with the legislation of the securities
market. Because the companies must formulate their goals and potential weaknesses,
investors – both domestic and foreign – will have a greater knowledge of the investment
profits or losses that they might be risking.
Two other characteristics of the equity market in Britain that are different from
those in the United States are transaction costs and the settlement period. Transaction
costs vary considerably between countries. The United States tax of .0033% is one of the
lowest in the world. The United Kingdom has a considerably larger tax of .5%, yet that is
still below the average of .64% in non-U.S. markets. The settlement period is the amount
of time it takes to make/receive payments and to obtain/deliver the securities. A shorter
settlement period is an attraction for sellers since it allows for a more rapid means of
raising cash. Conversely, a longer settlement period is a deterrent to investment. Before
1995, the United States had a settlement date of T+5 days, but since then has switched to
T+3. It takes longer in the U.K. to deliver securities, with a settlement date of T+5 days.
Before 1995 however, the United Kingdom’s settlement date was T+10 days. While
Britain’s settlement period is faster than those in the developing markets, it is
nevertheless behind most of Europe whose settlement date is T+3 days. (Levich 529,
531)
Like the United States, the equity market in the United Kingdom has evolved with
technology. The SEAQ-International (SEAQ-I) began in the London Stock Exchange in
1986. It is a screen-based, NASDAQ-style system, where designated market makers
distribute quotes and execute trades (Levich 557). As of 1991, a computerized paperless
system called TAURUS (Transfer and Automated Registration of Uncertified Stock) was
implemented in the ISE. This system carried the ISE from a paper-based system to an
electronical one, eliminating the need for share certificates and transfer forms.
Additionally, TAURUS solved the problem of a backlog of unsettled trades that at times
exceeded five billion pounds. (Pawley 220)
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The Financial Times Index is an index computed by the Financial Times to
measure U.K. Stock Exchange prices in the London Stock Exchange. The Financial
Times publishes several indexes in cooperation with the Institute of Actuaries, Faculty of
Actuaries, and the Stock Exchange. The indexes include the FT 300-share index (of the
30 leading shares), the Industrial Ordinary shares index, the 500-share index (of the 500
leading shares), and the All-Share index. (Walms ley 91)
Bond Market
In Britain, the central government, local authorities, and numerous companies
issue bonds. Those issued by the government and authorities are usually called “stock”,
while those issued by a company are called “debentures” or “loan stocks” (Revel 40).
There are two main classes of bonds – perpetual bonds and redeemable bonds.
Only local authorities might issue perpetual bonds, while the government can issue an
undated stock that has no final date by which it must be redeemed. Other types of stocks
traded are dated – they carry a date of redemption. Redeemable bonds usually have a
range of dates within which they may be redeemed. The borrower cannot redeem the
bond before the first date, but must redeem it before the last date. It would thus be
preferable for the borrower to have a range of redemption dates since he then has a
greater probability of selecting a relatively cheap moment at which to redeem the stock
and to replace it with another stock. On the other hand, lenders will prefer a narrower
range of redemption dates. (Revel 40-42)
Gilt-edged securities, commonly referred to as gilts, are sterling denominated
British government bonds issued by the Treasury. They are issued to fund the PSBR – the
United Kingdom’s Public Sector Borrowing Requirements. Gilts are fully guaranteed as
to interest and principle by the government. There are four categories of gilts -
1. Short – whose maturity is up to five years
2. Medium – from five to fifteen years
3. Long – greater than fifteen years
4. Undated – also called irredeemables since there is no repayment date.
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The size of a gilt issue is usually about one billion pounds. Nevertheless, the
minimum denomination in the secondary market is fifty to a hundred pounds, while the
maximum is one thousand to fifty thousand. (McLintock 170)
Like US Treasuries, gilts pay a semi-annual coupon and their prices are calculated
in 1/32 of a percentage point, rather than in 0.01 points as in most other markets. The
majority of gilts are standard fixed-rate bonds. Nevertheless, other popular gilts include
convertible gilts, created in the 1970’s, and floating-rate gilts that originated in 1994. The
floating-rate gilt market is a growing market whose issues are used for hedging purposes.
Convertible gilts have more than one potential maturity date. In some cases the
government has the option of an early redemption, while in other cases, the investor has
the opportunity of choosing the maturity date. For example, if the investor buys a short-
dated gilt he later has the option of converting into in a longer-dated paper. (Essex
143,144)
In 1986, the Bank of England undertook the reformation of the gilt market. Before
that time gilts were bought and sold wholesale on the floor of the London Stock
Exchange by jobbers and brokers who acted as intermediaries between the jobbers and
the investors. The Bank of England believed the system took advantage of investors and
so the Bank appointed primary dealers, who replaced the jobbers, and salespeople who
were to advise investors. The dealers are called GEMMs – gilt-edged market makers. The
GEMMs anonymously trade with each other using a screen-based service provided by
inter-dealer brokers (IDB). (Essex 138)
Other types of bonds include debenture bonds, unsecured loan stock, straight debt,
and convertibles. A debenture bond is secured against assets or revenues, while an
unsecured loan stock is unsecured and ranks behind the debenture bond. It nevertheless
ranks before the shareholders in the order of creditor claims. This definition is contrasted
to that in the United States where a bond is usually secured while a debenture is not. A
straight debt, often called a straight bond, is a fixed income bond with a fixed maturity
date at which the full principal is repaid. A convertible bond carries a fixed interest rate
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but provides the holder with the option to convert the bond into shares of the issuing
company’s stock at a predetermined rate of conversion. (McLintock 177)
Another type of bond is the Eurobond, which is denominated in a particular
currency and is usually issued simultaneously in the capital markets of several nations.
The Eurobond market is an international market for bonds that are not registered in any
country since there is no international authority with whom to register. Eurobonds are
issued in a different currency than the domestic currency of the country in which the
bond is being sold. The U.S. Dollar and the Deutschemark are the predominant currencies
used in the Eurobond market (Baughn 13).
The Eurobond market provides an alternative for borrowers who wish to obtain
new sources of funds and avoid the regulation and expense of floating the bond in the
domestic market. Eurobonds are negotiable, long-term debt instruments issued by
borrowers with high credit ratings. Since the borrower is able to quickly raise the
necessary funds with a minimum amount of expenses, the borrower will usually pay a
higher interest rate. Additionally, the investor will demand a higher return since there are
fewer safeguards in the unregulated Eurobond market. (Baughn 12)
Some characteristics that influence the price of a bond include:
1. Degrees of risk associated with the issuer. The government bonds have the
least amount of risk of default followed by the local authorities and then the
issuing company. Thus there will be price differentials between the three classes
of issuers.
2. The size of the bond issue also places additional risk on the bond. A larger
issue of stock is traded daily on the stock exchange and therefore has greater
liquidity. Conversely, smaller issues from a local authority or company bond are
less frequently traded and thus a seller might not easily find a purchaser in the
narrower market. (Revel 42)
The United Kingdom has benefited from the longest period of political stability,
enabling the country to claim that it has never defaulted on a government loan for the past
three hundred. Nevertheless, since World War II, the bond market has been damaged due
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to Britain’s policy of relying on inflation in order to reduce the national debt. Due to this
method, few small investors have purchased government bonds until the 1990’s when the
Bank of England began to reform the bond market. (Essex 123) It is quite possible that it
is because of this that Britain’s bond market, though sizeable, is nevertheless inferior to
the bond markets in Germany, Switzerland, and the United States.
Foreign Exchange Market
Foreign exchange markets, the world’s largest markets, are markets within which
participants buy and sell different currencies. Most of the trading takes place in only a
few currencies, such as the U.S. dollar, Japanese yen, German mark, and British pound
sterling. As of 1986, London had a greater percent of the foreign exchange market, with
about 45% of the market, while New York and Tokyo each had 25% of the market
(McLintock 19). Participants in the market include importers, who pay for goods in
foreign currencies; exporters, who may have foreign currency sales; brokers, who match
buying and selling orders; and commercial banks, which borrow in multiple currencies.
The foreign exchange markets are among the oldest in existence. Their
foundations are rooted in trade transactions and cross-border finance. The primary need
for the purchase of foreign currency arises from business transactions between residents
and foreign countries. This necessitates the requirement to make payments in foreign
currency. Foreign exchange markets are markets that convert issues of foreign money for
local units. Thus, banks that deal in foreign currency provide the perfect means to meet
customer claims.
The major players in the foreign exchange market are the banks that make up the
interbank market. In London, over 45% of the transactions undertaken by the banks are
inter-bank deals (McLintock 23). Banks participate in the market for three basic reasons.
First, banks need to service customer requirements. Second, banks have their own
financial transactions that involve foreign currencies. They must meet their own internal
requirements for current transactions or for hedging future transactions. Finally, banks
use the foreign exchange market to trade amongst themselves. (Baughn 333)
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Other dominant players in the foreign exchange market are the central banks,
which play a major role in intervention. According to the Bretton Woods Agreement of
1944, central banks were obligated to intervene in the foreign exchange markets at fixed
levels in order to preserve the established parities of their currencies against other major
currencies. This obligation is now overlooked since most currencies are allowed to float
freely against other currencies. Nevertheless, many central banks have retained the option
to intervene in the markets to influence the level of the exchange rates for their
currencies. (Baughn 335)
The foreign exchange has two markets – the wholesale market and the retail
market. In the wholesale market, banks in different centers deal with each other through
brokers, while in the retail market, customers approach their banks for foreign exchange
that come in the form of travelers’ checks or bank-notes. (Revel 51)
The foreign exchange process usually works in the following fashion. Either
banks trade between themselves or, for a fee, a broker brings two banks together to
transact a deal. A foreign exchange broker brings together professional buyers and sellers
of foreign exchange. There are hundreds of banks active in the international foreign
exchange market. Since it is time-consuming for each bank to search for the best
available price in the market, foreign exchange broker firms have been established. When
approached by a bank with an order to buy or sell, the broker will contact other banks and
will try to find a counter party.
All foreign currency transactions have the same characteristics – the exchange of
two currencies at an agreed exchange rate, the deal date, and value date. The deal date is
the date at which the transaction is agreed, while the value date is the date on which the
physical exchange occurs. (McLintock 20)
Exchange rates are rates for different currencies and their individual demand and
supply determine them. Factors affecting the rates include interest rates, inflation, and the
balance of payments position. Rates are quoted in terms of the spot rate – the current rate.
The United Kingdom uses the indirect quote that expresses the rate per unit of the home
currency. All other countries, however, use the direct quote, which defines the rate per
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unit of foreign currency. In addition, forward rates are also used for future dates. Quotes
include one, three, or six month forwards. (McLintock 20)
Since World War II and the Bretton Woods Agreement, the dollar has become the
world’s primary trading and financial currency, thereby fulfilling the role of the world’s
primary reserve currency. Thus, the majority of foreign exchange trading involves the
trading of individual currencies against the dollar. The central banks have traditionally
kept the bulk of their foreign exchange reserves in dollars. Due to the historic role of the
United Kingdom as a major financial center and trading country, sterling has remained an
important international currency even after its decline as the dominant currency of the
world’s international trading markets. Therefore, the British pound sterling still continues
to be actively traded in all the major financial centers. (Baughn 337)
One common foreign exchange transaction is the spot foreign exchange contract.
This contract is the foreign exchange transaction undertaken at the current rate of
exchange – the spot rate. The transaction is used to convert a sum in one currency into an
equivalent sum in another currency. It is usually undertaken by banks for the purpose of
inter-bank transactions to increase or decrease the balances of foreign currency in the
banks. In addition, the transaction may be used by a corporation or by a broker who has
to meet foreign currency obligations. The physical exchange of the currencies takes place
on the second working day from the deal date. This is the most common transaction on
the foreign exchange markets, representing about 70% of all transactions. (McLintock
23)
Another type of foreign exchange activity is a financial transaction. It has the
unique characteristic of almost always involving a swap, which is the simultaneous
purchase and sale of the same foreign currency for two different dates in time. (This is
also known as a straddle to commodity traders.) This type of transaction is performed for
the sake of increased marginal yields. (Baughn 327) However, since rates move at a fast
pace, only sophisticated and informed investors should execute such types of financial
transactions in order to avoid excessive losses.
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No actual physical market exists for foreign exchange. Instead, the markets are
unstructured and dealers and brokers transact over phone or computers. The foreign
exchange market is a 24-hour market, since one trading center is open while the other is
closed. Since business hours overlap around the world, it is not unusual for traders to
work around the clock.
The wholesale market is handled exclusively through telephones and tele-printers,
with direct telephone lines established between brokers and the main banks in London,
and tele-printer links between smaller banks in London and overseas banks. Deals are
usually concluded within a matter of seconds and are confirmed by the exchange of
written notes. The latest technological advance in communications is the Reuters Money
Dealing Service, which provides a high-speed computerized telex system. The new
system enables member banks to communicate with each other over computer terminals
at high speed (Baughn 336).
Futures Market
A futures contract refers to a deal in a commodity or financial instrument that is
made today for settlement at some future date. An organized futures market requires
some kind of standard contract and a clearinghouse through which payments are made.
Futures, like equities, require margin from investors as a check on their solvency. The
chief center of futures trading is the U.S. Commodities. Instruments traded include
copper, silver, gold, live hogs, and pork bellies. Financial instrument futures include U.S.
Treasury bills and bonds, Eurodollar deposits, and stock index futures. In London, futures
are traded on the London Metal Exchange (LME), the Baltic Exchange, and the London
International Financial Futures Exchange (LIFFE). The list of commodities includes
metals, rubber, cocoa, coffee, sugar, grain, and soybean oil. Included in the financial
instruments traded are sterling interest rate contracts, gilts, Eurodollar deposits, foreign
currencies, and the Stock Exchange Index. (Walsmely 100)
The London Metal Exchange (LME) is a major world center of metals trading.
The LME trades copper, silver, tin, lead, and zinc. It also organizes warehouse facilities
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for physical storage of metal. In contrast to the LME is the London Commodity
Exchange, which is a company responsible for the provision of services to the ‘soft’
(non-metal) commodity markets in London. Its members consist of the market
associations of the cocoa, coffee, petroleum, rubber, sugar, and wool markets. (Walmsley
132)
The primary function of the Baltic Exchange in London is the matching of
cargoes to ships and vice versa by a shipbroker. The Exchange, first established in 1744
under the name of Virginia and Baltic Coffee House, provides the only regulated
shipping market in the world. It is comprised of an international membership of 1500
individuals who represent over 670 companies virtually covering the entire shipping
spectrum. Ship owners, brokers, and commodity traders make up the core sector of the
network. (Baltic Exchange 1) The Baltic International Freight Futures and Options
Exchange (BIFFEX) is operated by the London Commodity Exchange and it offers ship
owners, charterers, traders, and brokers a means of protecting themselves against the
risks of dry bulk carrier freight rates. Risk control using futures trading is called hedging,
which is taking a position in a futures market as a substitute for a forward cash
transaction. If a charterer who has sold a commodity forward is afraid that freight rates
will rise, he will protect himself against a potential loss in profit by buying BIFFEX
futures contracts. If freight rates do rise the loss incurred will be offset by a profit on the
futures contract. (Baltic Exchange 18, 19)
The object of the London International Financial Futures Exchange (LIFFE) is to
provide facilities to enter into contracts for hedging due to possible changes in interest
rates, foreign currency rates of exchange, the price of government bonds, the price of
equity shares, and the price of agricultural and soft commodities (LIFFE Rules: Section
1.3.1). LIFFE began trading financial futures contracts for sterling, deutschemarks, and
yen against the dollar in 1982. It also began trading 20-year gilt-edged stock, and 3-
month time deposits in dollars and sterling (Walmsley 132). Under the Financial Services
Act of 1986, the Exchange must ensure proper investor protection and must attempt to
maintain a fair and orderly market (LIFFE Rules: Section 1.4.1). In order to trade on the
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Exchange a member must hold a permit issued by the Exchange, obtain a lease of a
permit from a member, or be granted a trading license (LIFFE Rules: Section 3.9.1).
The Financial Times Stock Exchange Index (FTSE) is an index of U.K. Stock
Exchange prices produced jointly by the Stock Exchange and the Financial Times. The
Index is continuously updated, minute-by-minute, to form the basis of futures trading on
LIFFE. In 1984, LIFFE introduced a contract based on FTSE. (Walmsley 91)
It is common practice for the futures market exchange to be organized so that
every contract traded on the floor of the exchange is executed with the clearinghouse as
counter party. The clearinghouse on LIFFE is the International Commodities Clearing
House, which is a London company that operates a clearing system for contracts traded
between members of LIFFE and the London commodity markets, as well as for the
Sydney Futures Exchange, the Australian Options Market, and the Hong Kong
Commodity Exchange. The International Commodities Clearing House was formerly
known as the London Produce Clearing House. It is now owned by the major British
clearing banks and the Standard Chartered Bank Ltd. (Walmsley 117)
The United Terminal Sugar Market Association administers the London Terminal
Sugar Market. The association provides standard contracts and clearing facilities for the
market via its alliance with International Commodities Clearing House and the London
Commodity Exchange. It is interesting to note that since the switch of the main sugar
contract from sterling to U.S. dollars, trading volume in the London market has declined,
with business being transferred to New York instead. (Walmsley 211)
In conclusion, this article has presented four financial markets in Britain.
Although this paper has shown that the country has an expansive infrastructure of
financial markets and London is at the center of many of these markets, other countries,
such as the United States, are becoming increasingly financially dominant. And while
Britain is well recognized for its long-standing tradition of financial prominence, it
cannot rely only on past merit. The United Kingdom must begin to challenge the United
States and win back some of its lost standing.
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