Embracing the New
“People here embrace new ways of thinking. There’s a willingness to innovate. It’s partly about business culture, and that’s why large US and international firms often have more trading desks here than in their home countries.”
– Paul Sizeland, Assistant Director Economic Development, City of London
The UK – specifically London’s financial markets – has some considerable structural advantages. For one, it’s the world’s most liquid market across a wide range of financial instruments.
“Innovation such as that involved in developing a carbon trading market takes liquidity. And that level of liquidity you find in London,” says Sizeland.
The UK also welcomes liquid investors into the financial system, offering a fund management location for sovereign wealth funds from countries as diverse as Kuwait and Singapore. Its open approach to international investment puts it in a strong position to capture a larger share of a sovereign wealth fund market forecast to reach US$10 trillion in assets under management by 2015.
The paradox of radical innovation is that it’s rooted in political and institutional stability. The UK’s liberal economy, stable political system and solid legal infrastructure allow it to optimise emerging trends.
It’s also home to the world's largest electronic exchange – the London International Financial Futures and Options Exchange (part of the NYSE Euronext Group). London dominates both securities trading and the global foreign exchange market.
The fact that regulation encourages rather than stifles innovation reduces the risk and potential cost associated with developing new products and approaches. That’s partly why London has often tried things before other financial markets pick them up and has been bullish about giving up innovations once they’ve passed their usefulness. It was the first to ditch on-floor trading, for instance.
Yet pro-innovation regulation, enterprise nerve and liquidity don’t sufficiently explain why London has outpaced most global financial capitals in developing financial vehicles.
Underpinning the UK’s status as a hub of financial services innovation is a super-skilled workforce sourced from the talent centres of the world. An emphasis on pulling in talent from wherever it’s found, combined with a domestic emphasis on professional qualifications, ensures that financial services people in the UK remain at the cutting edge of innovation and among the best in the world.
This nexus of talent-friendliness provides a world-class pool not only of liquidity but of expertise – and expertise attracts more expertise.
More broadly, he points to the emergence of the carbon trading market and its associated sub-markets. These include carbon finance, investment funds that invest in Kyoto-linked infrastructure projects, and voluntary offsetting products pioneered by financial services sector wizards.
“Carbon has become a whole diversified sub-industry,” says Duncan McKenzie, Director of Economics at International Financial Services London (IFSL) who has recently drafted a research report on the topic of Carbon markets in London.
“It’s a natural progression. Once you’ve invented a financial product, given the right conditions, it grows naturally.” Those “right conditions” include “expertise that other markets just don’t have”, McKenzie adds. “The key for the UK was in gaining first mover advantage from its voluntary UK Emissions Trading Scheme (ETS) that ran from 2002 to 2006.”
“The carbon market was constructed here,” says McKenzie, “and the expertise gained from UK ETS has enabled London to capture the lion’s share of trading in the EU Emissions trading Scheme that commenced in 2005. In 2007, 89% of exchange trading on EU ETS was transacted through the London-based Europe Climate Exchange (ECX). The world looks to us to source people and expertise for the carbon trading market.”
Since the launch of the London Carbon Trading Exchange in 2005, daily trading volumes have reached £40 million. “The carbon market was constructed here,” says Sizeland.
“People have been working on it for some time and now the expertise is focused here. The world looks to us to source people and expertise for the carbon trading market.”
- European capital of Islamic finance
Like the carbon trading market, the burgeoning market in Shariah-compliant (Islamic) finance is the result not of a British idea, but of an idea envisaged elsewhere and adapted to exploit the benefits of the UK’s liquid, open and proportionately regulated market.
Ernst & Young survey of investors cited in its most recent Islamic Funds and Investments Report (May 2008) that 90 per cent of investors identified the UK as their preferred location for Shariah-compliant funds, citing the pool of expertise as well as the UK’s stable political environment and legal framework.
Again, what innovators develop, financial services regulators encourage. The 2007 Budget introduced a new tax regime that will allow sukuk (Islamic bonds) to be traded on the same basis as conventional securities. London is home to the world’s first secondary Islamic bond market and Europe’s only licensed Islamic banks.
Regulatory flexibility has also enabled the development of takaful (Islamic insurance) market, with plans in the offing for a retakaful (reinsurance) counterpart.
- The home of alternative assets
Being able to build competitive advantage in new business environments is a vital skill. The UK has introduced innovations in private equity, hedge funds and derivatives.
Not least because of its status as the world’s most liquid market and a financial services culture that values credible risk and enterprise, the UK is home to Europe’s most developed venture capital markets. It accounts for 25 per cent of global private equity investment, and more than 50 per cent of the European venture capital market.
Another source of alternative asset expertise, the hedge fund industry, is worth US$1.75 billion globally, according to financial services specialists IFSL. London is its European capital with US$360 billion of assets under management – 79 per cent of European hedge fund assets and 21 per cent of the global market.
Expertise – and the size of the secondary market – account in large part for the UK’s strong record on innovative property finance, with pan-European and global deals structured from the City. More recently, the UK has led Europe in the market for property derivatives – a market underpinned by strong indices. Given the reliance of derivatives on credible data investors are prepared to trust – that is, market trust – the Government plays a supportive role that encourages enterprise.
Legislative changes in 2004 clarified tax issues and allowed derivatives to be treated as direct investments. At the same time, the Financial Services Authority allowed insurance firms to hold derivatives to ensure solvency.
The UK’s pioneering role in developing alternative asset classes and innovative investment vehicles indicates its role in developing not just new products but new ways of investing in them. After all, London isn’t just the world’s capital of new financial products; it’s also innovative in terms of how investors approach them.
“The UK is, and long has been, a centre for innovation both from the point of view of product innovation and portfolio investment,” says Sizeland.