Financial centers of power have shifted over time

What exactly is an international financial center?

From the earliest days of trade and commerce, international financial centers have been a fixture of economic life — convenient ports of call to facilitate the smooth, efficient exchange of goods and services. The towns along the ancient Silk Road connected Asian manufacturers of silks and spices with newfound demand among Europe’s urban classes. Readers of the ancient histories of maritime Mediterranean powers such as the Phoenicians and the Ionians know of the roles played by Tyre, Ephesus and other prosperous commercial city-states.

Innovation and revolution

The cities and regions over time that have truly left their mark as the most important international financial centers of their day, according to Michele Fratianni’s 2007 article in Social Science Research Network, all have one thing in common — they contributed to a deepening of the role of finance in their economies and to dramatic innovations in financial methods and instruments. The medieval principalities of Genoa, Florence and Venice were the commercial hubs of Europe from the 13th through the 17th centuries, specializing in various forms of trade throughout Europe and offering innovative financial services to lenders and borrowers. In 1407, the Genoese gave rise to the modern notion of a debt-for-equity swap with the creation of the Casa di San Giorgio, a single financial institution that consolidated all outstanding debt of the Republic of Genoa and gave investors an instrument that was relatively easily transferable and liquid as opposed to claims on diffuse, illiquid assets with high transaction costs.

Later, the antecedents of modern corporate finance emerged in 17th century Amsterdam and the Dutch East India and Dutch West India companies. In an arrangement familiar to all modern investors, as Fratianni notes, shareholders of these companies were able to buy and sell equity positions through an organized share trading mechanism, the Amsterdam Exchange. Today we take it for granted that if we, for example, buy 100 shares of IBM on the New York Stock Exchange, we can sell those 100 shares easily at any time we desire; however, organized share exchanges have only been a fixture of financial markets for the past 400 years or so.

The examples of 15th century Genoa and 17th century Amsterdam illustrate this important relationship between international financial centers and financial innovation. In their respective days, the Casa di San Giorgio and the Amsterdam Exchange were performing the crucial roles of enabling more efficient commerce through innovative financial instruments. The hallmarks of an efficient financial instrument, then as now, are: liquidity in the form of a deep pool of buyers and sellers; fungibility in the ease of transfer between one instrument and others like it with standardization of terms and conditions; and reliable, trustworthy market mechanisms through which to buy and sell. Over the course of the 18th and 19th centuries, the epicenters of innovation shifted from Amsterdam to London and then to New York. The Dow Jones Industrial Average, launched in 1896, continues today to serve as a bellwether for overall market performance — a shorthand measure for the direction and health of the economy.

The madness of crowds

In addition to their legacy of innovations that revolutionize finance and spur growth in international trade, financial centers almost invariably leave behind another legacy — the colorful tales of exuberance run amok that we all know as asset bubbles. It seems almost axiomatic that as financial markets become more accessible and the potential rewards therein more widely evident, popular euphoria sets in and runs rampant. Amsterdam, London and New York have all left their mark in this regard. In his classic “Extraordinary Popular Delusions and the Madness of Crowds,” author Charles Mackay wrote of the infamous Dutch “Tulipmania” of the 17th century and London’s South Sea Bubble a century later. Had Mackay lived to see the events of this decade, from the bursting of the dot-com bubble in 2000 to the meltdown in global credit markets today he would have no doubt been able to add considerably to the 96 pages of his 1841 treatise.

Eurodollars and the rise of offshore banking

International financial centers get their start when a solution presents itself to finance-related problems that businesses are experiencing. In the 1960s, the world’s major economies in North America and Western Europe were highly regulated with the presence of capital controls and ceilings on interest rates (for example, Regulation Q in the U.S., which capped the permissible rate on domestic dollar deposits). These restrictions led to U.S. financial institutions seeking new avenues for credit expansion. A solution presented itself in the form of the Eurodollar market — a market that presaged the rise of offshore banking in the 1970s and beyond.

The Eurodollar market (more properly Eurocurrency, to reflect the participation of a broad range of national currencies) allowed institutions in one market to raise funds elsewhere without being subject to the regulatory restrictions of the home market. This market grew in size from about $18 billion at the end of 1966 to $310 billion at the end of 1977, according to Ahmed Zoromé, writing for the International Monetary Fund. The original epicenter of the Euromarkets was London, but the robust growth in volume over this period prompted countries in other parts of the world, from Southeast Asia to the Caribbean and Latin America, to offer themselves as attractive destinations for Eurocurrency-related financial services, including banking, securities and insurance activities.

Anatomy of a Eurobond

The so-called Euromarket became, in fact, a global market interconnected by international financial centers performing specific functions. An example of a Euromarket transaction might be the following: a German auto manufacturer seeks to raise funds through medium-term corporate debt obligations. The company enlists the help of a London-headquartered diversified financial services firm to act as intermediary in underwriting the securities (which would be called Eurobonds or Euro MTNS for medium-term notes) and arranging the investment syndicate. The London-based intermediary will invite other financial firms — mostly from the U.S. and Western Europe but perhaps also from Japan, Hong Kong or Singapore — to act as a syndicate and place the securities with their investors (who will largely be institutions, such as insurance companies, pension funds, sovereign wealth funds and the like). A special purpose corporation will be formed in, for example, the Cayman Islands or British Virgin Islands and the securities will be issued through this entity bearing the full faith and credit — as evidenced by a rating applied by one or more international rating agencies such as Moody’s or Standard & Poor’s — of the German auto manufacturer.

Offshore finance, regulation and transparency

Of course, no marketplace is completely immune from unsavory practices and participants — wherever the potential for profit exists, so does the potential for mischief. But for the most part, the so-called offshore financial centers that have been part and parcel of the Euromarket phenomenon over the past 40 years have performed a legitimate service as an efficient conduit for global finance. It may sound suspect that the original motivation for the Eurodollar market back in the 1960s was the avoidance of capital controls in the home market — but on the other hand, according to Zoromé, the opportunity afforded by the Euromarkets relieved some of the pressure from what otherwise would have been a serious credit crunch, and eventually became indispensible to the rapid rise of global financial activity that characterized the 1980s and 1990s. In particular, the investor market for these activities is very much the domain of professionally managed investment institutions and highly sophisticated qualified individual buyers (QIBs) with both the knowledge and the financial means to assume the additional risks of a less-regulated market.

From globalization to global capital centers

If the rise of the Euromarkets in the 1960s and 1970s gave rise to the concept of offshore banking, then the phenomenon of globalization that started in the 1980s — from the exhortation of China’s Deng Xiaoping that “to get rich is glorious” to the dissolution of the Iron Curtain in Eastern Europe to the trade and currency liberalization of markets throughout Latin America — has spawned a new breed of international financial center. This new model is based on something that the traders of 15th century Venice and Genoa, 17th century Antwerp and Amsterdam, 18th century London and 19th century New York would have recognized in their day — natural geographic proximity to global centers of manufacturing and services. On a purchasing power parity (PPP) basis, the dynamic economies of China, India, Russia and Brazil have a combined gross domestic product slightly larger than that of the United States, according to the CIA World Factbook. Russia is the world’s fifth largest producer of electricity and its largest exporter of natural gas, while Qatar’s Financial Center Authority projects its 2010 production of liquefied natural gas (LNG) at 77 million tons per year will make it the world leader. India is a recognized world leader in high-level data analysis services.

In essence, much of the growth in the global economy today is happening in parts of

the world outside the U.S. and Western Europe. Companies doing business in these parts of the world are finding it advantageous to establish a local beachhead — a point of presence from which to pursue their competitive activities. This is the model that Hong Kong and then Singapore developed in the 1980s and 1990s — an efficient point of access for international businesses and financial institutions into the growing markets of China, India and elsewhere in the Asia Pacific region. More recently, the Gulf States economies of Dubai and Qatar are offering what in many ways are similar propositions to those of Hong Kong and Singapore — venues with developed profiles in a broad range of financial and business competences, an economically favorable, tax-advantaged environment with transparent and smart rather than cumbersome regulations, and an investment in education to increase the relevant skill sets of the local populations.

This model is a likely precursor to the next generation of international financial centers. Time has shown that the best of the breed — those financial centers that are the best in their time and place — may eventually cede their pre-eminence to others as the tectonic plates of finance collide and displace capital and opportunity from one venue to another. Amsterdam, for example, may no longer be the global center of finance, but it remains a thriving financial market with both a strong domestic financial market and a number of global leaders in diverse industries from banking to pharmaceuticals. London and New York both continue to sit atop the flow of global capital and attract legions of smart, talented young people to their locations each year. Every year, though, a little more of this capital will probably relocate to the growing marketplaces of Asia Pacific, Latin America, the Gulf States and Eastern Europe. Global capital centers will be as critical to these markets as their predecessors were in other days.