The Foreign Exchange Market of London: Development Since 1900 (Routledge Explorations in Economic History)

The Foreign Exchange Market of London Foreign exchange is big business in the City of London. At the start of the twenty-first century, turnover on the London foreign exchange market averaged a staggering $504 billion a day. It has not always been so. A hundred years ago, the London foreign exchange market played second fiddle to more important centres in New York, Paris and Berlin. This illuminating volume tells the history of this successful market in detail for the first time, examining the factors that led to the transformation of London’s foreign exchange market from a backwater into the world’s pre-eminent currency trading centre. An assessment is made of the contributions made by the key players, including banks, brokers and the Bank of England. The behaviour of exchange rates is noted and the influence of currency changes on trading conditions is evaluated. An analysis is made, based on official archive material, of the operation of the market during the two World Wars and of the effect of exchange controls on post-1945 progress of foreign exchange trading. Account is taken of the late twentieth-century IT revolution and the outlook for the London market is evaluated in the light of the key changes that have been brought about recently by electronic brokerage and Internet trading. Useful to analysts and of interest to those studying exchange and the economics of currency trading, this entertaining book sheds new light on the development of a global market powerhouse. John Atkin retired as an economic adviser for Citibank in 2000 after a 32-year career. A former Honorary Visiting Fellow at Cass Business School, he is the author of British Overseas Investment 1918–31 (Arno Press, 1977) and EMU: Challenge and Change (Thorogood, 1998). In addition, he has published articles in journals and newspapers including the Economic History Review, the Guardian and the Independent.

Routledge explorations in economic history 1 Economic Ideas and Government Policy Contributions to contemporary economic history Sir Alec Cairncross 2 The Organization of Labour Markets Modernity, culture and governance in Germany, Sweden, Britain and Japan Bo Stråth 3 Currency Convertibility The gold standard and beyond Edited by Jorge Braga de Macedo, Barry Eichengreen and Jaime Reis 4 Britain’s Place in the World A historical enquiry into import controls 1945–1960 Alan S.Milward and George Brennan 5 France and the International Economy From Vichy to the Treaty of Rome Frances M.B.Lynch 6 Monetary Standards and Exchange Rates M.C.Marcuzzo, L.Officer and A.Rosselli 7 Production Efficiency in Domesday England, 1086 John McDonald 8 Free Trade and its Reception 1815–1960 Freedom and trade: volume I Edited by Andrew Marrison 9 Conceiving Companies Joint-stock politics in Victorian England Timothy L.Alborn 10 The British Industrial Decline Reconsidered Edited by Jean-Pierre Dormois and Michael Dintenfass 11 The Conservatives and Industrial Efficiency, 1951–1964 Thirteen wasted years?

Nick Tiratsoo and Jim Tomlinson 12 Pacific Centuries Pacific and Pacific Rim economic history since the 16th century Edited by Dennis O.Flynn, Lionel Frost and A.J.H.Latham 13 The Premodern Chinese Economy Structural equilibrium and capitalist sterility Gang Deng 14 The Role of Banks in Monitoring Firms The case of the crédit mobilier Elisabeth Paulet 15 Management of the National Debt in the United Kingdom, 1900–1932 Jeremy Wormell 16 An Economic History of Sweden Lars Magnusson 17 Freedom and Growth The rise of states and markets in Europe, 1300–1750 S.R.Epstein 18 The Mediterranean Response to Globalization Before 1950 Sevket Pamuk and Jeffrey G.Williamson 19 Production and Consumption in English Households 1600–1750 Mark Overton, Jane Whittle, Darron Dean and Andrew Hann 20 Governance, The State, Regulation and Industrial Relations Ian Clark 21 Early Modern Capitalism Economic and social change in Europe 1400–1800 Edited by Maarten Prak 22 An Economic History of London, 1800–1914 Michael Ball and David Sunderland 23 The Origins of National Financial Systems Alexander Gerschenkron reconsidered Edited by Douglas J.Forsyth and Daniel Verdier 24 The Russian Revolutionary Economy, 1890–1940

Ideas, debates and alternatives Vincent Barnett 25 Land Rights, Ethno Nationality and Sovereignty in History Edited by Stanley L.Engerman and Jacob Metzer 26 An Economic History of Film Edited by John Sedgwick and Mike Pokorny 27 The Foreign Exchange Market of London Development since 1900 John Atkin

The Foreign Exchange Market of London Development since 1900

John Atkin

LONDON AND NEW YORK

First published 2005 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Ave, New York, NY 10016 Routledge is an imprint of the Taylor & Francis Group This edition published in the Taylor & Francis e-Library, 2005. To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk. © 2005 John Atkin All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalog record for this book has been requested ISBN 0-203-32269-X Master e-book ISBN

ISBN 0-415-34901-X (Print Edition)

To J, J & T

…this subject of foreign exchange is one I know very little about, and I believe very few people do know anything about it. Indeed, I have read that only one person knows the real arcana of foreign exchanges, and he is in a lunatic asylum. (Lt-Col Hurst, speech in House of Commons, 21 December 1920)

Contents

1 2 3 4 5 6 7 8

Acknowledgements Abbreviations

xii xiii

Introduction The somnolent years 1900–14 Innocence lost 1914–18 Tom Tiddler’s ground 1918–31 Off gold and into the Bank 1931–39 War and peace 1939–51 Regaining lost ground 1951–72 Innovation and deregulation 1972–86 On top of the world 1986–2003

1 5 23 37 58 76 101 124 148

Notes Bibliography Index

178 193 198

Acknowledgements I am grateful to the Bank of England; Guildhall Library, Corporation of London; Deutsche Bank (for Morgan Grenfell records); Dresdner Kleinwort Wasserstein (for Kleinwort Sons & Co records); HSBC (for Midland Bank archives); and to Euromoney for granting me permission to use material over which they hold copyright. Much of my career as an economist with a major international bank was spent in the company of foreign exchange dealers. This provided the inspiration to write this book—a project that could not have been undertaken without the assistance and support of the following institutions and individuals. I am indebted to Cass Business School for granting me an Honorary Visiting Fellowship for the duration of the project, to Sarah Millard and Henry Gillett for the assistance they provided at the Bank of England Archives, to the staff at the Guildhall Library and to Edwin Green for his hospitality and help at the HSBC Archives. I am also grateful to former colleagues at Citibank, including Terry Fitt, John Robertson, Frank Smith and Malcolm West for sharing with me their thoughts and memories on the London foreign exchange market (Malcolm West deserves additional thanks for reading earlier drafts of this book), to Michael Beales of the WMBA and to Derek Tullett for their comments on foreign exchange brokers and to my wife Joanna for providing invaluable IT support. However, my biggest vote of thanks must go to Professor Forrest Capie of Cass Business School for the time and care he has taken in reading each of the draft chapters, and for the many helpful suggestions he has made along the way. The errors that remain, of course, are entirely my own.

Abbreviations ACI

Association Cambiste International

BBA

British Bankers’ Association

BIS

Bank for International Settlements

BoE

Bank of England

BoEQB

Bank of England Quarterly Bulletin

CHAPS

Clearing House Automated Payment System

CHIPS

Clearing House Interbank Payment System

CLCB

Committee of London Clearing Banks

CLS

Continuous Linked Settlement

EEA

Exchange Equalisation Account

EEC

European Economic Community

EBS

Electronic Brokerage Service

EC

European Community

ECU

European Currency Unit

EMS

European Monetary System

EMU

Economic and Monetary Union

EPU

European Payments Union

ERI

Effective Rate Index

ERM

Exchange Rate Mechanism

EU

European Union

FEBA

Foreign Exchange Brokers’ Association

FECDBA

Foreign Exchange and Currency Deposit Brokers’ Association

FSA

Financial Services Authority

FXJSC

Foreign Exchange Joint Standing Committee

GL

Guildhall Library

IMF

International Monetary Fund

IMM

International Monetary Market

LEC

London Exchange Committee

LIFFE

London International Financial Futures Exchange

MLR

Minimum Lending Rate

NIP

Non-Investment Product

OTC

Over-The-Counter

STP

Straight Through Processing

SWIFT

Society for Worldwide Interbank Financial Telecommunications

WMBA

Wholesale Market Brokers’ Association

Introduction Foreign exchange is big business for the City of London. At the start of the twenty-first century, turnover on the London foreign exchange market averaged a staggering $504 billion a day. No other centre came anywhere near to matching this total. In 2001, 31 per cent of global foreign exchange activity took place in the United Kingdom (almost all of it in London), compared with only 16 per cent in the United States, and 9 per cent in Japan. London also accounted for more foreign exchange business than in all of the other EU centres taken together. It had not always been so. At the start of the twentieth century, the London foreign exchange market had played second fiddle to more important centres in Paris, Berlin and New York. Its lowly position had owed much to sterling’s pre-eminent position as an international currency. Virtually all of British, and much of global, external trade and finance were conducted in sterling. Sterling’s hegemonic international role helped to enrich the sterling acceptance market in London and to fuel turnover on currency markets abroad. However, it did little to stimulate foreign exchange trading in London, which existed as a backwater activity prior to 1914. The modest turnover on the London foreign exchange market was reduced even further during the First World War. However, the economic and political changes wrought by that conflict were to produce a dramatic shift in its fortunes and, by the early 1920s, London was widely considered to be the world’s leading foreign exchange centre. This transformation was aided by two key factors. The first was the emergence of the US dollar as a key international currency to rival sterling. Even before 1914, the London market had been the main European centre for trading the dollar, and the post-war surge in British and continental European demand for the US currency contributed to London’s march ahead of its regional competitors. The second development to contribute to this process was the post-war financial turmoil in Central and Eastern Europe. This helped the London market by hindering activity in Berlin and Vienna, two of its main rivals before 1914. Trading flourished during the early 1920s, when the market also took on a more modern appearance. Prior to 1914, foreign bills and drafts had been the principal instruments traded on the London market (which had had a physical presence at the Royal Exchange), the mail had served as the main channel of communication with foreign centres, forward exchange had been traded only lightly, and telegraphic transfers had been used only sparingly. However, after the war, the majority of deals were being initiated either by telephone or cable (with the latter medium being used to confirm transactions in foreign centres), spot rates were being set with fixed value dates and active dealings were being undertaken both in outright forward exchange and in swaps. During the 1920s, dealers sought to profit from the currency instability in Central and Eastern Europe. Sterling, which had formally moved off gold in 1919, also became a volatile currency, and this contributed to a boom in foreign exchange turnover, especially

The foreign exchange market of London

2

in the fast growing forward market. The speculative bubble burst in the mid-1920s, with the restoration of the gold standard, but the currency markets were not to remain quiescent for long. Sterling’s $4.86 gold parity was abandoned in September 1931 and, as more and more countries adopted floating exchange rates, hopes soon were raised of a renewed boom in currency dealings. These hopes were not fulfilled. During the 1930s, turnover on the London foreign exchange market recovered from the lacklustre levels seen in the late 1920s, but a boom was put firmly off the agenda by the global economic depression, by the widespread adoption of exchange controls in Europe and Latin America and by the decision of a number of countries to link their currencies to sterling. Steady rather than spectacular progress, therefore, was made during this period. And this was brought to an abrupt halt with the outbreak of the Second World War on 3 September 1939. When trading resumed on 5 September 1939, the inter-bank market in all of the major currencies was shut, the Bank of England (whose peace-time interest in the foreign exchange market had really only developed over the previous ten years) was given the sole right to act as market maker in these ‘specified’ currencies, and UK residents were obliged to sell all their holdings of them to the Bank, using the authorised banks that were appointed by the authorities for this purpose. These measures all but expunged traditional foreign exchange trading in London, and only a tiny open market involving the sterling area currencies and a few minor foreign currencies remained in existence. The Second World War marked the high point of the Bank of England’s power and influence over the London foreign exchange market. However, its sway diminished only gradually over the next three decades, due to its continuing responsibilities for enforcing exchange controls and for supporting sterling on the exchange markets. Things began to change during the last two decades of the century. Financial deregulation (exchange controls were scrapped in 1979), financial reform (prudential supervision of banks was transferred from the Bank to the Financial Services Authority in 1997), as well as the adoption of more prudent domestic economic policies (which diminished the need for official intervention after the 1992 ERM debacle), progressively reduced both the Bank’s role and profile on the London exchange market. The wartime procedures that had been enforced by the Bank survived for six years after the conclusion of hostilities. It was not until December 1951 that trading in the specified currencies was returned to the open market. However, trading in these currencies still remained highly restricted. The freedom of UK residents to wheel and deal in foreign currencies was constrained by exchange controls, whereas non-residents were given only qualified rights to convert sterling into other currencies. It was only after the restoration of convertibility (or the right of non-residents to convert sterling into any foreign currency), in December 1958, that London was given the opportunity to rebuild its lost foreign currency business. Great strides were made in this direction over the next twenty years. The renaissance of foreign exchange activity in London received its biggest boost from the formation and rapid growth of the international banking and bond markets in the City. These markets not only generated indirect demand for foreign exchange, but also attracted a massive influx of foreign banks into London, most of whom also entered the foreign exchange market.

Introduction

3

High inflation, petro-dollar recycling and currency instability boosted foreign exchange turnover during the 1970s, but this was just an appetiser for the boom in trading that occurred over the following two decades. The seeds of this boom were sown by the widespread adoption of floating exchange rates, by the lifting of exchange controls in Britain and in other countries, by the increasing integration of global capital markets and by the growing need and desire of companies and financial institutions to hedge their currency exposures. The London market benefited fully from this explosion in currency trading and, by the late 1970s, it had reclaimed its earlier title as the world’s premier foreign exchange centre. According to official survey data it has retained this exalted position ever since. Dramatic changes have taken place in the operating procedures of the market since the time that London first reclaimed its leadership role. During the early 1970s, dealers were working in much the same way as their counterparts had done fifty years beforehand. The revolution in information technology, however, was to change all this over the next thirty years. The way in which dealers ply their trade has been transformed by the use of online information systems and personal computers (introduced first in the 1970s), computerised dealing systems (1980s), and electronic brokerage and corporate internet portals (1990s). Many of these developments were pioneered in the London market. London’s willingness to use technology has contributed to the success as a currency centre, something that has been nurtured over the years by three other key factors. The first has been the historically close financial ties between Britain and the United States, which have led to the concentration of European dealings in the US dollar in London. The second has been the co-location in London of global markets in insurance, gold, derivatives and international bonds and loans. These markets not only have generated local demand for foreign exchange, but also have helped to sustain the support services (IT specialists, accountants, lawyers etc.) on which all financial markets depend. The final factor has been the size and importance of London’s foreign bank population. Foreign exchange was the first market in the City to experience what today is known as the ‘Wimbledon phenomenon’ (where the facilities are in London, but the key players are mostly foreign). As early as 1900, the biggest players on the London foreign exchange market were foreign branch banks. Over the years, the skills and resources brought by foreign banks have made a powerful contribution to the success of the London market. Foreign owned banks account nowadays for around 80 per cent of the turnover on the London foreign exchange market. The City always has provided a warm welcome to these institutions, and their presence has been vital in providing the capital required to support the high level of activity undertaken on its foreign exchange market. Foreign banks also have been helpful in another way. Over the years, they have proved to be much more inclined, than their British counterparts, to question and challenge the restrictive practices (such as the ban on direct dealing and the foreign exchange brokers’ cartel) that once blighted the London market. Had these practices—which were all too readily condoned by the authorities—been retained, London might have struggled to obtain its present dominant position in foreign exchange. The London foreign exchange prospered during the 1980s and 1990s, but—in common with most other centres—it experienced a setback at the start of the new century. Between 1998 and 2001, turnover dropped by 21 per cent, due to a sharp contraction in

The foreign exchange market of London

4

inter-dealer activity. New methods dealing occasioned by the introduction of electronic brokerage and internet trading had much to do with this setback, which left many of the players in the London market worrying about whether trading in the future would be either as exciting, or as profitable, as it had been in prior years.

1 The somnolent years 1900–14 At the dawn of the twentieth century, the City of London held an unrivalled position as an international financial and commercial centre. Markets located in the City were the focal point of global trading in gold, commodities, insurance and shipping; the London Stock Exchange served as the principal forum for trading international securities; and British-based merchant banks and finance houses arranged the lion’s share of international capital issues. Each of these activities contributed significantly to the City’s wealth and reputation, but none of them were able to match the contribution made by its star performer, the sterling bill market. Prior to 1914, it is reckoned that around 90 per cent of British external trade and as much as 50 per cent of world trade were financed by means of the sterling bill of exchange.1 The widespread use of sterling in financing international trade enriched those institutions involved in accepting, discounting and collecting the unending supply of paper entering the sterling bill market. However, the success of this market had one damaging side effect. It hindered the expansion of foreign exchange trading in London. Whereas the City boasted world leadership in most areas of financial activity, it struggled to compete with Paris, Berlin and New York as a foreign exchange centre. The old adage ‘London draws few bills, but accepts many’, hints at the main competitive disadvantage suffered by the London foreign exchange market. This was that Britain’s overseas trade brought few foreign currency bills to London. It was noted at the time that: Every import that we take from France or any other country means that somebody there has a claim on our money, and can draw a bill on us. Every export that we make means that someone abroad has a claim to meet here and wants to buy a bill on us.2 Such behaviour ensured that the bulk of the foreign exchange business arising out of British overseas trade was conducted in foreign centres rather than in London. Those selling goods to this country invariably would have sold the sterling bills they had drawn to local banks for domestic currency, whereas those buying goods from this country invariably would have bought a sterling bill or draft with domestic currency from a local bank. Sterling bills, however, were not just drawn in connection with British overseas trade. The depth and liquidity of the sterling acceptance market ensured that they were also used to intermediate both third country trade and international capital movements. It was common practice, for instance, for the unspent proceeds of foreign bond issues in London to be remitted home through the medium of a sterling bill drawn on the issuing house involved, and for British banks wishing to place short-term funds abroad to instruct their

The foreign exchange market of London

6

foreign agent or correspondent to draw on them in sterling. The sterling bills so created typically would have been sold in the local exchange market with the purchaser taking the responsibility of sending them to London to be accepted. If sterling’s international role hindered the expansion of the London foreign exchange market, it positively stimulated the development of markets abroad. Around the world companies and individuals had a constant need to acquire sterling to settle their external obligations, and a constant need to dispose of sterling obtained from their international transactions. In most overseas markets the key exchange rate was that for the local currency against sterling. In the words of a contemporary US observer: What proportion of the total exchange dealt in the New York market consists of sterling is impossible to determine, but that it is as great as the volume of all the other kinds of exchange put together can be safely said.3

London seeks a position Despite suffering from low trading volumes, London still managed to carve out a credible role on the pre-1914 global foreign exchange market. Little attempt was made to rival Paris, Amsterdam, Vienna and Berlin in trading the key continental European currencies. Instead emphasis was placed on exploiting the opportunities created by Britain’s farflung political and economic ties. London was the pre-eminent market in Europe for trading the currencies of the British Empire. It was also a key centre for exchanging the Latin American currencies. But the jewel in its currency crown was the US dollar. The heavy ebb and flow of securities between the New York and London stock exchanges created a natural market for dollars in London, and it was towards this market that the other European centres turned when they wished to trade the US currency.4 During the first two decades of the twentieth century, the market had a physical presence at the Royal Exchange—which had served as a centre of commercial and currency trading since the sixteenth century.5 Dealers and brokers met there twice a week, on Tuesdays and Thursdays, to buy and sell foreign bills. The exchange rates fixed during each session on Change were published the following day in the national press under the title of the London Course of Exchange. Daily quotes also were published in the papers, but these were for rates against sterling quoted in foreign centres. Foreign exchange trading in London was not confined just to two meetings a week at the Royal Exchange.6 While this part-time physical market in foreign currency bills more than met the needs of those with only light or occasional trading requirements, it failed to satisfy the needs of international arbitrageurs, stockbrokers and investors. These operators needed to buy and sell foreign exchange throughout the week, and to service their requirements dealers and brokers would engage in bilateral transactions—which were conducted either face-to-face or over the telephone—both on the days when the Royal Exchange was closed as well as after the formal sessions on Tuesdays and Thursdays. Deals struck during ‘after hours’ trading on these two days invariably were done at rates different to those fixed during the formal sessions. The rates published for transactions on Change, therefore, were fairly symbolic given that, even on the days

The somnolent years 1900–14

7

when it was in session, a significant volume of foreign exchange business, especially in telegraphic transfers, was being conducted elsewhere in the City. Prior to 1914, it was common practice, although not a requirement, for deals struck between banks to be intermediated by a broker. In 1900, there were around twenty exchange brokers serving the London market. Some of these firms were highly specialised (R.W.Carter & Co limited itself to broking only the eastern silver currencies), some were fairly specialised (M. Marshall & Son—which in 1922 evolved into the more familiar M.W.Marshall & Co—were renowned for broking the US dollar), and some just sought whatever business they could find. Exchange broking scarcely provided a steady living, and only a few of the firms listed in The Bankers’ Almanac in 1900 were to survive into the post-First World War period. The comparatively low turnover on the London market meant that it was a price taker rather than a price maker. Around this time, it was noted that: As the bills drawn on London from abroad vastly outnumber the bills drawn on abroad from London, the demand and supply of the former exercise a proportionately greater influence over the course of exchange than the latter. In other words, the actual rise or fall takes place on the foreign market, and London in most instances merely adjusts its rates according to the rates telegraphed from abroad.7 The reference to the telegraph in the above quotation, which is taken from a text published in 1894, confirms that technology had made inroads into the operations of the market by the end of the nineteenth century. By that time, the telegraph was being used to convey financial information, to expedite communications with overseas business associates and to execute some exchange transactions; the telephone was being used to a limited extent to conduct transactions within the London market; and mechanical calculating machines were being used as dealing tools. The foreign exchange market, however, was by no means in the forefront of those exploiting the new technology of the Victorian and Edwardian periods. The telephone was a case in point. The earliest telephone links with the Continent were established with Paris (in 1891) and with Brussels (1903). London stockbrokers wasted little time in using these connections to initiate arbitrage transactions with continental bourses.8 Foreign exchange traders, in contrast, did not use the telephone to initiate foreign exchange transactions with continental Europe until after the First World War. In the early 1900s, a three-minute telephone call from London to Paris cost 8s, or ten times more than a telegram.9 Stockbrokers were not put off by the cost of a continental telephone call because (a) fast moving stock prices justified the use of this costly but speedy means of communication and (b) the high unit value of some of their cross-border transactions made them more willing than others to absorb high telephone charges. Foreign exchange dealers had less incentive to act in the same way. Many of their deals were for sums measured in the tens or hundreds of pounds and many of the currencies in which they dealt were not prone to violent price changes. Accordingly, they lacked both the need and the desire to make early use of the international telephone. The same factors that caused foreign exchange dealers to eschew early use of the international telephone

The foreign exchange market of London

8

also persuaded them to ration their use of the international telegraph. Indeed, in the early years of the twentieth century, the operations of the foreign exchange market still bore a close resemblance to those of the midnineteenth century. While foreign exchange dealers were making some use of the telephone and of the telegraph for initiating big transactions (especially with far distant centres), the bulk of their business was conducted in a more ‘low tech’ way. Foreign bills and drafts still were their main stock-in-trade, and the mail remained their principal means of communication with the outside world (hardly surprising given that foreign bills ultimately had to be mailed to a foreign centre for settlement). The market also continued to operate at a fairly leisurely pace. For instance, it was common practice to exchange offers between London and the Continent by post, which were accepted or refused by cable on the following day.10 Tranquil exchange rates under the gold standard There was little urgency behind dealing because the currency market in those days was in a state of somnolence. Currencies were prone to only minor and infrequent fluctuation due to the widespread adoption of the gold standard. By the end of the nineteenth century, virtually all of the major currencies of Europe and North America had established mint parities based on their respective gold content. Fluctuations around these parities were confined within narrow bands set by specie import and export points (which reflected the costs—shipping, insurance, packing etc.—of moving gold between countries). The gold standard parity for the US dollar against sterling was fixed at $4.8665. Prior to 1914, the point at which it paid to buy and export gold to the United States instead of purchasing dollars was reckoned to be around $4.827, and the point at which it paid to import gold from the United States instead of selling dollars was reckoned to be around $4.8901 For much of the time, the US dollar/sterling rate traded well within these points. It was not just the gold pegged currencies of Europe and the United States that displayed low volatility. A number of countries that eschewed the gold standard still had sought, by the opening years of the twentieth century, to stabilise the external value of their currencies by giving them a fixed parity against one or other of the gold currencies, most commonly sterling or the US dollar. Chief among this group were India, Mexico, Brazil and Argentina. Countries on the gold exchange standard defended their parities by buying or selling assets denominated in the gold currency against which their own currencies were fixed. There were only lean pickings for traders looking for volatility during the classical gold standard era. The main excitement was provided by some of the silver based currencies of the East and by the few floating currencies, such as the Chilean peso, still remaining in Latin America. Mint parities could be established between two silver currencies, but not between a silver standard and a gold standard currency. In normal circumstances, the exchange rate between currencies on these two different standards would fluctuate—sometimes quite significantly—in step with changes in the ratio between gold and silver prices. For instance, between 1900 and 1914, the year-end rate

The somnolent years 1900–14

9

between the silver Shanghai tael and sterling oscillated in a range between 2s 2d and 3s 1d. From Britain’s standpoint, the most important of the silver based currencies was the Indian rupee. Trading in this currency, however, was a soporific activity, because of India’s adoption of the gold exchange standard. In 1899, the rupee had been given a central rate of 1 rupee=1s 4d, and fluctuations between it and sterling were kept within a very narrow range by the actions of the Indian authorities who bought rupees with sterling at 1s and sold rupees for sterling at 1s . The general stability of exchange rates, in the pre-1914 period, diminished—but did not entirely remove—the need for operators to protect themselves against currency risk either by purchasing long-dated foreign currency bills, or by engaging in forward exchange transactions. Markets in forward exchange, in which rates are fixed today for currencies to be delivered or received at a future date, had developed in continental Europe during the second half of the nineteenth century. Instability in the Austrian gulden, which eventually was replaced by a stable gold linked currency in the 1890s, had encouraged forward exchange trading in Vienna, whereas active arbitrage dealings between Austria and Germany had fostered the development of a forward market in Berlin, on which deals also were struck in Russian roubles, the South American currencies and even sterling.12 Exchange risk between two gold standard currencies may have been low, but it was not entirely absent. Indeed, it was not unheard of for a gold currency to rise or fall rapidly between (and, in a crisis, even beyond) its lower and upper specie points. For instance, during the US financial panic of October 1907, it was observed that, ‘Within two or three days perhaps a million shares of American stocks were jettisoned…[on the New York market]…by the foreigners, while exchange rose by leaps and bounds nearly 10 cents to the pound, to the unheard of price of 4.91’.13 When it is recognised that the gold currencies also were prone to fluctuation against some of the silver and South American currencies, it is not too surprising to find that even in London an embryonic forward market had developed by the start of the twentieth century. Its existence is confirmed in a note sent on 2 May 1907 by the London City and Midland Bank’s chief trader, Mr H.van Beek, to Edward Holden (at that time the bank’s managing director). According to van Beek: Another part of the transactions which pass through our account consists of business done from one to three months previously on forward transactions. Of course, when this Bank entered into this business we could not very well refuse to quote for forward transactions, as all other Banks here do so, and a considerable business is carried on.14 Exchange rate sensitive transactions arising out of gold and stock market arbitrage also provided the forward market in London with a stream of early business. The simplest way for a bank to cover a forward sale of a currency was by immediately purchasing the appropriate amount of the currency involved and placing it on deposit in the relevant foreign centre. Accordingly, the development of a healthy and viable forward market depended on two things. The first was the presence of stable banking conditions in those

The foreign exchange market of London

10

countries whose currencies were being traded on the forward market. The second was the ability of traders to transfer deposits freely and speedily between these countries. In the early 1900s, the mail often would be delivered in a day or so to foreign exchange centres on the near Continent, such as Paris and Amsterdam. However, it took about eight days for sea-borne mail to reach New York, and six weeks for it to reach the Far East. It follows, that the remittance of funds by mail was an inappropriate way of supporting forward exchange activity between far distant countries. Telegraphic transfers were far more suitable for this purpose. In order to remit funds by way of a telegraphic transfer, a bank needed to maintain an operating account either with a branch, or with a correspondent bank abroad. Instructions to move money out of this account would be telegraphed to the latter using an agreed code (for security) and test word (in lieu of a signature). The birth of cable The telegraph wires to the United States were set in deep submarine cables, and shortly after the first transactions were transmitted across these wires, in the 1870s, the moniker of ‘cable’ was adopted for telegraphic transfers between Britain and the United States. The US dollar/sterling exchange rate has retained this nickname ever since. Telegraphic transfers eventually would become the basic method of executing foreign exchange transactions. But they were used only sparingly before the First World War, because broadly stable exchange rates diminished the need for urgency in most exchange transactions. In the tranquil conditions prevailing at that time, the majority of banks and companies needing to buy or sell foreign currency were content to confine their dealing activities to the tried and tested foreign currency bill. Settling the purchase of goods with a long currency bill, rather than with a telegraphic transfer, also had the key advantage of providing the importer with extended credit. Those who resorted to telegraphic transfers invariably had a specific reason for doing so. This medium was useful to those trading the currencies of countries (such as China, India and Australia) with long mailing times, because it obviated the need for money to be tied up during the time it took a foreign bill to reach its destination. Foreign bills had to be settled in sterling the day after purchase, and telegraphic transfers appealed to operators reckoning to have a better use for their money, or expecting a more favourable exchange rate to appear, during the time a bill was travelling on the high seas. Fast execution of currency purchases and sales sometimes was required for international stock market transactions, and cable deals in US dollar/sterling often were undertaken for this purpose. Such deals, in fact, accounted for a significant proportion of the turnover in this currency pair in London. Other virtues of remitting funds by a cable, rather than via a bill, were that their delivery in a foreign centre not only was more time certain (the mails could be delayed), but also was more secure (bills could go astray). Accordingly, this method was favoured where large sums were involved. In a communication relating to a substantial transaction in North Pacific common stock, sent from J.S.Morgan & Co (in London) to J.P.Morgan & Co (its partner firm in New York), it was stressed, ‘Cable your instructions and remit by cable as amounts very large’.15

The somnolent years 1900–14

11

The role of the foreign bill Despite the inroads made by the telegraphic transfer, the foreign bill was still king of the pre-1914 London foreign exchange market. Indeed, it was common for contemporary writers to ignore other instruments, and to treat the market in bills as the foreign exchange market. Bills traded in London were payable anywhere from sight up to 6 months. Those with a time before payment (or usance) of less than one month were deemed to be short bills, and those with a time before payment greater than one month were deemed to be long bills. In the case of Europe, the common usance on long bills was 3 months, whereas in the case of the United States it was 60 days (although 90 days bills also were used). Bills could be drawn ‘after date’ or ‘after sight’, with (for any stated tenor) the former reaching maturity from the date of issue, and the latter reaching maturity from the time they were sighted, or presented for acceptance to the drawee. The time left to run on a bill had an important bearing on its price. As noted previously, foreign bills were settled in sterling the day after purchase, which meant that a purchaser would be out of funds until a bill was paid in a foreign centre. Accordingly, foreign exchange traders had to take account of the time value of money when quoting for foreign bills. Bills of differing maturities were given a present value by discounting them by the appropriate interest rate in the relevant foreign centre. Thus, for a given amount of US dollars, the purchaser of a short bill would have had to proffer more sterling than the purchaser of a long bill. Put the other way around, £100 spent on a short bill would have delivered fewer dollars than £100 spent on a long bill. Given that the exchange rate between Britain and the United States is quoted in foreign currency terms (dollars per pound), the short rate of exchange for dollars in London always would have produced a lower figure than the long rate of exchange. The price of a bill also was affected by its quality. A foreign bill drawn on, or accepted by, a prime bank would have produced a better price for its seller than a trade bill. The different credit risk between these two classes of bills was reflected in the higher discount rate applied to the latter. In consequence, the seller of a dollar bank bill would have been obliged to deliver less foreign currency for sterling than the seller of a dollar trade bill. These various factors gave rise, at any point in time, to a ladder of exchange rates for bills denominated in the same foreign currency. For the purpose of illustration, this might have ranged from $4.8450 to $4.8950 for dollar bills in London, with the lowest rate of $4.8450 applying to bank sight bills or cheques (both of which were payable on presentation), and the highest rate of $4.8950 applying to 90 days trade bills. The situation was even more complicated than this because an even lower rate would have applied for cables. It took about eight days for a sight bill or cheque to reach New York from London, and slightly longer for good value to be obtained. In contrast, cable instructions arrived within minutes with the transferred funds commonly being cleared two days later. The purchaser of cable, therefore, received a slightly lower exchange rate than the purchaser of cheque because the latter needed to be compensated for the extra time it took before cleared funds were obtained in New York. This consideration was less important in respect of transactions with near centres in continental Europe (where the

The foreign exchange market of London

12

mail arrived in a day or two) and, in the case of say the French franc/sterling rate, there was scarcely any difference between the rates quoted for telegraphic transfers and for cheque. Traders, therefore, had to take account of a multitude of factors—from the tenor and quality of a bill to the time a beneficiary would receive cleared funds—when undertaking an exchange rate transaction. Mistakes were never far away. On 24 February 1911, Brown Shipley were obliged to send the following apology via their New York associates, Brothers & Co: After consideration we quite agree that Mr Curtis is entitled to the additional $189.77 mentioned by you and would, therefore, be obliged if you would credit him with this amount debiting our London Foreign Exchange Account. We should be pleased if you would advise Mr Curtis and offer our apologies for not remitting by cable instead of by mail.16 Those engaged in currency trading had to contend with a further issue. This was the poor and erratic supply of foreign currency bills entering the London market. Foreign currency transactions arise when goods, services and capital are traded across national boundaries. The use of sterling, however, to finance so much of British trade in goods meant that most of the foreign exchange business arising from this source was conducted in centres abroad. While this kept the London currency market on short commons, traders still were able to make a worthwhile living by facilitating the exchange transactions generated by Britain’s invisible trade and capital flows with the outside world. Invisible trade and capital flows boost volumes Four items of invisible trade provided decent pickings for currency traders. British shipping companies, who ranked among the more important commercial customers of foreign exchange banks, had a constant need both to remit money abroad (for bunkers, supplies and port dues) and to receive money from abroad (for freight payments). Insurance companies were in a similar position, given that they had not only to collect premiums in a number of countries, but also to pay claims and, in many cases, to transact in foreign securities. Foreign travellers to Britain were another source of exchange market activity. This applied, in particular, to visitors from the other side of the Atlantic. In pre-1914 London, due to sterling’s hegemonic position, the exchange transactions generated by overseas travellers provided many bank workers with their only contact with foreign currencies. Tourists met their need for sterling by selling foreign currency notes, by drawing drafts under travellers’ circular letters of credit, by selling personal cheques and by selling drafts issued by banks abroad. Drafts and cheques were fed into the normal flow of paper passing through the market, but foreign currency notes normally were sold to specialist dealers after purchase. Mainstream dealers looked down upon those engaged in this line of business. In a letter sent, in 1907, to J.E. Gardin of National City Bank, by van Beek of London City and Midland Bank, the latter noted, ‘…Messrs Frederick Burt & Co [who recently had been taken over by London and County Bank]— are really not Foreign Exchange dealers, being too small for such purposes. Their

The somnolent years 1900–14

13

principal business consists of the purchase of coupons and the purchase and sale of foreign money (notes and coin)’.17 The above letter hints at the final item of invisible trade to bring succour to the London foreign exchange market. In 1913, Britain’s investments in overseas quoted securities were worth anywhere between £2.6 billion and £3.8 billion.18 A significant proportion of these portfolio investments were denominated in sterling, which meant that foreign borrowers needing to pay interest to their sterling bondholders invariably would do so either from funds retained for that purpose in London, or by remitting funds to their London paying agent by means of a sterling bill. British investors, however, also held foreign currency securities that were acquired either through purchases of existing stocks and bonds abroad, or through participation in syndicates formed to acquire new issues on foreign markets. For instance, most of the US railroad securities held by British investors (which accounted for over 12 per cent of total overseas investments) were obtained through these two channels. Holders of foreign currency bearer bonds had to clip the interest coupons attached and present them for payment on the due date. This could be a cumbersome process where the paying agent was located abroad, and some British merchant banks were inclined to lodge such securities with a correspondent bank in the appropriate foreign centre, whose job it was to collect the interest due and remit it to London. However, when foreign currency bearer bonds were held in London, it was common practice for investors to clip and sell the relevant interest coupons on the foreign exchange market, and to leave the purchaser with the job of collecting the interest from the foreign paying agent. Foreign interest coupons formed part of the natural flow of paper passing through the London market, although trading in these instruments was not deemed to be a mainstream activity, and so was left mostly to a handful of specialist dealers. In the absence of statistical data, it is dangerous to be too dogmatic about the distribution of activity on the pre-1914 foreign exchange market. However, it seems likely that capital account transactions brought far more business to London than either visible or invisible trade transactions. The contribution from this source, however, owed little to the heavy volume of new overseas issues absorbed each year by financial institutions in the City. The new issue business was not a good hunting ground for foreign exchange traders. Most issues were denominated in sterling, and the funds so raised either were spent in the United Kingdom, or were remitted abroad by means of a sterling bill of exchange drawn on the issuing house involved. An extreme example of an issue being raised to cover expenditures in the United Kingdom is highlighted in a cable sent on 1 March 1901 by J.S. Morgan to J.P.Morgan. ‘We have been asked to take charge and distribute £6,000,000 Russian Northern Railway 4% Bonds to be distributed England and will be taken mainly by English contractors in payment rails equipment’.19 The richest source of foreign exchange business emanated not from the primary market in new overseas issues, but from secondary market trading in outstanding foreign securities.20 Investors in Britain, continental Europe and the United States were adept in trading securities listed on foreign markets. Cross-border trading in stocks and shares was

The foreign exchange market of London

14

commonplace within Europe, with the biggest flows being generated by the relentless buying by continental European investors of overseas securities quoted on the London market. For instance, the French were active investors in South African, ‘Westralian’ and Spanish mining shares; German investors were partial to foreign government bonds; and the Dutch were keen on Latin American securities.21 The biggest flows, however, were between Britain and the United States. Indeed, during the first few years of the twentieth century, the London Stock Exchange was considered to be a more important market for American securities than the New York Stock Exchange.22 The combination of high savings levels in Britain and high investment returns in the United States stimulated the acquisition of US securities by British investors. However, the traffic was not all one-way since US investors, apart from buying back American securities whenever they were dumped by fickle British investors, also were occasional purchasers of British shares and gilts. Two-way flows such as these helped to forge close links between the London and New York stock markets. In turn, these links served to swell dealings in the US dollar/sterling exchange rate. Arbitrage transactions With so many US securities traded in London, much time and effort was spent by professional investors seeking to arbitrage small price differences between the London and New York markets. The need for timely settlement in stock arbitrage transactions meant that they were commonly paid for by cable rather than by cheque. According to Palgrave, telegraphic transfers were not used, ‘…as a means of remittance except in connection with certain special classes of business transactions. Among these, stock exchange arbitrage dealings, which necessitate very quick payment, are the most prominent’.23 British merchant banks with a heavy involvement in US securities often would establish a joint account with an investment bank or house on the other side of the Atlantic to facilitate their activities. This account would be drawn upon when purchasing securities and it would be kept in the black through the remittance of funds by cable, cheque or bill. Purchases of securities were made jointly with the US associate and stock trading profits were shared. Reciprocal facilities usually were provided in London. Cross-border transactions in securities also were settled by means of stock drafts or cheques. These instruments were favoured to settle trades between two parties without close business ties, because they diminished settlement risk by providing for deliveryversus-payment. For instance, a London stockbroker selling securities to an investor in the United States would draw a dollar draft, on a bank designated by the latter, to which would be attached the securities involved in the sale. The whole package would then be sold for sterling on the London foreign exchange market (at an exchange rate that took due account of the interest lost while the draft was in transit) with the currency trader sending it to the United States, where the investor would authorise payment of the dollar draft against delivery of the securities involved in the transaction. Apart from international securities trading, other capital transactions—often connected with some form of arbitrage—also generated business for the London exchange market.

The somnolent years 1900–14

15

During this period banks in London were actively engaged both in foreign exchange and in gold arbitrage (while gold arbitrage involved the purchase and sale of a visible good, it is probably better classified as a short-term capital account transaction due to gold’s monetary role). In the traditional textbook explanation of the workings of the gold standard, specie flowed from one country to another when importers found it cheaper to buy and ship gold, than to buy foreign currency, in order to pay their suppliers. In reality, merchandise trade was hardly ever settled with gold. The job of keeping currencies within their specie points was left to professional arbitrageurs in merchant banks, who often dealt for very small profits per transaction. Most of the merchant banks in London maintained joint accounts with banks and finance houses abroad for this very purpose. For instance, Kleinwort Sons & Co kept a joint gold account with Labouchere & Co in Amsterdam, and J.S.Morgan maintained one with Drexels in New York.24 When it paid to send gold to London, because sterling was trading at its upper specie point in a foreign centre, the overseas associate would have bought gold with local currency and sent it to London. On arrival, the gold would have been sold for sterling. The proceeds then would have been converted into the appropriate foreign currency and remitted back to the country where the gold had been bought. The profits on the transaction would have been shared between the two banks involved. Gold arbitrage and also foreign exchange arbitrage (which involved the transfer of funds to exploit small differences in the quotes for the same currency pairs in two different centres) were activities undertaken by banks on their own account rather than on behalf of their customers. Such proprietary trading formed part of the normal day-to-day workings of the market. Professional traders added depth and liquidity to the market, but their job was complicated, in the pre-1914 period, by the shallow and erratic supply of foreign currency bills on the London market. Dealers wishing to sell foreign currency had to acquire foreign currency instruments or balances in the first place. When foreign bills were in short supply in London, they had to search for other ways of securing the required funds. Purchasing a telegraphic trans-fer was one way out of this impasse, but this solution was unsuitable for those either wishing to trade small amounts (cable costs were relatively high), or without the necessary overseas banking relationships. In consequence, most dealers tackled this problem by drawing finance bills. In contrast with trade bills, which were drawn to finance specific shipments of goods, finance bills were drawn simply to raise cash (which explains why they were also known as accommodation paper). Whereas trade bills were self-liquidating, the means of repayment being provided by the sale of the goods against which they were drawn, the security of a finance bill depended mostly on the credit worthiness of the drawer and drawee. Finance bills were frowned upon by central banks, because they were not selfliquidating, and this made banks careful to limit the amount of such paper with their names on in the market. To improve the quality of this paper, drawers sometimes were asked to lodge marketable securities as collateral.

The foreign exchange market of London

16

Extensive use of finance bills Notwithstanding these constraints, finance bills provided an essential lubricant for the pre-1914 foreign exchange market, and they were widely used on both sides of the Atlantic. For instance, it was common for US banks to draw and sell 3 months sterling finance bills for dollars in the summer, when the dollar often was at a seasonal low, and to sell dollar sight drafts as cover in the autumn, when the US currency usually was buoyed up by crop exports. This trading gambit paid off in most years, but success was not guaranteed and in 1909 a number of fingers were burnt after an unexpectedly poor US harvest caused the dollar to weaken and not strengthen in the autumn. Worthwhile profits also were not ensured in regular trading activity. Low turnover and narrow spreads, of around 10 points in cable, meant that dealers struggled to make a decent return trading demand exchange (cheques and sight drafts) in the same currency. Better opportunities usually existed in trading cable against cheque. In such a trade, the dollars purchased by cable would have been settled two days later, whereas the dollars sold by cheque would not have been settled until eight to ten days after the transaction. The trader, therefore, would have obtained the use of dollars in New York for six to eight days. Since the time value of money would have been recognised in the different exchange rates quoted for cable and cheque, the trader would have had to have given the purchaser of cheque more foreign currency per pound than he had received himself through the prior purchase of cable. In this instance, the amount would have been based on the interest paid by New York banks for sight deposits over a six to eight day period. However, the trader would have squeezed more profit out of the deal if, instead of leaving the dollars on deposit, he had been able to make a short-term stock market loan in New York at a higher rate of interest. The main bread and butter trade on the London market was the sale of cheque against the purchase of long exchange (in the same currency). Active traders maintained at least one overseas bank account for each currency in which they dealt, upon which they were able either to write cheques or to draw sight drafts, in order to square their currency positions, following their purchase of long foreign bills. The simultaneous purchase of long exchange and sale of cheque would have denuded a trader’s foreign currency bank account until such time as the foreign bill he had acquired became payable. However, the interest foregone on this account would have been allowed for in the differing exchange rates quoted for cheque and long bills. Two options were open to traders seeking to amplify their profits from this standard foreign exchange transaction. Both of these options involved a degree of risk taking. The first involved waiting to sell cheque as cover in anticipation of a favourable movement in the exchange rate. The second involved trading cheque against the purchase of low quality trade bills. For any given currency, there was a wider gap between the exchange rates quoted for cheque and prime bankers’ acceptances, than for cheque and trade bills. Accordingly, a trader could achieve a few extra points by dabbling in lower quality paper. Contemporaries were keen to stress the need to distinguish between the different risks involved in currency trading, and they were critical of those who sought to boost their trading profits by accepting too much credit risk. They were also critical of those who

The somnolent years 1900–14

17

exploited the differing exchange rates quoted for any given currency in order to garner business. This was made clear in a sharply worded letter sent by Brown Shipley to Brown Brothers & Co on 7 June 1912: If there is no profit in the Exchange business it does not appear that…it is our fault, but it is obviously wrong to bolster up the Exchange business and encourage ourselves in transferring to that business profit that does not really belong to it. If other Bankers and Exchange Houses buy a Trade Bill on the basis of a fine Bankers’ Bill they are obviously making a loss on the Exchange business, but of course they may have some ulterior motive for doing so.25

Foreign banks lead the market At the start of the twentieth century, the biggest players on the London foreign exchange market were (a) the British merchant banks, (b) the London branches of foreign banks and (c) the London offices of banks operating in the British Empire. The most conspicuous absentees from this list were the British clearing banks. With only one exception (Martins Bank), the clearing banks did not have a presence on the London foreign exchange market in 1900. The situation was to change over the next fourteen years and, by the start of the First World War, most of the clearers had established foreign exchange departments. However, in the period up to 1914, the clearers played second fiddle to the merchant banks and foreign banks and it was only after the upheaval of the 1914–18 war that they marched ahead of these competitors to become, at least for a while, the dominant force in the market. The Empire banks were far more specialised in their currency dealings than the other players on the London market. Most of these banks had been established with British capital, and many of them (such as the Union Bank of Australia, the National Bank of New Zealand, the Standard Bank of South Africa and the Mercantile Bank of India) had retained their head offices in London. Their foreign exchange business was heavily concentrated on dealing in their domestic currencies against sterling. However, there were exceptions to this rule, and Indian and other eastern banks—known collectively as Exchange banks—exploited their local knowledge of the silver standard by making the market in London for the silver currencies of the Dutch East Indies, Philippines, Siam, China etc. Trading the key Empire currencies was scarcely an exciting pastime, given that the Australian, New Zealand and South African pounds possessed the same gold standard parity as sterling, whereas the Indian rupee was fixed artificially in a narrow band against British currency. Unsurprisingly, the other foreign exchange banks in London were not much interested in this mundane segment of the market, and this gave the Empire banks a virtual monopoly over trades involving their own currencies. This point, however, applied with less force to the Canadian dollar, which—because of its close identity with the US dollar—was treated as a global currency, and so was traded actively by other than just the London offices of the Canadian banks. In terms of mainstream trading, the biggest players were the merchant banks and the

The foreign exchange market of London

18

foreign branch banks. Despite the intrusion of the telegraphic transfer, the pre-1914 currency market was still dominated by paper remittances and, given their deep involvement in the sterling bill market, it was a natural step for the merchant banks also to carve out a significant role in the foreign bill market. However, many of the bigger merchant banks would have regarded this role either as ancillary to, or as a by-product of, their main business dealings in sterling acceptances, overseas securities and gold. Banks such as N.M.Rothschild & Sons, Kleinwort Sons and Co and J.S.Morgan and Co (which was reconstituted as Morgan Grenfell in 1910) would have fallen into this camp. Foreign exchange trading was more of a core business activity for a number of the small and medium sized merchant banks, including Frederick Huth and Co, S.Japhet and Co, Seligman Brothers and Samuel Montagu and Co. Beneath this group were the financial boutiques who specialised almost exclusively in trading foreign exchange and/or foreign currency notes and coupons. Frederick Burt & Co would have come under this heading. Despite the important role played by the merchant banks, the key players on the foreign exchange market in the opening years of the twentieth century were the foreign branch banks. In 1901, The Bankers’ Magazine noted wistfully, ‘…the foreign banks have stolen a march on us. Exchange business always has been chiefly in their hands. The ordinary London banker knows little or nothing about it’.26 Care needs to be taken in interpreting this statement, because contemporaries were not always that diligent in distinguishing between foreign owned banks and the many British merchant banks whose founders had come from continental Europe. However, with some of the bigger merchant banks treating foreign exchange as a mere sideline, it seems safe to conclude that the foreign branch banks were the principal force on the London foreign exchange market during the period between 1900 and 1914. According to information in The Bankers’ Almanac there were 20 foreign owned banks with offices in the City in 1909. More than half were from Western Europe, with France (4) and Germany (3) boasting the greatest representation from this region. Unsurprisingly, banks from these two countries ranked among the biggest players on the London market (see Table 1.1). Prior to the 1913 Federal Reserve Act, US national banks were not permitted to open foreign branches, but state chartered banks and trust companies were not so constrained and, by 1909, one bank (the Connecticut chartered International Banking Corporation) and three trust companies (the Guaranty Trust Company of New York, the Farmers’ Loan and Trust Company and the Trust Company of America) had set up shop in London to

Table 1.1 Foreign banks with London branches, 1909 Banco de Chile Bank of Roumania Bank of Spain Buitenlandsche Bankvereeniging Comptoir National d’Escompte de Paris Cortes Commercial and Banking Company

The somnolent years 1900–14

19

Crédit Industriel et Commercial Crédit Lyonnais (Lombard Street and West End) Deutsche Bank Direction der Disconto-Gesellschaft Dresdner Bank Farmers’ Loan and Trust Company Guaranty Trust Company of New York International Banking Corporation Oesterreichische Länderbank Russian Bank for Foreign Trade Russo-Chinese Bank (Banque Russo-Chinoise) Sociéte Belge de Crédit Industriel et Commercial et de Depôts. Sociéte Générale pour Favoriser le Developpement du Commerce et de l’lndustrie en France Swiss Bankverein Trust Company of America Yokohama Specie Bank Source: The Bankers’ Almanac.

engage, amongst other things, in foreign exchange trading. In 1900 it was noted that: …the Guaranty Trust Co of New York…does a very considerable amount of exchange in connexion with the importation of cotton and other goods into this country, and with regard to the export of our own manufactures to the other side of the Atlantic.27 Within the foreign banking community the three German banks, Deutsche, Dresdner and Direction der Disconto-Gesellschaft (the latter was to amalgamate with Deutsche Bank in 1928) attracted a great deal of comment, not all of which was flattering. Indeed, something akin to the ‘Made in Germany’ scare that had developed in the manufacturing sector during the 1890s, had spread to the financial sector by the opening years of the new century. The fuss aroused by the German banks was unsurprising, given that they were easily regarded as the most feared competitors on the London market. Challenge to clearing banks The Institute of Bankers, commenting in 1900 on foreign competition in banking, exclaimed that, ‘As in almost every field of competition we are met by the energetic and pushing German’.28 Anxiety about both German banks and German bankers was brought out further in a letter sent in 1905 by Edward Holden of the London City and Midland Bank to the Dean of the Faculty of Commerce at Birmingham University. Holden, who

The foreign exchange market of London

20

had recently returned from the United States, noted that: The banks over there have within recent years taken up the buying and selling of foreign exchange…they have placed at the head of this new department Germans who have thus found a new opening. Naturally, in business they give preference, as far as they possibly can, to people of their own nationality and consequently a great deal of international finance comes into the possession of foreign bankers which otherwise might come into the hands of British bankers.29 The important role played by foreign bankers (not just German) in the pre-1914 foreign exchange market, was frequently attributed in the City to the better commercial training given to bankers abroad. While there was probably some truth in this point, the real advantage possessed by foreign banks was their access to a natural flow of foreign exchange business. The widespread use of sterling as a medium of international exchange meant that the customers of banks in continental Europe and the United States had a constant need to trade their own currencies against sterling. In meeting this need foreign banks acquired a technical proficiency that they were able to put to good use when they entered the City and competed for the leaner pickings available on the London foreign exchange market. Foreign branch banks also were not shy in seeking new business. Cold calling, something that would have been quite abhorrent to the clearing banks, formed an essential part of their marketing strategy. The Journal of the Institute of Bankers noted admiringly: One of the greatest factors in the success of foreign banks is their wonderful system of obtaining and classifying information regarding those with whom they deal. Immediately a new name comes to their notice a representative of the bank calls on the firm and asks a series of searching questions as to the nature, volume and resources of the business, at the same time having a good look around the office or factories.30 This approach, however, did not always pay dividends. On 15 November 1905, J.P.Morgan were told by its London partners that, ‘Dresdner Bank agent came in to talk about arrangements between JSM & Co and Dresdner Bank here because of arrangements between JPM & Co and themselves’. The next day, J.P.Morgan cabled the following terse reply, ‘Do not quite see why Dresdner Bank London agency should communicate with you’.31 The strong position of foreign branch banks on the London foreign exchange markets worried the British clearing banks, because of the platform it provided the former to make incursions into other banking activities in the United Kingdom. The clearers may have been largely absent from the foreign exchange market, but they made a pretty penny providing agency (i.e. correspondent banking) services in London to banks abroad. Services coming under this heading included the collection of sterling bills and drafts, the provision of documentary letters of credit, the safekeeping of securities and the clearing of sterling cheques and payments. While the exclusion of foreign banks (and, for that

The somnolent years 1900–14

21

matter, also the merchant banks) from the Bankers’ Clearing House protected the clearers from competition in payments services, their other agency work was vulnerable to poaching by foreign branch banks. This was spelt out in crystal clear terms in the 1899 annual report of Credit Lyonnais. Using words that must have sent a chill down the spine of many a clearing banker, the French bank noted: Your London office gradually attains the development to which it always seemed to be called. It becomes more and more the London correspondent of a great number of different foreign houses. Further, its dealings in exchanges, bonds and Stock Exchange affairs increase greatly in importance.32 The belated move by the clearing banks into the foreign exchange market was motivated not so much by the desire to expand the range of their services as by the need to weaken the platform being used by foreign branch banks to attack their profitable correspondent banking business. However, it was a move that the clearing banks took with some reluctance. With large deposits, but with only a modest capital base, they were inherently risk-averse institutions. Engaging in foreign exchange trading, therefore, was not the easiest step for them to take. But with the foreign banks chipping away at their agency business, they were effectively not given a free choice. This realisation dawned first on Martins Bank, which in the early 1890s obtained a market presence through its acquisition of Allard & Co, a foreign exchange boutique.33 London City & Midland, however, was the first clearing bank to set up a de novo foreign exchange department. Edward Holden was the driving force behind this bold move. In 1904, he had visited the United States where he had been impressed with the foreign exchange operations of US commercial banks. The ability of these institutions to combine foreign exchange trading successfully with traditional commercial banking activities provided a model that Holden chose to emulate when he returned to Britain. The London City & Midland Bank opened its foreign exchange department in 1905, and the decision to establish a joint foreign exchange account immediately with the National City Bank of New York, underlines the importance of Holden’s US tour in shaping the initial tactics of his bank in the foreign exchange market. The London and County Bank took a similar route to Martins when it moved into the market in 1907. Rather than build a department totally from scratch it bought in some of the required expertise through the acquisition of Frederick Burt & Co. One problem all of the newcomers faced when building or expanding their foreign exchange departments was recruiting the right staff. The dearth of indigenous currency traders within the commercial bank sector forced the clearers to look outside, and as if to retaliate for the foreign branch banks incursion into their agency business, they were not averse to headhunting talent from the foreign banks in London. For instance, the London City & Midland recruited liberally from Credit Lyonnais, and the London and County hired the first manager of its foreign exchange department from Société Générale.34 Following these early moves, foreign exchange trading was taken up by one clearing bank after another, and by the outbreak of the First World War this activity had become

The foreign exchange market of London

22

part and parcel of the services provided by these banks. They could not have timed their entrance into the market any better. The changes wrought by the war played straight into the hands of the clearers, and by the end of the conflict they had secured a position of dominance on the London foreign exchange market that they were to retain during the inter-war period.

2 Innocence lost 1914–18 The First World War was more than just a time corridor between the sleepy dealing days of the Edwardian era and the foreign exchange trading boom of the early 1920s. The emergence after the hostilities of a ‘modern’ foreign exchange market dominated by big commercial banks and characterised by speedy communications had much to do with the direct impact of the war on the everyday life of the City. The unreliability of the mails between 1914 and 1918 encouraged the greater use of the telegraph by financial institutions, the political and military uncertainties of the time led to the faster settlement of cross-border payments, and the liquidation of the branches of enemy owned banks in Britain redrew the competitive map of the currency market. The previous stability in exchange rates also was disturbed by the conflict. The gold standard fell into abeyance within the first few days of the war, and the major currencies soon lost touch with their old gold standard parities. Heavy war-time purchases in the United States, however, meant that the authorities could ill afford to allow sterling’s level to be set by market forces and, from 1914 onwards, they resorted to a panoply of measures—including controls, moral suasion and direct intervention—to influence the behaviour of the exchange rate. Indeed, the war marked the end of the age of innocence for the exchange market. Prior to 1914, the government had been a mere spectator of events on the international currency stage, whereas the Bank of England had limited its involvement to altering Bank rate in order to ensure the smooth working of the gold standard. However, during the war, both the Bank and the government became directly involved and, with varying degrees of intensity, their presence would continue to be felt in the market during much of the remainder of the twentieth century. War paralyses the market Troubles developed on the London foreign exchange market some days in advance of Britain’s declaration of war on Germany on 4 August 1914.1 Rising political tensions in central Europe provoked a scramble for liquidity, and towards the end of July the commercial banks began withdrawing short-term loans from the discount market. The discount houses responded to this cash squeeze by refusing to discount new sterling bills, and by seeking to rediscount their existing holdings at the Bank of England. In turn, the Bank responded to the unprecedented demand for accommodation by lifting Bank rate from 3 per cent to 4 per cent on 30 July, to 8 per cent on 31 July and to 10 per cent on 1 August. The seizure in the discount market along with an abrupt loss in the City’s appetite for cross-border risk led the merchant banks to refuse to accept new sterling bills from 27

The foreign exchange market of London

24

July. Foreigners accustomed to drawing new bills to repay their maturing obligations had no choice but to buy sterling to remit to London. The ensuing scramble for sterling bills abroad caused turmoil in the foreign exchange markets, and—notwithstanding the shipment of some gold to Britain at the end of July—the pound soared above its upper gold point against all but one of the major currencies. The one exception was the French franc against which sterling fell steeply following the withdrawal by French banks of their ample liquid balances in London. Elsewhere sterling remittances became harder and harder to find and by 1 August (the day that Germany declared war on Russia) the US dollar/sterling rate reached the unheard of level $6.50.2 This rate, however, was pretty notional because by the beginning of August activity on the foreign exchange market had all but ground to a halt. The market was to remain in a state of near paralysis over the next six weeks. The virtual disappearance of the sterling bill in overseas markets prevented foreigners from remitting to London, whereas the imposition—by the start of the war—of moratoria on short-term obligations in most of the continental European countries destroyed the demand for foreign bills in London. On 4 August, or the day that Britain declared war, emergency measures were introduced to allow maturing sterling bills to be rolled over for one month. This moratorium was designed to protect acceptors, who otherwise would have had to meet the obligations that foreign drawees were no longer able to remit to cover. A three-day bank holiday also was declared. While the banks re-opened on 7 August (when Bank rate also was reduced to 6 per cent), the foreign exchange market remained idle. The widespread imposition of moratoria made it impossible to negotiate finance bills, so denying the market the lubricant upon which it had so heavily relied before 1914. The shipment of gold, which also had contributed to the smooth functioning of the pre-war market, became almost impossible to initiate in early August due to soaring insurance premiums, to the imposition of legal gold export embargoes by Germany, Russia and Argentina, and to the imposition of a de facto export embargo by France.3 During the second week of the war, the British authorities took their first tentative step towards breaking the impasse on the foreign exchange market. On 12 August, the Bank of England launched an initiative to facilitate the transfer of funds from the United States to Britain. Such transfers had ground to halt because remitters not only were unable to lay their hands on sterling bills in New York, but also were unwilling to ship gold across the Atlantic, due to the problem of finding suitable insurance cover. The Bank eased this blockage by opening a new transatlantic payments channel. Those wishing to make remittances to the United Kingdom were allowed to deposit gold for the Bank’s account with the Canadian Finance Minister in Ottawa and in return they were provided with sterling in London at a price corresponding to an exchange rate of $4.90.4 Over the next two months, the equivalent of $104 million was remitted in this way. On 12 August, the Bank of England also sought to improve liquidity in the sterling acceptance market. However, because the measures it adopted provided greater relief to the holders of bills (the commercial banks and discount houses) than to the acceptors of bills (the merchant banks) they failed to secure the re-opening of the market. Given sterling’s pivotal role in global finance, the continued unwillingness of the merchant banks to accept new sterling bills effectively ensured that foreign exchange markets around the world remained in a state of paralysis.

Innocence lost 1914–18

25

Drive to revive trading While foreign exchange quotations began to appear in the press from 25 August, these were largely nominal and little business was undertaken.5 However, official steps were taken on 5 September, which put the exchange market back on a slow road to recovery. On that day, arrangements were made for the 4 August moratorium to be extended into October, and for the Bank of England to advance funds, repayable after the war, to acceptors to meet any acceptances that were left unpaid, once the moratorium finally was lifted. The latter measure was intended to deal with bills drawn on enemy countries, although it turned out that, ‘a large proportion proved in the end to be not German but Russian’.6 In mid-September, the government acted to remove a further obstacle preventing the re-opening of the foreign exchange market by amending the 1882 Bills of Exchange Act. Under this Act, a bill payable after sight had to be presented for acceptance abroad within a reasonable time, otherwise the holder would cease to have recourse against the drawer or endorser. The amendment referred to above preserved the legal right of recourse in those cases where a bill had not been presented in a timely fashion due to logistical and other difficulties arising from the war. Following this move, The Economist noted, on 12 September, that, ‘A real attempt to re-establish foreign exchange rates is to be made next week…’. This attempt bore some fruit and 17 September witnessed the resumption of the regular bi-weekly meetings at the Royal Exchange. However, the situation remained far from normal, because overseas markets—upon which London was so reliant—were not yet being fed with a free supply of sterling bills. The full benefit of the measures taken on 5 September were not realised until the middle of October, and it was only from that time on that the London foreign exchange market returned to proper working order. The war, of course, ensured that the market would operate in a new and less hospitable environment. The cessation of direct financial ties with Austria, Germany and Hungary; the lengthy closure of the London stock exchange (it remained shut until 4 January 1915); the abandonment of the global gold standard; the disruption to shipping and the mails; and the diversion of resources from exports to armaments production meant that there would be no return to the benign conditions of the pre-1914 period. The flows of money across the exchanges began to alter within a short period after the commencement of hostilities. Sterling’s earlier all-round strength, other than against the French franc, gave way to a more mixed performance. On the one hand, increased imports of food and munitions exerted downward pressure on sterling’s exchange rate against the currencies of the United States and other neutral countries. On the other hand, increased purchases in Britain—which served as a key financier and supplier to its European allies—by France, Russia and Italy caused sterling to strengthen against the franc, rouble and lira. Sterling’s exchange rate against the US dollar received the greatest official attention, due to the high and rising volume of goods being purchased in the United States for the war effort. Weighed down by these purchases sterling soon relinquished the high ground it briefly held at the onset of the war. By the end of 1914, the US dollar/sterling rate had

The foreign exchange market of London

26

returned to a more normal level of $4.86. However, the slide did not stop there and by the opening months of 1915, the pound was trading at $4.81, or just below the level ($4.827) that would have served as a floor if the gold standard had been operating normally. With heavy purchases to make in the United States, the government was very sensitive to the impact on import costs of a falling US dollar/sterling exchange rate and, in February 1915, the first official move was made to directly support sterling on the New York currency market.7 This effort was not blessed with enduring success and over the following months sterling resumed its decline to reach a low of $4.47 in August. That marked the nadir of sterling’s fortunes and the subsequent enlargement of the British authorities ‘war-chest’ in the United States, through the mobilisation of foreign securities and by heavy borrowing in New York, led to a firming in the exchange rate and to the eventual adoption of a fixed rate of in January 1916. Sterling was to be supported at that rate until March 1919. From Britain’s standpoint, the French franc was the next most important wartime currency after the US dollar, and so it is unsurprising that moves to stabilise it also were taken in early 1916. The gold par for the French franc/sterling rate had been Fr25.125 but, after briefly climbing to Fr24.0 at the outbreak of war, the franc had eased back toward par in early 1915, before slipping—in response to increased imports from Britain—to a low of Fr28.48 in March 1916. In the following month, the British and French governments reached an agreement aimed at stabilising this exchange rate. While the French franc/sterling rate was not rigidly pegged in the same way as the US dollar/sterling rate, official support helped to strengthen the franc to Fr27.80 by the end of 1916, and it stabilised in a fairly narrow Fr27.15 to Fr27.80 range during the rest of the war, before being carried up by a wave of speculative demand to Fr25.97 at the end of 1918. Despite the removal of the straightjacket previously imposed by the gold standard on exchange rates, the determined efforts of the authorities to stabilise the relationships between sterling, the US dollar and the French franc ensured that the economic disruption resulting from the war provided foreign exchange operators with only limited speculative trading opportunities. The best hunting grounds for those seeking volatility were in the markets trading the currencies of the neutral countries. Sterling exhibited general weakness against these currencies during most of the war, due to a sharp deterioration in British exports to, and to a substantial rise in food and raw material imports from, countries in Latin America and the Far East. For instance, between 1914 and 1917, the Chilean peso soared against sterling rising from pence to pence, before easing back to pence at the end of 1918. Wartime pressures also made it impossible to sustain the long established peg between the Indian rupee and sterling, and after remaining glued to its old parity of 1s 4d during the first year or so of the hostilities, the rupee appreciated steadily to 1s 6d by the end of 1918. Official involvement in the market Sterling’s broad stability during the war, other than against some of the neutral

Innocence lost 1914–18

27

currencies, had much to do with the wide-ranging measures taken by the British government to influence its behaviour on the currency markets. However, in contrast with the draconian exchange regulations that would be adopted during the Second World War, the government exerted control over the exchange rate between 1914 and 1918 in a way that still provided a reasonable degree of freedom for individuals to engage in currency transactions. The main measures adopted to support sterling were: • Direct intervention on the currency markets. • External borrowing to finance wartime supplies. • Controls on capital outflows. • Restrictions on certain imports. Direct intervention During the first few months of the war, the underlying strength of sterling obviated the need for any direct involvement by the authorities in the exchange markets. However, the situation changed during 1915, as rising imports from the United States exerted their toll on the critical US dollar/sterling rate. In order to intervene, the authorities required a stockpile of gold and foreign currencies. The Bank of England possessed gold, but the bulk of this could not be easily used for intervention because it was held in the Issue Department, where it was legally required to back the issue of Bank of England notes (domestic convertibility was not suspended during the war). There were some foreign assets in the Banking Department, but these were far too small to provide much comfort. Accordingly, the authorities realised early on that any meaningful support for sterling would require them to undertake heavy foreign currency borrowing. They also realised that it was important to conserve the Bank’s gold holdings, given that they provided the final line of defence for sterling (in extremis legislation could have been passed to secure the release of gold from the Issue Department). In contrast with most of the other combatant nations Britain did not remove, during the war, the legal right of individuals to export gold. The fact that few sought to exercise this right was attributed, at the time, simply to the exigencies of war. According to the 1918 Cunliffe Committee, undue weakness in the exchange rate failed to trigger outflows of gold, because: During the present war the depredations of enemy submarines, high freights, and the refusal of the Government to extend state insurance to gold cargoes have greatly increased the cost of sending gold abroad. The actual specie point has, therefore, moved a long way from its old position.8 However, it appears that the government relied on more than just the altered economics of shipping gold to keep a grip on Britain’s stockpile of the yellow metal. In a letter to the Secretary of the London Exchange Committee, an official body formed by the Treasury in November 1915, the British Bank of South America Ltd, which had sought advice about insuring a possible shipment of gold, claimed the Treasury had told it that, ‘lt is undesirable at the present time that any bank doing business in Great Britain should participate in, or in any way facilitate, operations relating to the shipments of gold from

The foreign exchange market of London

28

Great Britain, or from the United States of America or Canada, to any parts of the world’.9 Arm-twisting also was used to dissuade UK residents from exercising their legal right to convert Bank of England notes into gold.10 Apart from protecting its existing stocks, the Bank of England, at the government’s behest, also acted to increase its gold holdings by buying up at source the output of the gold producing countries of the Empire. In 1916, the Bank cast its net even wider by purchasing all other gold entering the United Kingdom. Most of the Bank’s incremental gold holdings were shipped to North America. While the authorities made good use of these incremental holdings (early foreign currency borrowings in the United States, for instance, were repaid from the Bank’s gold horde in Ottawa), the implementation of a sustained programme of intervention on the exchange markets required access to a greater supply of liquid foreign currency assets. To obtain these resources, the authorities resorted not only to foreign borrowing, but also to the mobilisation of foreign securities held by UK residents. The earliest borrowings took place at the beginning of 1915, when J.P.Morgan & Co—who had just been appointed as the government’s purchasing agent in the United States—provided the Bank of England with short-term credits that were used in an ultimately vain attempt to hold sterling above $4.81. Sterling’s slide over the summer of 1915 prompted the government to take more decisive action both to boost its foreign currency resources, and to strengthen its influence over the exchange rate. In July, the Treasury instructed the Bank of England to buy dollar securities in Britain for onward transmission and sale in New York, and two months later the Treasury successfully negotiated a joint $500 million Anglo-French loan through J.P. Morgan in New York. Armed now with greater firepower the government decided to set up a command and control centre for its foreign exchange operations. This was achieved in November, when the Chancellor of the Exchequer Reginald McKenna established a committee, initially called the American Exchange Committee, but soon to be known as the London Exchange Committee (LEC).11 The LEC was supposed to have exclusive control over the authorities’ gold and foreign currency assets in North America, but in practice it did not have the power to prevent the Treasury sometimes from independently sanctioning the use of these assets.12 As the war progressed, the resources overseen by the LEC would be bolstered by the further mobilisation of foreign securities (some of which would be sold, while others would be used as collateral for loans), and also by additional foreign currency borrowing (including loans from the US government following America’s entry into the war). The LEC was comprised of four individuals. Its founding members were Lord Cunliffe, Governor of the Bank of England, who served as chairman; Sir Brien Cokayne, deputy Governor of the Bank of England; Sir Edward Holden, chairman of London City & Midland Bank (a position he had ascended to in 1910, or one year after his knighthood); and Sir Felix Schuster, chairman of Union of London and Smiths Bank. Sir Edward’s tenure, however, only lasted a few months due to his unwillingness to observe the Committee’s strict rules regarding contact with the press.13 He was replaced by Gaspard Farrer of Barings Brothers & Co. Despite the inclusion of two outsiders, the LEC acted very much as an arm of the Bank of England. It met at the Bank, and it was chaired and also kept on a short rein by Lord Cunliffe.14

Innocence lost 1914–18

29

Most of the assets controlled by the LEC were kept with J.P.Morgan & Co in New York. The government maintained two accounts with this firm. The first of these (which was known as the ‘British Government Commercial Agency Account’) had been opened in January 1915, following Morgan’s appointment as the government’s purchasing agent in the United States. However, in September 1915, a new and separate ‘British Government Treasury Account’ was opened to manage the foreign currency balances controlled by the LEC. It was from this account that funds would be drawn to finance intervention on the exchange markets. The primary target of intervention was the US dollar/sterling rate, which—as already has been indicated—was supported at a fixed rate from January 1916 onwards. Virtually all of the intervention to support the US dollar/sterling rate was undertaken in New York. These operations were arranged by Morgans and were implemented through a sub-committee comprised of three banks, namely: National City Bank, Guaranty Trust Co and Bankers Trust Co.15 For most of the time, the rate quoted in London slavishly followed the officially supported rate in New York (the London market was still a price taker rather than a price maker) but, with communication and other difficulties impinging on the level of arbitrage activity, the need occasionally arose for official action to nudge the London rate into line. The authorities, however, were reluctant to reveal their hand on this side of the Atlantic. On 24 December 1915, Sir Edward Holden wrote to Lord Cunliffe, ‘In order to keep the name of the Bank of England out of it… I have planned that transactions…should be carried out either with the London and City and Midland Bank or with the Union of London and Smiths Bank’.16 Important wartime supplies were obtained from a number of neutral countries, and sterling’s weak performance against the currencies of these countries concerned the government sufficiently for the LEC to be directed to divert some of its resources to moderate sterling’s depreciation in neutral markets. During the course of the war, action was taken in support of sterling on the Dutch, Scandinavian, Swiss and Argentine exchanges.17 Complex arbitrage transactions sometimes were initiated by the LEC to contain the cost of intervention in these markets.18 External borrowing for imports During the opening months of the hostilities, the government paid for the essential supplies it acquired from abroad with foreign exchange purchased on the open market. This policy, however, came under review in 1915, as Britain’s ever expanding appetite for imports exerted downward pressure on the US dollar/sterling rate. However, little could be changed until the third quarter of 1915, or until the acquisition of significant foreign currency holdings by the government. Once this had been achieved, the Treasury recast the government’s overseas procurement policy, and decisions on whether to pay for imports with bought foreign exchange or from the proceeds of foreign loans were heavily influenced by the size and timing of transactions and their concomitant affect on sterling. This was touched upon in a letter sent on 8 November 1915, by the Treasury’s Sir John Bradbury to Lord Cunliffe, in which the former noted that the government’s dollar resources in the United States had been partly used to cover, ‘Special remittances for the

The foreign exchange market of London

30

purpose of keeping off the exchange market large payments which would otherwise be made by buying exchange’.19 Using borrowed money to pay for imports clearly made sense if the alternative would have been a hefty fall in the exchange rate that would have used even more foreign currency to correct through direct intervention. Following its establishment in mid-November, the LEC assumed the task of policing the funds held at J.P.Morgan, and of granting official bodies access to them. Not all applicants were given a warm welcome. In a tersely written letter to the Treasury, the Secretary of the LEC stated: …the Committee direct me to say that they note with surprise the request made by the Royal Commission on Wheat Supplies regarding payment out of the Treasury Account in New York as… Mr Anderson [of the Commission]… attended a meeting of the Committee regarding the financing of purchases made by the Commission. The Committee advised that the purchases should be financed through the ordinary trade channels and Mr Anderson expressed himself entirely in agreement with their views.20 Between 1915 and 1919, $2,021 million was defrayed from the Treasury Account to finance direct support for sterling on the foreign exchange markets. But, a far greater sum, equal to $5,932 million, was defrayed to finance official purchases of munitions and essential supplies both in the United States and elsewhere.21 The settlement of these purchases away from the exchange markets made an import contribution to official efforts to stabilise the external value of sterling but, of course, it also restricted the flow of business entering the wartime foreign exchange markets. Capital controls The needs of the wartime economy also forced the government to impinge on the freedom of UK residents to engage in cross-border financial transactions. While comprehensive exchange controls were avoided, various piecemeal measures were adopted aimed at restricting not only new overseas capital issues in London, but also the acquisition of securities on foreign stock markets by UK residents. The measures taken between 1914 and 1918 opened a new and scarcely illustrious chapter in British financial history, given that—with the exception of a handful of years in the 1920s—the next sixty years or so would witness the heavy hand of government interfering, in one way or another, with the external financial transactions of the private sector. Restrictions on overseas investment were imposed within a few months of the outbreak of the war. On 24 December 1914, in a move designed to dis-courage the acquisition of new securities on foreign markets, a temporary regulation was passed prohibiting dealings in securities that had not been physically held in Britain since September 1914. Controls on overseas issues on the London market were imposed the following month. On 19 January 1915, the Treasury established a Capital Issues Committee to whom all prospective borrowers (i.e. domestic as well as foreign) had to apply before raising new capital. This process did not result in an outright ban on overseas issues, and during the war a modest amount of capital was raised in London, mostly by Empire and Allied governments.

Innocence lost 1914–18

31

The fact that all capital issues were subject to official control indicates that this measure was intended more to reduce competition for funds on the London market, in order to allow the British government to meet its hugely enlarged borrowing requirement on the best possible terms, than to avoid selling pressure on sterling. The same cannot be said for the tighter restrictions that were imposed, as the war progressed, on purchases of foreign securities abroad. It has been noted already that, prior to 1914, cross-border transactions in outstanding securities probably generated the biggest single flow of business for the London exchange market.22 This flow offered itself, therefore, as an obvious target for regulation once official support for sterling began to impose a significant strain on the Treasury’s precious financial resources in New York. Allowing UK residents the unfettered freedom to sell sterling and buy securities abroad anyway would have been quite illogical, given that the authorities were actively mobilising existing holdings in the United Kingdom to raise foreign currency for the purpose of supporting sterling on the currency markets. Action to block purchases of securities abroad reached its fullest expression with the passage of Defence of the Realm Regulation 41D in November 1917. This regulation can be regarded as the grandfather of codified exchange control in the United Kingdom. It stated: A person resident in the United Kingdom shall not without permission in writing from the Treasury, directly or indirectly, either on his own behalf or on behalf of any other person in the United Kingdom…send money out of the United Kingdom for the purpose of…making or subscribing to any issue of capital outside of the United Kingdom, or purchasing any stock…if the securities are not in the United Kingdom….23 No attempt was made during the First World War to ban individuals from buying and holding foreign exchange. However, the use of Regulation 41D to prevent them from using foreign currency in order to acquire foreign securities still marked the earliest use of legal powers by a British government to restrict the freedom of individuals in the exchange market. Import controls Imports remained free from direct control during the first year and a half of the war. However, they were not left entirely untouched by the authorities. In September 1915, in a move that marked a sharp break with Britain’s free trade tradition, Chancellor of the Exchequer Mckenna slapped a 33 per cent duty on certain imports, including motorcars, motorcycles and watches. This move was intended not so much to protect domestic industry as to reduce imports in order to relieve pressure both on sterling and on shipping space. Subsequently, further heavy shipping losses called out for even tougher action. The need to reserve precious cargo space for munitions and food led to the imposition, during 1916–17, of import controls on bulky and/or nonessential imports. In March 1916, for instance, a ban was imposed on imports of motorcars, motorcycles, musical instruments and spirits (other than brandy and rum). The list of banned imports was widened

The foreign exchange market of London

32

considerably further—to include such things as wine, coffee, textiles and timber—in March 1917. The Economist, commenting on these later measures, claimed that: …[they] are framed with the avowed intention of reserving mercantile tonnage for the carriage of more essential goods. They will, if rigorously administered, at the same time serve a hardly less important purpose, by reducing substantially the adverse balance of trade.24 In effect, import controls—while ostensibly imposed to save cargo space—served as a form of exchange control, by curbing balance of payments outflows and so the demand for foreign exchange. To the extent that they acted in this way, import controls played a helping hand in supporting sterling at its officially ordained

rate.

Trading in wartime It was not just increased government regulation and control that currency dealers had to contend with during the war. The moratoria on short-term obligations in August 1914 provided an early reminder of the heightened cross-border risks that accompany any conflict. Even when these moratoria were lifted and the exchange markets re-opened, dealers found it difficult to return to their old procedures and practices. The long bill, which served as the bedrock of the pre-1914 system of international trade finance, struggled to survive in the harsher condition that now prevailed on the currency markets. The virtue of the long bill was that it provided, in a single instrument, the means of conveying not only money but also credit across national borders. However, once armies started to trample across some of these borders, the markets took fright and became less willing to provide extended credit to counterparties abroad. It was noted in the Journal of the Institute of Bankers that, ‘…credit is greatly restricted, and there is a marked inclination of traders all over the world to insist on prompt settlement, so that many transactions which would ordinarily be settled by a three months draft are now paid at sight…’.25 The exchange market’s previous reliance on long bills, as well as on other forms of paper remittance, also was weakened by another factor. This was the unreliability of the mails. Starting in 1915, the reservation of shipping for military use led to a sharp deterioration in the punctuality of overseas mail deliveries, even to near centres in continental Europe. Bankers and traders no longer could be sure when their remittances would arrive and when their payment instructions would be acted upon. In this less certain environment greater resort was made than hitherto to telegraphic transfers. Whereas before the war this means of remittance had been mostly favoured for large sums and/or for payments to far distant countries, it was now pressed into wider service. It became commonplace, for instance, for telegraphic transfers to be substituted for paper remittances to continental Europe.26 This is borne out by the entries in Kleinwort’s foreign exchange ledger, which show a significant rise, as the war progressed, in the volume of telegraphic transfers to near European centres, such as Paris.27 In turn, the

Innocence lost 1914–18

33

expansion in telegraphic transfers gave rise to a related expansion in the use of common value dates for foreign exchange transactions. As already has been noted, the buyer of a foreign sight bill or cheque paid in sterling the day after purchase, but only obtained use of the foreign currency proceeds once his remittance had arrived, and had been cleared, in a foreign centre. The length of time he was out of pocket (and so needed to be compensated) depended both on the distance his remittance had to travel and on the efficiency of the foreign clearing system.28 The fact, however, that instructions conveyed by telegram arrived in a matter of minutes, without the risk of delays attendant with the mails, enabled counterparties in transactions conducted via this medium to arrange for cleared funds to be paid/received prospectively in both centres on the same day, thereby obviating the need for either party to receive any interest compensation. During the First World War, it became customary for telegraphic transfers to the near European centres to be given a common value date three days from the initiation of the transaction (this would be reduced, in some cases, to two days after the war. Eventually two days would become the norm for all spot transactions). Transactions carried out in this way were said to be ‘valeur compensée’, that is with good value being obtained ‘here and there’ on the same day. Since there was no need for the time value of money to be recognised in such transactions, they were conducted at exchange rates that were unadulterated by interest rate considerations. This marked the origin of spot trading on the foreign exchange market. Market trends favour the clearing banks The level of activity on the foreign exchange markets was severely undermined between 1914 and 1918, as the needs of the wartime economy interrupted everyday business life. Despite a sharp escalation in inflation, the value of exports remained flat throughout the war, due to the diversion of productive resources from international trade to the war effort. In contrast, soaring demand for foreign food and munitions caused the value of imports to almost double from £660 million in 1914, to £1,170 million in 1918. Foreign exchange dealers, however, did not benefit fully from this import boom, because a significant part of the government’s overseas procurement programme—which made a powerful contribution to the surge in imports—was paid directly out of its ‘Treasury Account’ at Morgans in New York, and so by-passed the exchange markets. Against this, a greater share of normal imports, than previously had been the case, were invoiced in foreign currency, as the rise in sight payments and the associated decline in the long sterling bill led overseas suppliers to rely more heavily on the US dollar as an international vehicle currency. In turn, this put more importers in the unaccustomed position of having to buy foreign currency in London in order to settle their purchases from abroad. During the war, poor communications made it far more difficult for traders to engage in foreign exchange arbitrage and, from 1915 onward, it was quite common for wide discrepancies to appear in quotations given for the same exchange rate in two different centres. If foreign exchange arbitrage was curtailed by poor communications, gold arbitrage was totally expunged by official action. Government bans on gold exports in

The foreign exchange market of London

34

continental Europe, along with the British government’s success in ‘persuading’ UK residents to refrain from shipping gold, put an end to international arbitrage in this metal, and to the business it had previously generated for currency traders. An even bigger dent was made in foreign exchange turnover by official curbs on capital outflows. The measures that really hurt were those that either impeded or restricted the acquisition of securities abroad. Curbs on new overseas issues were less damaging, given that a significant part of the proceeds of such issues always had been spent in the United Kingdom. Before 1914, foreign exchange deals generated by the ebb and flow of dollar securities between New York and London had been a big moneyspinner for London currency traders. This business simply evaporated during the war. Dealings in dollar securities turned into a one-way flow as British holders were forced to disinvest. However, even such disinvestments failed to support activity on the London foreign exchange market, because the discarded dollar securities either were borrowed by the Treasury, or bought by it for sterling. Thereafter, the securities were despatched to New York in order to be used as collateral for British government borrowings, or to be sold for cash. Before the hostilities, the foreign banks and merchant banks had been the dominant providers on the London foreign exchange market, with the Empire banks and the British clearing banks trailing some way behind. The balance of power, however, was to change significantly during the war. This process started, and in quite a dramatic fashion, within three days of the declaration of hostilities. When the banks re-opened on 7 August 1914, following the extended bank holiday, German and Austrian banks operating in the London market were instructed by the government to keep their doors firmly bolted to new business. This instruction covered the branches of Deutsche Bank, Dresdner Bank, Direction der Disconto-Gesellschaft and Oesterreichische Länderbank, as well as the operations of the British based AngloAustrian Bank. These five institutions were granted temporary licences to liquidate their assets under official supervision, and despite rumours that they had surreptitiously removed money from the United Kingdom during the last few days of July, no balance sheet deficiencies were found, and their London offices were finally shut down in midOctober.29 The German banks easily had been the most feared competitors on the pre-war London foreign exchange market so their sudden departure would have come as a great relief to the remaining participants. However, those still active had other things to worry about, not the least of which was the constriction in foreign exchange market activity resulting from the war. In particular, the British merchant banks, which had given the foreign banks a good run for their money in pre-war days, found it hard to capitalise on the departure of their German and Austrian rivals. The earlier strength of the merchant banks had owed much to the ancillary foreign exchange business that they had derived from their deep involvement in the global markets for short-term paper, securities and gold. Unfortunately for these institutions, this ancillary business suffered during the war as cross-border trading in securities and gold was curbed by official action, and as the telegraphic transfer stole more and more ground from sterling and foreign bills in settling international trade transactions.

Innocence lost 1914–18

35

The clearing banks were the principal beneficiaries of the altered conditions on the wartime exchange markets. They had already made significant strides towards catching up with their foreign and merchant bank rivals in the years just before the war, and this was recognised by the selection of a clearing banker, E.F.Davies, assistant manager of the London County and Westminster Bank, to chair the association of foreign exchange traders that was formed at the outset of this war. This association, called the Committee of English and Foreign Bankers in London, advised the Treasury on technical matters relating to the exchange market and played a key role in securing the amendment to the Bills of Exchange Act that contributed to the re-opening of the market in September 1914.30 Clearing banks prospered in the wartime exchange market, because they were better positioned than other providers to benefit from the shift from long bills, to sight bills and telegraphic transfers, in settling international transactions. Their comparative advantage derived from their direct participation in the UK payments system, from their extensive reciprocal payments links with money centre banks across the world and from their dominant role in extending overdrafts. The first two factors gave them a slight edge in executing telegraphic transfers, whereas the third meant they were well situated to fill the credit void left by the decline of the long bill. With the war spoiling the appetite of the acceptance houses and the discount market for cross-border risk, British exporters had to incur more of this risk themselves, by using their own overdraft facilities, whenever they needed to provide credit to their overseas customers. British importers also had to rely more on domestic credit, as overseas suppliers switched from drawing long bills to demanding cash on the nail in payment for the goods they shipped to this country. With sight bills and telegraphic transfers gaining ground at the expense of long bills, and with overdrafts playing a more important role in financing international trade, it was the clearing banks that now became a natural port of call for those wishing to buy and sell foreign exchange on the London market. While the foreign branch banks and the merchant banks were far from idle, they lost ground to the clearers in competing for the restricted flow of business entering the wartime exchange markets. The clearers’ ascendancy was confirmed by the authorities’ reliance on them not only for advice (viz. the key role played by clearing bankers on wartime committees on foreign exchange), but also as foreign exchange providers. The Bank of England certainly felt confident to use the clearing banks for surreptitious intervention on the London market, whereas the government—no doubt mindful of their impeccable credit standing and widespread links with correspondents abroad—used them extensively to supply foreign exchange for that part of its overseas procurement programme that was settled on the open market. Thanks to this sort of patronage the clearing banks’ foreign exchange departments had a very good war. This point is vividly illustrated by the phenomenal growth in the foreign exchange activities of the London City and Midland Bank. Two years after its inauguration in 1905, the Midland’s foreign exchange department had moved to new offices in Finch Lane, where it was given the title of Foreign Branch Office. Rapid expansion during the war, however, created a serious premises problem, which the bank resolved in a way that was laced with irony. Looking back on this period, some years later, the Midland’s staff magazine noted:

The foreign exchange market of London

36

War conditions made necessary a quite extraordinary development of the international financial machinery of London, and the Midland Bank’s Foreign Branch Office was swiftly changed out of all knowledge. Towards the time of the Armistice it had become the Overseas Branch, housed in the former premises of the Dresdner Bank in Old Broad Street and manned by a Staff nearly a hundred times greater than the little pioneer company of the Finch Lane days.31 The Armistice concluding the First World War was signed on 11 November 1918. Peace, however, did not bring about the immediate return of normal conditions on the financial markets. Most of the wartime controls and procedures remained in place for a few months longer, and traders who took to the streets to celebrate on Armistice Day would not have had the slightest notion of the dramatic changes that were in store for the London foreign exchange market over the next two decades. From being a backwater activity before 1914, foreign exchange trading soon was to become one of the most important and exciting functions undertaken within the Square Mile.

3 Tom Tiddler’s ground 1918–31 Within months of the ending of the First World War the London foreign exchange market was caught up in a frenzied trading boom that was to last, with varying degrees of intensity, until the middle of the 1920s. The boom—which took place at a time when most currencies were off the gold standard and floating freely—owed much to the wild currency gyrations that were sponsored by the post-war economic and political instability in Central and Eastern Europe. While calmer conditions prevailed after 1924, the market had by then secured a prominence and also obtained the sort of visibility that would have been unheard of only a few years beforehand. Sharply higher turnover and increased volatility offered the promise, although not always the reality, of easy profits to those engaged in currency trading, and this resulted in a significant increase in the number of banks and brokers participating in the London market. Not all of the newcomers were top drawer, and the rapid expansion in activity was accompanied by an unwelcome rise in corruption and sharp practice. The London foreign exchange market, which had struggled to keep up with other key centres before the war, appeared to edge ahead of its rivals during the 1920s.1 Its main competitors during this period were Paris and New York. Post-war instability in Germany and Austria had allowed Paris to pull ahead of Berlin and Vienna as the principal centre for trading the continental currencies, whereas New York’s position had been strengthened by the emergence of the United States as an international creditor nation. Paradoxically, the enhanced international financial position of the United States helped rather than hindered the development of London as a dominant currency centre. London always had been the principal market in Europe for trading the US dollar, and this ensured that the greatly increased post-war financial flows between Europe and the United States—which resulted from the US dollar’s expanded role as an international transactions and investment currency—not only boosted turnover on the London market, but also endowed it with a much greater say over the pricing of the continental European currencies (given that the rates between these currencies and the US dollar were increasingly derived from their rates against sterling on the one hand, and the US dollar/sterling rate on the other). In addition, London’s position was elevated still further by its active involvement in trading the currencies of the new European nation states spawned by the Versailles Treaty, and by its long-standing role as the main European centre for trading the currencies of the far flung countries of the Empire and Latin America. Currencies in chaos The curtain on the twentieth century’s first serious currency trading boom was drawn on

The foreign exchange market of London

38

20 March 1919, when the British government announced that it would no longer support sterling at its wartime pegged rate of . This step along with the decision, taken on 1 April 1919, to legally ban the export of gold bullion and coin from the United Kingdom recast sterling as a floating currency. Floating currencies and exchange rate volatility are not inevitable bed companions, because it requires also a healthy dose of economic and/or political instability to induce sharp swings in exchange rates. Such conditions, however, were served up in full measure during the early post-war years (a) by a short-lived inflationary boom in Britain, (b) by severe budgetary and inflationary problems in the newly independent states of Central and Eastern Europe and (c) by a reparations crisis and rampant inflation in Austria and Germany. Sterling had fluctuated outside of its gold standard parity band during the first year or so of the war. However, the mild exchange rate movements of that period would have provided dealers with little guidance on how to cope with the extreme currency volatility that characterised the period between 1919 and 1924. The earliest excitement was provided by the US dollar/ sterling rate, which tumbled from to $3.84 during the last nine months of 1919, before sliding further to $3.54 by the end of 1920. Thereafter, a deceleration in British inflation triggered a recovery by sterling, which appreciated to $4.21 by the end of 1921, and to $4.64 by the end of 1922. While sterling fell back during the German financial crisis of 1923, it embarked on a new rally, during 1924, in response to mounting speculation about a future return to gold. This speculation was well grounded and on 29 April 1925 the government placed sterling back on the gold standard at its old parity of $4.86656. Britain’s post-war economic problems were far less acute than those encountered by other Western European countries and, even between 1919 and 1920, when sterling was sliding against the US dollar, it still managed to exhibit general strength against the continental European currencies. For instance, the French franc/sterling rate (the moribund gold standard parity rate for which was Fr25.2250) moved from Fr25.97 at the end of 1918, to Fr59.75 by the end of 1920, before falling further to Fr123 in 1926, or until the de facto stabilisation of the franc in terms of gold (France did not return formally to the gold standard until 1928). Much bigger swings, however, were to affect the currencies both of the former enemy countries and of the newly independent European states. The collapse of the German mark (Rm) during the hyperinflation of the early 1920s provides the most extreme, and also the best known, example of currency abuse during this period. Prior to 1914, the gold par for the German mark/sterling rate had been Rm20.42, but, by the end of 1923, the German currency was trading at the utterly meaningless rate of 18,400,000,000,000=£1. Crippling reparation demands, domestic political instability and the reckless use of the printing press to meet the governments ever widening fiscal deficit were the main factors behind the mark’s slide into oblivion. Betting on a weaker mark, however, was not an entirely risk-free pastime for speculators because, between 1919 and 1923, the German currency was prone to sharp, if short-lived, rallies. For instance, speculation about domestic fiscal reforms caused it to strengthen from Rm338 to Rm146 against sterling between February and June 1920, whereas talk of a badly needed foreign loan to meet reparation payments led to a brief

Tom Tiddler's ground 1918–31

39

surge from Rm1,170 to Rm779 in the closing four weeks of 1921. However, following the occupation of the Ruhr in early 1923, the mark entered into freefall, and it was only after a series of monetary reforms—which led to the eventual replacement of the worthless mark by the new gold backed reichsmark in 1924—that Germany regained a meaningful currency. The same forces that had destroyed the mark also debilitated the Austrian crown, although its slide was both shorter and less acute than that of its German neighbour. Between early 1920 and September 1922, it tumbled from £1=1,110 crowns, to £1=320,000 crowns, but it was then stabilised with the help of a League of Nations loan and eventually was replaced, in March 1925, by a new gold unit, the schilling (Figure 3.1). Trading activity was enlivened after the war not only by wild swings in exchange rates, but also by the introduction of a batch of exotic currencies issued by the newly independent states of Central and Eastern Europe. While Lithuania (which delayed issuing its own currency—the litas—until 1922, and in the meantime used the German mark) and Finland (which had issued its own currency, the Finnish mark, long before obtaining full independence from Russia in 1917) did not contribute fully to this process, the list of internationally traded currencies still lengthened significantly after the Armistice.2 Newcomers to the international currency stage included the Polish mark (which was replaced by the zloty in 1924), the Czechoslovakian crown, the Latvian rouble (which was replaced by the gold lat in 1922) and the Estonian rouble (which was replaced by the Estonian crown in 1924). The fact that so many of these newborn currencies had to be replaced even before they reached adolescence hints at the contribution they made to the early post-war turmoil on the foreign exchange markets. With the notable exception of the Czechoslovakian crown, which actually strengthened against sterling during the early 1920s, the fledglings entered into an all too familiar downward spiral induced by inflationary fiscal and monetary policies. The most wayward

The foreign exchange market of London

40

Figure 3.1 Foreign exchange turbulence 1919–25 (source of data: The Economist).

member of this group was the Polish mark, which collapsed from 540=£1 in February 1920, to 40,000,000=£1 in February 1924. Volatile markets beckon speculators The combination of a floating pound, of economic and financial instability in continental Europe, and of the birth of new and volatile European currencies created a potent cocktail to intoxicate foreign exchange operators. The London stock exchange may have failed to provide, during the 1920s, the same excitement for British investors that Wall Street offered to their US counterparts, but at least during the early part of the decade, the London foreign exchange market provided a happy hunting ground for those hoping to

Tom Tiddler's ground 1918–31

41

make a fast buck. Turnover soared, especially between 1919 and 1921, as individuals who normally would not have engaged in regular currency trading entered the market in the hope of turning a quick profit; and as industrial and commercial companies sought to protect themselves from volatile exchange rate movements, by making greater use of the fast expanding forward exchange market. Increased customer activity boosted the foreign exchange business of all of the banks operating in the London market. While some also sought to make a profit by dabbling in the market on their own account, others were prohibited from acting in that way. This applied especially to the big British commercial banks. The foreign exchange departments of these banks worked under strict instructions from risk-averse senior managers not to run overnight open positions, and contemporaries were proud to declare that, ‘the large British banks and finance houses have adopted a very strict attitude against foreign currency speculation of all descriptions’.3 Be that as it may, these banks still were able to profit from the dramatic currency movements that characterised this period. They did so by: • Meeting the enlarged foreign exchange requirements of their customers, especially for forward exchange. • Benefiting from the wider bid-offer spread that opened up during periods of tension on the market. • Running intra-day open positions (potential gains were possible with many currencies moving rapidly even during the course of a day). • Servicing the foreign currency needs of those engaged in speculation. • Engaging in multi-centre arbitrage to exploit the divergent rate quotations that arose in fast moving markets. The merchant and foreign banks were less fastidious than the big commercial banks about betting their own money on the markets. J.H.Schröder & Co, for instance, ran open currency positions during this period.4 However, it was the foreign banks, along with foreign nationals working for the exchange departments of British banks, which were deemed by contemporaries to be the biggest contributors to the speculative frenzy on the markets. Looking back on this period, George Bolton—who worked as a dealer in the City during the 1920s, before joining the Bank of England in 1933—noted: I cannot stress too strongly the complete ignorance of the banks in all countries of the consequences of the collapse of the gold standard and the emergence of a new breed of operators, undisciplined, remarkable in their capacity to take a short view, and without any long-term objectives, unless making money is a long-term objective. Most of these operators were European, mainly Central European, and the magnitude of their transactions completely overwhelmed the embryonic accounting and control capacity in the banks they served.5 Then, just as later, foreigners were blamed for the real or imagined ills of the London foreign exchange market. Yet it is clear that British citizens were no less enthralled by currency speculation than the hapless foreigners condemned by Bolton. During the early 1920s, money that otherwise might have found its way onto the London stock market was

The foreign exchange market of London

42

invested instead in ad hoc syndicates formed for the express purpose of betting on currencies. The most celebrated member of such a syndicate was the economist John Maynard Keynes.6 In January 1920, Keynes—who already had made a nice profit from shorting sterling against the US dollar—formed a currency syndicate with his stockbroker, Foxy Falk of Buckmaster and Moore. Keynes invested £15,000 on behalf of himself, family and friends, but all of this capital was wiped out in the opening months of 1920 by a sharp and unforeseen rally by the continental European currencies. However, Keynes saved the day by entering a new syndicate with another stockbroker. This syndicate also took a dim view of the continental European currencies (marks, francs and lire were sold on the forward market), but this time around these currencies obliged the great economist and his fellow speculators by displaying the buoyancy of lead.7 Good times rarely last forever and the fizz started to go out of the market by the mid1920s, as more and more currencies, including those of Central and Eastern Europe, were stabilised in terms of gold. The shifting tempo of the market during the course of the decade is well described in the evidence given by Sir Robert Kindersley of Lazards to the 1931 Macmillan Committee. According to Sir Robert: After the War…the volume of foreign exchange was very large owing to inflation…and the general market in foreign exchange became very big in this country. As foreign countries got on to the gold standard… the interest in the business and the profit in it gradually disappeared, until today you can say there is very little compared with three or four years ago—there is a big volume all the time, but the profit on it is very small because the fluctuations are within narrow limits with the exception of a country like Spain that will not go onto the gold standard and, therefore, is the prey to everyone who wishes to speculate in foreign exchange.8 Even during the boom years, turnover on the London market was maintained by more than just the demand of currency speculators. The rapid dismantlement of wartime controls and regulations allowed the market to benefit from an early revival in everyday corporate and commercial transactions. While most of Britain’s overseas trade still was conducted in sterling, more foreign exchange business was generated from this source than before the war, as a deepening in the market in London for the continental European currencies led some European banks to turn to London to lay-off the sterling they had acquired from local importers and exporters; and as the emergence of the US dollar as an international currency led to a slow but inexorable rise in the share of British imports invoiced and settled in foreign currency. In April 1919, the British government repealed Defence of the Realm Regulation 41D, which had prohibited the purchase of foreign securities on overseas markets, and this move re-opened the door to investment by British investors on Wall Street, and elsewhere.9 Intermittent control, however, was retained over new overseas issues on the London market. Until November 1919, this control was exercised under Defence of the Realm Regulation 30F but, after this was scrapped, the Bank of England entered the picture and imposed, from time to time, an informal embargo on overseas issues. During

Tom Tiddler's ground 1918–31

43

the early 1920s, the desire to limit competition on the domestic bond market, in order to facilitate the conversion of the excessive floating debt incurred by the Treasury during the war, provided the primary justification for these controls. However, the desire to protect sterling was the main aim behind the embargoes that were imposed in 1924–25 and in 1929–31.10 The regained freedom of British investors to wheel and deal on foreign stock markets was more consequential for the London foreign exchange market than the intermittent controls imposed over new overseas issues, given the propensity of foreign borrowers to use part of the proceeds of their sterling issues to cover expenditures in the United Kingdom, and also the high volume of cross-border securities trading. The Wall Street boom provided British investors with a strong incentive to purchase US securities and the restoration of flows between the London and New York stock exchanges soon led to a revival of stock arbitrage. This benefited the merchant banks, which had long specialised in this line of activity.11 The telephone disconnects the exchange Increased trading volumes and heightened exchange rate volatility accelerated the changes in the market’s procedures and practices that anyway had been underway for some time. The ‘modernisation’ of the market claimed an historic victim at the end of 1920. On 24 December 1920, The Times reported: An institution which has existed in the City for generations is about to come to an end, owing to the altered conditions existing at the present day. We refer to the meeting of merchants, bankers and brokers which took place at the Royal Exchange on Tuesdays and Thursdays for dealings in foreign exchange. Originally these dealings were in the form of bills; nowadays with the telegraphs and telephones in operation dealings in foreign exchange take place at a furious pace all day long, and they are mainly in cable transfers which fluctuate every few minutes. The necessity of the old post day meetings has, therefore, largely disappeared, hence it has been decided to discontinue these biweekly meetings after Thursday next. The foreign bill traditionally had served not only as a form of payment, but also as a means of credit. However, both of these roles had been undermined during the war as shipping losses diminished the reliability of the mails, and as the market’s reduced appetite for risk led to a rise in cash payments. These two developments spurred the use of telegraphic transfers and, even though the return of peace was accompanied by a revival in the use of bills, especially by small and medium sized companies, the telegraphic transfer soon came to dominate the post-war foreign exchange market. By the mid-1920s, the press had ceased to publish quotations for bills and cheques, preferring instead to publicise the ‘spot’ rates for telegraphic transfers (known as the cable rate in the case of US dollar/sterling), and the rates for forward exchange. The way most foreign bills were handled after the war anyway made them irrelevant as

The foreign exchange market of London

44

conveyors of price information. Instead of being traded in their own right on the exchange markets, such bills increasingly were sold to banks for collection, in transactions involving the following three separate processes (a) sale of foreign currency consideration for sterling on the forward exchange market, (b) collection of foreign currency proceeds of bills and (c) use of foreign currency proceeds to settle, at maturity, the earlier forward purchases of sterling. The volatile currency conditions of the early post-war period demanded speedy execution and settlement and this made it almost inevitable that the telegraphic transfer would replace the bill and cheque as the cornerstone of foreign exchange trading. This instrument was especially widely used for inter-bank transactions, and for deals performed by banks both for large companies and for other financial institutions, such as stockbrokers and insurance companies. The emergence of the commercial banks as the dominant institutions on the market helped to facilitate the ascendancy of the telegraphic transfer, because these institutions provided the network of overseas operating accounts, courtesy of their correspondent bank relationships, that were needed to support this means of payment. Extensive use of telegraphic transfers enabled value dates to be agreed and set for most of the currencies traded on the London market. Value dates differed from one currency to another during this period owing to variations in the efficiency and practices of local banking systems. For instance, by 1925, value dates were being set at two days for the US dollar, French franc and Swiss franc; at three days for the German mark and Italian lira; and at seven days for the currencies of the Balkan states.12 The fact that the rates set for telegraphic transfers were not adulterated by interest rate considerations ensured that they served as a benchmark against which the exchange rates for other instruments (in the same currency) were calculated, including importantly those for mail transfers and for forward exchange. The ascendancy of the commercial banks in foreign exchange trading resulted in an expanded role for the mail transfer, which had made its debut before the First World War, and this soon overtook the cheque and draft as the most popular instrument used for effecting near-term, but non-urgent, payments abroad. In keeping with the telegraphic transfer, the mail transfer was an instruction from a bank in one country to a bank in another to pay money to a stated beneficiary. However, because it was sent by mail it took longer to execute than a telegraphic transfer, and this meant—just as in the case of cheque—the rate of exchange quoted for it had to allow for the time value of money. A company remitting abroad by way of a mail transfer would have obtained, therefore, slightly more foreign currency per £1 than a company that had sent the remittance by way of a telegraphic transfer (with the amount varying according to the mailing times involved).13 Mail transfers possessed two key advantages over cheques and drafts, namely (a) they did not incur stamp duty and (b) they provided users with greater security, because the responsibility for their safe arrival rested with the bank executing them and not with the remitter. The exact timing of the payment involved, of course, was still subject to the vagaries of the mails. However, a slight variant of this instrument—the guaranteed mail transfer—was available for those requiring absolute payment certainty. With a guaranteed mail transfer, the bank executing the transaction undertook to effect payment

Tom Tiddler's ground 1918–31

45

in the relevant foreign centre at the date stated on the transfer. A cable would be sent, at a deferred rate, to the branch or paying agent abroad to ensure this result. This feature made it slightly more expensive to send money abroad by guaranteed mail transfer than by ordinary mail transfer.14 The fact that telegraphic transfers were settled sooner than mail transfers, especially in far distant centres, provided banks with the opportunity to shift very short-term funds from one centre to another by trading these instruments against one another. For instance, a bank needing temporary funds in New York would have sold sterling and bought US dollars via cable and would have covered its long position by selling US dollars for sterling via a mail transfer. Exchanging foreign currency instruments with different settlement dates, of course, was not a new pastime and it had been commonplace before the war for operators to trade cheque against long bills, as well as telegraphic transfers against cheque. The forward market blossoms During the 1920s the growing use of telegraphic transfers and mail transfers was accompanied by another, and arguably more important, development. This was the rapid expansion of the forward exchange market in London. An embryonic forward market had existed in London before the First World War, but it failed to survive in the altered trading conditions that arose during the conflict.15 However, the market soon sprang back to life after the war, when it enjoyed a period of spectacular growth in response to: • Heightened exchange rate volatility. • Increased exposure of UK operators to exchange risk (due to gradual decline in sterling’s international role). • Greater demand for protection against exchange rate risk (especially during the first half of the 1920s). • Growing involvement of speculators in forward transactions. • Increased hedging of short-term capital flows. In a forward exchange transaction, an exchange rate is fixed today for the purchase or sale of a currency at a specific future date. Prior to 1914, most forward business was conducted for delivery at the end of calendar months, but after the war the London market switched to a rolling monthly basis (i.e. on any day, forward deals were struck for so many—one, three, six etc.—months ahead). Settlement of a forward transaction takes place at the maturation, and not at the initiation, of a contract. Hence, an operator entering a contract to buy $100,000 in three months time, at a forward rate of say £1=$4.00, would have received this sum, so long as he met his part of the deal by delivering £25,000, when the contract matured. While forward exchange had been dealt in on the London market before 1914, it had not been the only—or even the most favoured—means used during that period to cover exchange risk. Prior to the First World War, it had been common practice for those seeking exchange rate protection to wheel and deal in long foreign bills. An operator buying a three months foreign bill today for $100,000 would have

The foreign exchange market of London

46

achieved the same degree of protection as one buying $100,000 three months ahead on the forward market, because in both cases the amount of sterling needed to secure this prospective dollar sum would have been known at the initiation of the transaction. The long bill, however, existed as a less efficient means of covering currency risk than forward exchange. Long bills were not always available in the right quality, quantity or amount to satisfy the needs of those needing to cover a future risk. Finding a first-rate merchant bank willing to issue finance paper in the rounded amount required by a hedger would have overcome these problems, but even so this would not have eliminated the biggest comparative drawback of using the long bill as a hedging instrument. This was that it had to be paid for up front. Whereas forward exchange deals are settled at the maturation of a transaction, purchases of long foreign bills had to be settled in sterling at the initiation of a deal. To be sure, it was normal practice during the inter-war period for banks to require their less credit-worthy customers, such as currency syndicates, to maintain a 10–25 per cent cash margin as security for a forward contract, but even so this did little to dim the allure of the forward market relative to the long bill. The displacement of bills by telegraphic transfers in day-to-day foreign exchange transactions anyway served to gradually restrict the amount of long bills available to purchase to hedge currency risks. It is somewhat ironical that the rapid expansion in the forward market was spurred by the demands both of those wishing to profit from, and those seeking protection from, exchange rate volatility. Speculators found the market so appealing, because it allowed them to bet on future currency movements for only a small initial outlay (the cash margin normally required by the bank executing the deal). Their activities sometimes were so intense that they exerted a disproportionate influence on forward rates, which, in consequence, did not always perform in accordance with textbook rules. In a perfect market, forward exchange rates—which are quoted at a premium or discount to the appropriate spot rate—ought to equate to the relevant interest rate differential between the currencies involved in a transaction (this condition is known as interest parity). For instance, if the twelve months outright forward rate for sterling against the dollar is being quoted at a 2 per cent discount to the prevailing spot rate, interest parity would require twelve months interest rates to be 2 percentage points lower in New York than in London. However, if for some reason interest rates in New York were standing only 1 percentage point lower, it would pay operators to decline the outright forward rate and instead borrow sterling for twelve months, convert their borrowings into dollars at the prevailing spot rate and to then deposit the proceeds in New York for twelve months. This transaction would generate a known sum of dollars in twelve months time, in the same way as a forward deal, but at a cost saving (ignoring dealing spreads and transaction charges) of 1 percentage point. Other operators, however, eventually would follow suit and their actions would force up interest rates in London relative to those in New York— a process that would continue until the differential between them fell into line with the forward discount on sterling. Perfect market conditions did not always exist during the 1920s, and at times of heightened exchange rate volatility speculative pressure on forward rates often caused them to differ from the levels dictated by interest parity.16 That the forward market

Tom Tiddler's ground 1918–31

47

offered speculators a leveraged play on exchange rates tended to give it a bad name in official circles. The belief that the forward market facilitated currency speculation was strongly held in the Bank of England, and throughout the period between the two world wars forward trading was viewed with some suspicion in Threadneedle Street.17 There was some justification for this view. Between 1919 and 1923, it was not uncommon for the currencies of the Eastern and Central European countries to depreciate by upwards of 30 per cent a month. Such extreme movements were rarely anticipated by the forward market and this offered speculators the potential to make big profits by selling these currencies forward in the hope of being able to buy cover more cheaply in the spot market at the maturity of the forward contract. Many of the currency syndicates existing at that time were actively engaged in these sorts of deals. Keynes, for instance, cleared his earlier debts by selling marks, French francs and lire on the forward market.18 The forward exchange market, of course, did not just exist as a playground for speculators. Volatile exchange rates also created a strong demand from industrial and commercial companies for protection against currency risks. The market proved to be fairly resilient and banks continued to offer forward cover throughout most of the turbulence of the early 1920s. However, even they were forced to suspend forward trading in the reichsmark during the final stages of its plummet into the abyss. Growing market in swaps Most companies seeking such protection would have entered into an outright forward deal with a bank, in which they would have been given an absolute rate for exchanging one currency for another at a future date. Banks trading forward exchange with their corporate customers normally would have covered the transaction in one of two ways. Either they would have entered into another, but offsetting, outright forward deal with a second counterparty; or they would have covered their main exposure immediately with an offsetting spot exchange rate deal, and their remaining risk (the difference between the spot and forward rate) in a subsequent swap transaction. A swap involves the purchase (sale) of a currency in a spot transaction and the simultaneous sale (purchase) of the same currency for forward delivery at a selected date. The price of a swap will be quoted in terms of a margin relative to the spot rate equating to the discount or premium for the currency in question in the forward market, which itself will be largely a function of the relevant interest differential between the two centres involved. Apart from being employed by banks in their day-to-day dealing operations, swaps also were widely used to transmit short-term loans between countries. Many of the new nation states created after the Armistice relied on this mechanism to obtain short-term borrowings, which otherwise might not have been provided, from the richer countries of Western Europe. By buying a weak country’s currency spot and simultaneously selling it forward, London based banks were able to place short-term funds temporarily in Eastern and Central Europe without incurring an exchange rate exposure. Swaps were not used just to transmit short-term funds to the fledgling markets of Central and Eastern Europe. This mechanism also was widely adopted to move short-

The foreign exchange market of London

48

term balances between the main international financial centres. Prior to the First World War, such transactions had been executed largely on an un-hedged basis via the sterling acceptance market. That certainly had been true in the case of flows between London and New York. However, the volatile exchange rates of the early 1920s made the swap a far more suitable vehicle than the sterling bill for conveying short-term funds between London and other centres. The speed and efficiency of the swap also ensured that it continued to be used for this purpose long after the currency instability of the immediate post-war period had faded from the headlines. Dealers in short supply The rapid expansion in, and growing complexity of, foreign exchange trading created not only opportunities but also challenges for banks operating in the London market. Arguably, the biggest challenge faced by them was of finding suitable personnel to staff their burgeoning foreign exchange departments. Foreign exchange trading had not been a dominant activity in London before 1914, and this meant that there was an inadequate pool of appropriately skilled workers to meet the strong post-war demand for dealing staff. This point was eloquently made by the editor of The Bankers’ Magazine in a speech given on 12 November 1919. Arthur W.Kiddy observed: …in the many channels now opening up for lucrative employment I know of none where the prizes are greater than those likely to fall to men who are in the near future prepared to acquire a complete knowledge of the foreign exchanges especially if to such knowledge is added the mastery of one or more foreign languages. In London at the present time the enquiries for such men at very high salaries are being made almost every day, and for the most part are being made in vain.19 Women (implicitly) were not considered by Kiddy to be suitable to fill the skills gap. Foreign exchange trading, in fact, was very much a male preserve at that time—and so it continued to be right up until the last three decades of the twentieth century. Banks sought to meet their desperate need for foreign exchange traders both by training new hires and retraining staff from other departments, and by poaching seasoned traders from one another. The pressure ‘to grow’ more foreign exchange traders in the City clearly was felt by those with a responsibility for maintaining professional standards within the British banking system. In 1918, the Institute of Bankers recast its post-war examination syllabus, with the biggest change involving,‘…the inclusion of two new subjects—Foreign Exchange and Commercial Geography’.20 Merchant banks and foreign branch banks had been the biggest players on the pre-1914 market, and they had a long history of poaching staff from one another and of being tapped by other institutions wishing either to open, or to expand, their own foreign exchange departments. Those with wellestablished departments continued to haemorrhage trained personnel after the war. The loyalty even of long-serving staff was sorely tested as newcomers bid up salaries to attract experienced traders. On 24

Tom Tiddler's ground 1918–31

49

December 1912, Brown Shipley had mentioned their gloriously entitled ‘exchanger’, a certain Mr McPhail, in a letter to Brown Brothers & Co in New York. However, on 24 October 1920, they were obliged to inform their New York associates that, ‘…Mr McPhail has today informed us that he has received and accepted an offer from elsewhere’.21 Commercial banks dominate dealing During the 1920s, there were almost 140 banks operating in the London foreign exchange market.22 The tremendous expansion in the market meant that there was plenty of business to go around, and most of these banks witnessed a rise in their foreign exchange volumes. However, the main beneficiaries of the post-war trading boom were the big British clearing banks and their counterparts from Western Europe and North America. Being at the heart of the payment systems in their respective countries, the commercial banks were better placed than other key players, such as the merchant banks and the British owned overseas banks, to benefit from the inexorable shift from bills to telegraphic transfers in the settlement of international transactions. Amalgamations had led to significant concentration within the British commercial banking sector, which by this time was dominated by the ‘Big Five’. This grouping comprised Barclays Bank, Lloyds Bank, Midland Bank (previously the London City and Midland), National Provincial Bank and Westminster Bank (previously the London County and Westminster). The foreign departments or branches of these and of other British commercial banks—such as Martins Bank—quickly became, ‘…the largest regular dealers in Foreign Exchange for commercial purposes’.23 The main competition they faced in securing the foreign exchange business of British companies came from the branches of foreign commercial banks. The closure of the London offices of the German banks in 1914 (German banks were to remain without a physical presence in London until Dresdner re-established a branch in 1967) altered the balance of power within the foreign banking sector. In the absence of the German branches, leadership of this sector passed to the French and US banks. Two factors helped to strengthen the position of the French banks. The first was the increased importance of Paris as a centre for trading the continental European currencies—a position it obtained largely at the expense of Berlin. The second was the expanded flow of foreign exchange business between Paris and London generated by the growing volume of transactions between the continental European currencies and the US dollar. The unrivalled liquidity of the US dollar market in London often led these transactions to be consummated through a pair of trades involving the purchase (sale) of sterling against a continental currency on the one hand, and the sale (purchase) of sterling against US dollars on the other. The close connection of French banks with such trades deepened their involvement in the London market and, during the 1920s, long established players such as Crédit Lyonnais and Société Générale were joined in the City by newcomers such as Credit Commercial de France and Credit Foncier d’Algérie et de Tunisie. The emergence of a bi-polar international currency system, in which sterling was

The foreign exchange market of London

50

forced to share the global stage with the US dollar, also worked to the advantage of US banks. Increased demand for the US currency, both in Britain and in continental Europe, boosted the level of trading in US dollar/sterling in London. Prior to 1914, the extensive use of the sterling acceptance not only to settle British imports from the United States, but also to facilitate short-term capital flows from London to New York had done little to support turnover on the London foreign exchange market. However, during the 1920s, London captured a bigger share of US dollar/sterling trades, as more British companies were asked to settle their US purchases in dollars, and as telegraphic transfers and swaps replaced the sterling bill of exchange as the principal means of transmitting short-term balances to New York. US banks were natural candidates to participate in the rapidly expanding US dollar/sterling market in London. It is noteworthy that all the members of the triumvirate (Bankers Trust, Guaranty Trust and National City Bank) that had been used by the Treasury to support sterling in New York during the war had obtained a presence in London by the early 1920s. Of the three, only Guaranty Trust had had an office in London before 1914 (it had set up shop in 1895). However, National City Bank made its entrance in 1915, when it acquired a controlling interest in the International Banking Corporation (which had been represented in London since 1902). Full ownership was obtained in 1918, at which time the latter’s London office was converted into a branch of National City Bank. The third member of the wartime triumvirate, Bankers Trust, moved into London in 1922. Other American banks to enter the City around this time included the First National Bank of Boston in 1922, and the Chase National Bank. The latter opened a representative office in 1923, but it only entered the London foreign exchange market in 1930 (when it acquired the Equitable Trust Company, which under the guise first of the North American Trust Company of New York, and then of the Trust Company of America, had been in London since 1900).24 Much of the pre-1914 foreign exchange business of the big British merchant banks had arisen out of their international trading activities in shortterm paper, securities and gold. Such activities had almost ground to a halt during the conflict and this had seriously weakened their position in the foreign exchange market. While things improved with the return of peace, the growing importance both of the British and of the foreign commercial banks in foreign exchange trading prevented the merchant banks from recapturing the same market share they had boasted in pre-war days, when they had vied with the foreign branch banks for market dominance. The merchant banks, however, still benefited from the early post-war surge in trading volumes and, as has already been noted, they were less shy than the clearing banks about exploiting the sharp swings in exchange rates by running open positions. The return of calmer trading conditions by the mid-1920s caused the merchant banks to rely more on their traditional areas of expertise in order to make a profit on currency trading. The main competitive advantage of these banks always had been in stock, foreign exchange and gold arbitrage and it was towards these activities, as well as towards servicing the foreign currency requirements of their own corporate customers, that they turned to generate revenues for their foreign exchange departments. Just as before 1914, the Australasian, South African and Eastern banks continued to

Tom Tiddler's ground 1918–31

51

possess a virtual monopoly over trading in the Empire currencies on the London market. Dealing in these currencies remained a backwater activity, although those involved in this sector gained a bit of excitement during this period from some unaccustomed exchange rate volatility involving the Indian rupee and the Australian and New Zealand pounds. The rupee, which had abandoned its old 1s 4d sterling peg during the war, appreciated sharply to 2s by the end of 1919, in response both to sterling weakness and to sharply rising silver prices. However, the termination of the post-war silver boom caused it to weaken to a low of 1s 4d by the end of 1921. Over the next five years, the rupee traded in a fairly narrow 1s 4d to 1s range, before being fixed against sterling— following the Indian government’s decision to use gold for external transactions—with a mint parity of 1s 6d in 1927. In 1929, or only two years after the stabilisation of the rupee in terms of gold, Australia was forced to abandon the gold standard as its economy was plunged into recession by collapsing commodity prices. New Zealand was obliged to follow suit in 1930. These moves terminated the traditional 1:1 relationship between both the Australian and the New Zealand pounds and sterling. By the time of Britain’s own departure from gold, in September 1931, these two currencies had depreciated against sterling, with the Australian pound falling to no less than 30 per cent below its old parity level. New communication needs All of the banks operating in the London foreign exchange market needed access to speedy communications in order not to be wrong-footed by the big currency swings that characterised so much of the inter-war period. They met this need by placing increasing reliance on the telephone and the telegraph. Some use had been made of the telephone within the London market before the war, but at that time it was still commonplace for bankers and brokers to meet face to face either at the Royal Exchange, or elsewhere in the City. In contrast, after the war, virtually all professional trading (i.e. between banks and brokers) took place over the telephone. The London foreign exchange market, in effect, had become—by the time trading ceased at the Royal Exchange—a ‘virtual’ market totally dependent on the telephone. This distinguished London from most rival centres elsewhere in Europe where dealings continued to be conducted during part of the day on a physical market (usually a room in the local stock exchange, or bourse). Military needs during the war had led to a significant expansion both in the scale and in the quality of the telecommunications network. This had been particularly true in the case of cross-Channel communications. While the first submarine cable allowing telephonic communication between Britain and France had been laid in 1891, capacity remained so limited, and tariffs so high, that prior to 1914 only light commercial use was made of this international means of communication.25 However, after the Armistice, the release of military cables for civilian use provided the capacity needed to facilitate regular commercial voice communication across the Channel. Initially, trunk calls only could be made to near continental centres, such as Paris and Brussels. The network, however, spread rapidly during the 1920s and, by the middle of

The foreign exchange market of London

52

the decade, telephone contact had been established between London and Berlin, Vienna and Rome. Around this time two-way voice communication also became feasible, courtesy of radiotelephony, between Britain and the United States. However, this was an expensive means of communication and, by 1929, only 50 calls were being made a day.26 While usage increased during the 1930s, the telegraph still remained the principal means of conveying fast messages to the United States until the mid-1950s, or until the laying of the first transatlantic telephone cable. London foreign exchange dealers, who had eschewed using the telephone to initiate international transactions before the war, began to exploit this means of communication with continental Europe after 1918. The first telephone dealings with the continent are believed to have taken place with Brussels in 1919, and during the following decade it became commonplace for business to be conducted in this way with all the main centres in Europe.27 The service was not always up to scratch, and during the early 1920s delays of up to four hours were not unknown for trunk calls to Europe. Be that as it may, this new communications link increased the efficiency of the London market, by making it easier for dealers to trade with their European counterparts not only to arbitrage exchange rates but also to cover outstanding deals. With telephone communication between London and New York limited both by costs and capacity, banks were obliged to find other ways of speeding up communications between these two centres. Some sought to make smarter use of the telegraph. Typically, messages to be transmitted via this medium were ‘walked’, or were sent by way of a private line, to a cable company’s office for onward despatch. In the 1920s, however, some banks managed to speed up this process by negotiating with the telegraph companies for a direct line linking them with their associates or head offices in the United States. Kleinwort Sons & Company and the City office of National City Bank are examples of two London based banks that acted in this way.28 Technological improvements were not just confined to telecommunications. Increased turnover called for greater back-office mechanisation. While calculating machines and typewriters had made an appearance before the First World War, most of the back-office work at that time still was done by hand. The level of mechanisation, however, increased during the 1920s with the introduction both of bookkeeping machines, and of fanfold machines and manifold forms for producing exchange contracts. Innovations such as these were to touch the day-to-day lives not just of the dealers, but also of the brokers, working in the London foreign exchange market. Growing band of brokers At the beginning of the century there had been around 20 exchange brokers in the City. The contraction in foreign exchange turnover during the 1914–18 war had forced a number of firms out of business, but the boom of the early 1920s served to swell the ranks of the broking fraternity, and by the middle of that decade there were about 40 to 50 brokers serving the market.29 Entry costs into foreign exchange broking were not especially high. In the words of a contemporary observer:

Tom Tiddler's ground 1918–31

53

Very little capital is needed, for the broker is only an intermediary. He does not need a large office or staff, and his main expense is telephones. As the leading brokers have upwards of fifty private lines to the banks—which are naturally installed by the broker and for which he pays the rent—it will be realized readily that this is a very heavy item of expenditure.30 The existence of low entry costs and the absence of official barriers meant that there was little or no control over those wishing to set themselves up as brokers. Many of those who did so were honest, but the allure of easy money also attracted a number of undesirables. The main utility of using a broker was that it reduced the search time needed by a bank to find a suitable counterparty in an exchange deal. Acting through a broker also allowed a bank to find a counterparty without publicising its needs to the open market (something that might have influenced the prices quoted to it by other principals). Brokers were rewarded by the payment of a small commission, or brokerage. Typically, this was paid by both of the parties (i.e. the buyer and the seller) in a transaction. Some brokers were generalists, whereas others operated only in specific currencies, such as the Eastern silver currencies and the Latin American currencies. Most banks, therefore, were obliged to deal with a wide range of brokers, something they would have done anyway for prudential reasons (to diminish the risk of collusion between dealers and brokers). During the early 1920s, it was commonplace for banks to deal with upwards of 20 foreign exchange brokers, using a number of the bigger firms— such as M.W.Marshall & Co and Godsell & Co—for their dealings in the major currencies, but also employing many of the smaller firms for transactions in the minor currencies. The latter often received commissions amounting to only a few pounds a month from each of their bank customers. Foreign exchange brokers were not held in the highest regard in the City, especially in the immediate post-war years. Looking back on this period, George Bolton noted caustically, ‘A reliable indication of the types among the brokers could be seen from their offices: on the ground floor would be a responsible bookmaking business but the first floor housed, without any indication, the foreign exchange broking business’.31 Ethical standards left a lot to be desired. During the boom in foreign exchange trading both brokers and bank dealers were guilty of unseemly practices. According to Bolton: Very soon corruption and several practices of the worst order were rife. Brokers shared commissions with dealers; dealers purchased a firm of brokers and manufactured transactions in order to inflate their brokerage accounts; dealers opened speculative positions via forward contracts passing their banks’ names through smaller banks in London who were willing to carry a broker’s name; brokers speculated on their own account; junior dealers lunched and dined at brokers’ expense; foreign managers were overwhelmed with presents regularly; some dealers repudiated contracts proved unprofitable and left the broker to make it good to the counterpart. Several scandals came to light but many were hushed up.32

The foreign exchange market of London

54

Formation of professional bodies An attempt was made to improve professional standards in the broking community with the establishment, in 1922, of the Association of Foreign Exchange Brokers. The Association not only monitored the procedures of its members, but also vetted new applicants in an effort to keep undesirables from entering the market. However, it had another (and less altruistic) aim. This was to set a fixed scale of commissions for its members to apply in their dealings with banks. The banks too had a representative body, although this was a lower key and less formal organisation than the Brokers’ Association. The body established by the banks sometimes was referred to as the Dealers’ Association, and at other times as the Foreign Exchange Committee, and ‘…it was formed upon the initiative of the Westminster Bank…in 1920’.33 Westminster Bank had been the leading light behind the formation of a similar committee in 1914, and it is not entirely clear whether the Dealers’ Association was a direct descendant of that earlier organisation. The Association was comprised of, ‘…about twelve dealers, all the Big Five being represented. It has no regular constitution nor has it been recognised officially by the Bankers’.34 The senior management of the big commercial banks probably would have seen little need to give their official blessing to the Dealers’ Association, given that it was populated only by middle-ranking staff (chief traders were mostly assistant managers or managers) and it was concerned merely with technical matters relating to the day-to-day operations of the market. These would have included such things as value dates, penalties on overdue payments and relations with brokers. Rates of brokerage often were a matter of heated debate between dealers and brokers. As a general rule, widely traded currencies benefited from much lower brokerage than those that were only lightly traded. For instance, in 1928, deals involving the US dollar— which easily was the most actively traded currency in London—attracted brokerage of 0.03 per mille; whereas deals involving the less favoured Japanese yen were subject to a brokerage rate of 0.3125 per mille.35 Banks were not obliged to deal through brokers in the London market, and this was one of a number of factors that served to undermine the power and authority of the Association of Foreign Exchange Brokers. London based banks were able to avoid the fixed brokerages imposed by the Association, both by dealing directly between themselves and, as the international telephone network expanded, by covering deals with banks on the Continent. They also had another option. This was to deal through a broker who was not a member of the Brokers’ Association. Some of the smaller London brokers refused to join the Association, and their aloofness made it difficult for the latter not only to defend their brokerage charges, but also to police the market. The smaller brokers were widely regarded by contemporaries to be the most to blame for the abuses that abounded in the foreign exchange market at this time. The brokerage rates set by the Association were not set in stone, and adjustments were made from time to time to take account of changes in market conditions. Unsurprisingly, little criticism was levelled at its charges during its first two years of existence, which coincided with the final stages of the boom in foreign exchange trading and turnover. The

Tom Tiddler's ground 1918–31

55

trouble set in once trading and profitability declined, following the stabilisation of exchange rates in the mid-1920s. While the Association did reduce its charges, in response to the slowdown in trading activity, it did not do so at a fast enough pace to satisfy the banks. By 1928, it was reckoned that, ‘…50 per cent or more of the Foreign Exchange transactions in the London market are effected direct and not through the medium of a broker’.36 Foreign exchange turnover continued to weaken into 1929, and this only added to the woes of the Brokers’ Association, by encouraging banks to take further steps to reduce their transaction costs. The business garnered by its members decelerated sharply, as banks stepped up their direct dealings not only in London, but also with continental centres; and as dealers became more willing to transact with non-member brokers. The latter too had been badly affected by the slowdown in the market, and in an attempt to drum up trade they began to offer banks deals at only half brokerage. The Association of Foreign Exchange Brokers now was under attack on all fronts. The situation, in fact, was so parlous that there was little left that it could do to improve the lot of its members. In mid-1929, the Association exercised the only real option open to it. It threw in the towel. Following its dissolution, the level of brokerage in the London market entered into a free fall. A Bank of England official noted, ‘Competition has become so keen that a general lowering of commission has taken place and in the case of M.W. Marshall & Company, the scale has been reduced by roughly one half’.37 Many of the smaller brokers formed in the early 1920s went out of business at this time. Gold loses its shine It would have come as little comfort to those who suffered this fate to know that the tranquil exchange rate conditions, which indirectly had contributed to their demise, were shortly to give way to a new bout of currency instability. The international economic and financial situation deteriorated sharply during the course of 1929, in response both to tumbling world commodity prices and to the crash in shares on Wall Street. These two developments helped to precipitate a deep and sustained contraction in global output, which—by denting the trade, and weakening the finances, of so many countries— effectively wrote the death warrant of the old currency order. The ability and willingness of governments to keep their currencies on the gold standard waned as their economies plunged deeper and deeper into recession. The primary producing countries were the first to fall on hard times, and so it is unsurprising that they were also first to run into currency troubles. Sliding export receipts forced countries such as Australia, New Zealand, Argentina, Brazil and Peru to depreciate their currencies in 1929–30.38 The unfolding depression was to claim a much bigger victim in 1931 when, on 21 September, Britain also abandoned the gold standard. An underlying deterioration in Britain’s current account position provided the backdrop for the sterling crisis that developed over the summer months of 1931, but the immediate catalyst was provided by banking failures in Austria and Germany and the ensuing scramble for liquidity across Europe. In July 1931, the German government imposed a temporary debt moratorium. This

The foreign exchange market of London

56

move froze almost £100 million of British short-term assets in Germany—something that did not pass unnoticed by Britain’s own shortterm creditors. Sterling came under pressure, and this intensified following the publication of the Macmillan Committee, on 13 July, which for the first time estimated the full scale (£254 million) of Britain’s net external shortterm liabilities. However, further domestic banking problems in continental Europe reinforced the demand for cash, and this led foreigners to accelerate the rundown of their balances in London. The Bank of England suffered a loss of gold as sterling weakened, and as some European central banks sought to obtain gold to bolster their own reserves. On 1 August 1931, the Treasury announced, ‘The Bank of France and the Federal Reserve Bank of New York have each placed at the disposal of the Bank of England a credit for the equivalent of £25,000,000 making a total equivalent of £50,000,000’.39 Under the normal rules of the gold stan-dard game the Bank should have responded to the pressure on sterling by raising Bank rate. However, times were not normal, and with the global economy mired in recession, the Bank chose instead to intervene on the exchange markets. Two years previously, Robert Kay (the London manager of Anglo-Austrian Bank) had been recruited by the Bank as its first foreign exchange specialist.40 The fledgling foreign exchange function was run by Kay and was located within the Chief Cashier’s Office. George Bolton, who joined the Bank as Kay’s assistant in 1933, was less than impressed with the arrangements that had been put in place. He recalled: The techniques in daily use were embryonic, consisting of a private line to Rothschilds to give them the opportunity of selling or not selling South African Reserve Bank gold at the fixing, and one line to a Foreign Exchange Broker who, though honest, was in my experience the most incompetent Broker in the Market.41 The channels open to the Bank may have been limited, but this did not stop it from rapidly exhausting the £50 million credits. The Bank’s strategy had been to protect its gold stock, by supporting sterling at $4.86 (or well above the gold export point).42 The Bank intervened not just in the spot, but also in the forward market during August and September, a move that drew little applause in a subsequent internal review, which noted, ‘We, therefore, supplied the market through the clearing banks with outright sales of forward exchange totalling…£17.5 million. The policy of supporting sterling forward was only grudgingly entered into by the Bank and it was evident later that it had facilitated speculative operations against sterling’.43 Then, as later, the Bank discovered that heavy support for a discredited exchange rate simply provided speculators with a safe escape route from sterling. In a last ditch attempt to salvage the situation, the authorities negotiated additional credits worth the equivalent of £80 million from the United States and France. These credits were granted to the Treasury on 28 August 1931. However, they bought only a temporary respite, and in recognition that further borrowings would be difficult—if not impossible—to negotiate, and also in response to a further (if modest) outflow of gold in the middle of September, the decision was taken to leave the gold standard and allow

Tom Tiddler's ground 1918–31

57

sterling to float. The announcement of this move, on 21 September, must have sent a few hearts racing in the City. Foreign exchange trading had been in the doldrums over the previous four or five years, and the reappearance of a floating exchange rate is likely to have stirred memories in the minds of dealers and brokers alike of the good old days of the early 1920s. Turnover did pick up during the 1930s. However, the growing involvement of governments and central banks in shaping the rules and behaviour of the foreign exchange markets as well as the gloomy international economic environment ensured that there would be no repetition of the earlier trading boom.

4 Off gold and into the Bank 1931–39 The abandonment of the gold standard, on 21 September 1931, led to a significant increase in the role and importance of the Bank of England on the London foreign exchange market. Its greater involvement was the product of hard economic times. Faced with an unfolding global recession, and with high and rising levels of unemployment at home, the government was unwilling to allow sterling to float freely following its departure from gold. The achievement of a competitive exchange rate became a key policy objective in Whitehall, and the Bank of England was co-opted as a willing partner in the pursuit of this aim. In seeking to keep sterling at an officially desired level, the Bank was obliged to intervene on a regular basis in the exchange markets. It obtained the resources needed for this task with the establishment of the Exchange Equalisation Account (EEA) in July 1932. The resources of the EEA were supplied and owned by the Treasury, but the Bank was given the important tasks both of managing these resources and also of using them to undertake direct intervention in support of sterling. These roles required the Bank to deepen its lines of communication not only with Treasury, but also with market. New committees were established for bank dealers (in September 1931), and for foreign exchange brokers (in July 1932), and it was largely through these committees that the Bank conveyed its wishes and desires to the market. During the 1930s, official intervention proved more successful in smoothing short-term movements in the exchange rate than in preventing significant longer-term variations in sterling’s external value. Indeed, between 1931 and 1939, the floating pound fluctuated just as widely as it had done during the 1919–25 foreign exchange trading boom. This time around, however, floating was to prove less rewarding for currency dealers. A number of factors ensured that there would be no return to the champagne years of the early 1920s. Turnover on the currency market was curtailed by the slump and subsequent slow recovery in world trade, by declining international capital movements, by the introduction of exchange controls in many Central and Eastern European countries and by a reduction in dealing lines between banks during the European and US banking failures of 1931–33. The progress of the market also was affected by increased central bank intervention, which served to diminish—although not to remove—the scope for profitable intra-day position taking, and by the decision of certain countries to peg their currencies to sterling (something that lowered the overall volatility on the London market). Despite these difficulties, most banks—especially those with a deep involvement in forward exchange trading—were able to make a decent return on their activities in the foreign exchange market between 1931 and 1939. This period, however, was to end with

Off gold and into the bank 1931–39

59

the biggest calamity ever to beset the London foreign exchange market. Following the outbreak of the Second World War, the market was all but shut down and its principal activities were transferred to the Bank of England. The market was to remain in the Old Lady’s clutches right up until the end of 1951. The shock of the old Sterling’s departure from gold was not exactly a flight into the unknown. The market had acquired plenty of experience in coping with a floating exchange rate between 1919 and 1925, and with this earlier episode still reasonably fresh in dealers’ minds there was little need for them to discover or learn new trading skills. During its first few months off gold, sterling displayed the buoyancy of lead, with its pivotal rate against the US dollar sliding to around $3.40 by the end of 1931. Eventually, the pursuit of a low and competitive exchange rate would become a key objective for the government, but the pound’s initial slide was anything but welcomed by the Treasury. The overriding official need during the early days of floating was to minimise the exchange cost of repaying the £130 million foreign credits that had been obtained by the Treasury and the Bank of England in their vain attempt to defend sterling’s gold standard parity. These credits were repayable in US dollars and French francs, which meant that the cost of settling them rose in step with each drop in the exchange rate. The authorities, therefore, had a good reason for seeking to check the initial depreciation in the exchange rate. Towards this end, Bank rate was raised to 6 per cent on 21 September 1931 and, on the same day, the Treasury adopted, for the first time in peacetime, legislation to control the activities of UK residents on the foreign exchange markets. The steps taken by the Treasury, which were to remain in force until March 1932, were set out in an order issued under Section 1 (3) of the Gold Standard Amendment Act 1931. This stated that: …purchases of foreign exchange, or transfers of funds with the object of acquiring such exchange directly, or indirectly, by British subjects or persons resident in the United Kingdom shall be prohibited except for financing: 1 Normal trading requirements. 2 Contracts existing before 21 September 1931. 3 Reasonable travelling or other personal purposes.1 Capital outflows from the United Kingdom were the principal target of this banning order. However, the fact sterling fell sharply in the three months immediately following its introduction suggests that it was not rigorously enforced. Paul Einzig was not greatly impressed by these early (and now little remembered) exchange controls. Writing in 1934, he noted that, ‘…they did not aim at the creation of a watertight system and were not applied with much vigour’.2 The Bank of England was given the dual task of interpreting the Treasury’s order, and of seeking its enforcement. The Bank, however, lacked the resources to effectively police the market, and this meant that compliance with the regulations ultimately depended on

The foreign exchange market of London

60

the care taken by the banks in vetting their customers’ foreign exchange transactions. If Einzig is to be believed, the banks were not always meticulous in executing this task. Those who did take their responsibilities seriously were able to turn to the Bank for guidance. For instance, in January 1932, the London branch of the National City Bank of New York asked the Bank, ‘…whether it would be in order for an Englishman who bought dollars prior to 21 September, to sell them now for sterling against the repurchase of dollars for three months ahead?’.3 The Bank believed that these funds were being moved merely to take temporary advantage of relatively high UK interest rates. Since there was no obvious commercial rationale for the transaction, National City was informed that it was, ‘…distinctly contrary to the Treasury order and so should not be undertaken’. It is doubtful whether these leaky exchange controls made much, if any, contribution to the steady recovery that took place in the exchange rate during the opening months of 1932 (the pound was trading around $3.70 by the spring of that year). The allure of relatively high UK short-term interest rates and the perception that its earlier fall had been overdone were the main factors behind sterling’s spirited rally. The recovery in the exchange rate encouraged the Bank of England to enter the market to buy the foreign currency needed to pay off the outstanding foreign credits. These were largely repaid by the end of March, and this allowed the Treasury to lift its now superfluous exchange controls (the Bank of England, however, maintained an unofficial embargo against foreign issues on the London capital market throughout the 1930s). Birth of the EEA With the foreign credits no longer preying on the official mind, the authorities were able to redirect their exchange rate and monetary policies towards combating the weakness in domestic economic activity. Bank rate was slashed to 2 per cent by the end of June. And achieving a competitive rate for sterling became a key objective for the Treasury. The pursuit of this objective informed the decision to establish the Exchange Equalisation Account in July 1932. The stated aim of the EEA was to check undue fluctuations in the exchange value of sterling. However, its true purpose was to fry a very much bigger fish. According to a senior Treasury official, the EEA was established, ‘…to keep down the pound’.4 The Treasury seeded the EEA with £150 million in sterling securities and with £20 million in US dollars, the latter being transferred from an account that had been used to accumulate funds for war debt repayments to the United States. The initially low foreign currency and gold holdings of the EEA were expanded through the subsequent sale of sterling for foreign assets on the exchange markets. The Treasury retained ownership of the assets of the EEA, but the Bank of England was charged not only with managing these resources but also of using them to intervene on the exchange markets. Official intervention was directed towards achieving an exchange rate target for sterling, which was set by the Treasury after consultation with the Bank. This target was unpublished, and it was altered from time to time in response to changing economic and financial circumstances. The Treasury’s initial target level was

Off gold and into the bank 1931–39

61

$3.40.5 Sterling’s managed float occurred at a time when most of the other major trading currencies were still tied to gold, although some (such as the German reichsmark) were so heavily blanketed by exchange controls that their membership of the gold bloc was merely token. Sterling’s fall from $4.86, by conferring a significant competitive advantage to Britain, already had disconcerted the gold standard countries and their unease intensified, during the early part of 1933, as the Bank of England intervened heavily on the currency markets to prevent sterling from appreciating. With the world economy mired in recession, it was only a matter of time before other countries would seek to secure the benefits they perceived that Britain had obtained by depreciating its currency. The first to jump was the United States, which abandoned the gold standard on 19 April 1933. This move provoked heavy speculative selling of the dollar, which fell steeply against the other major trading currencies. Its decline gathered momentum in October after the US government took deliberate steps, in the open market, to push up the dollar price of gold.6 It was only after the desire for a lower exchange rate had been fully realised—the US dollar/sterling rate was trading above $5.00 by the end of 1933—that steps were taken to re-establish a link between the dollar and gold. In January 1934, the US Treasury fixed a price for gold at $35 per ounce (this compared with the old fixed price of $20.67 per ounce). It stood prepared to sell gold at this price, although only to the central banks of countries with gold standard currencies. These countries (who collectively formed the gold bloc) were France, Belgium, the Netherlands and Switzerland. And it was towards the stable currencies of this bloc that the British authorities turned after April 1933, when they decided to re-base their exchange rate target. With the dollar sinking like a stone, it no longer made any sense for them to express their aspirations for sterling in terms of the US currency. Instead, the Bank was instructed to target the French franc/sterling rate (which remained the focus of British policy until 1936, when once again the US dollar/sterling rate was returned to prominence).7 The gold bloc, however, was not to remain an oasis of stability for long. The sharp appreciation by the gold currencies against the US dollar and sterling caused them to become severely overvalued, and this increased the pressure on the countries concerned to participate in the merry-go-round of competitive devaluations. The first to do so was Belgium, which left the gold standard in March 1935. The belga entered into a free fall although, after depreciating by 28 per cent in terms of gold, it was restored to the gold standard in March 1936 with a new and lower parity. Devaluation of the belga placed the currencies of the other gold bloc countries under even closer scrutiny. France, in particular, suffered a massive outflow of capital over the summer of 1936. The French responded to this pressure by entering into secret negotiations with Britain and the United States in an effort to resolve the currency problems that had destabilised the international economy over the preceding five years. These negotiations culminated in the simultaneous announcement, on 25 September 1936, of a swingeing devaluation of the French franc and of the Tripartite Agreement. France remained on the gold standard, but the government was given the right to vary the gold parity of the franc within a range that was set at 65.6–74.8 per cent of its previous

The foreign exchange market of London

62

parity. The readjustment in the French franc’s external value provoked an immediate reaction elsewhere in the gold bloc. At the end of September 1936, Holland devalued by 19.6 per cent and Switzerland followed suit with an even bigger devaluation of 30 per cent. Tripartite Agreement fails to calm franc During the course of 1934–35, the Bank of England had succeeded in keeping sterling close to $5 and Fr75, but the devaluation of the French franc soon put paid to this brief episode of stability. In the wake of the French devaluation, sterling appreciated to Fr105. However, the decision of Britain, France and the United States to sign the Tripartite Agreement at least held out hope that the realignment of the gold bloc currencies would mark an end to the fruitless cycle of competitive devaluations which had been initiated by sterling’s departure from gold in September 1931. This Agreement (which was later to be signed also by Belgium, Holland and Switzerland) sought to ban competitive devaluations and to promote exchange rate stability.8 The resources of the EEA, the US stabilisation fund (which had been established at the beginning of 1934) and the French stabilisation fund (which was established in September 1936) were mobilised to secure these objectives. The results were somewhat mixed. Intervention ironed out day-to-day fluctuations in exchange rates, and most countries signing the Agreement were able to chart a stable medium-term course for their own currencies. However, this was not true of France, and the franc proved to be a weak and volatile currency well into 1938. The Tripartite Agreement required the British, French and American central banks to agree in the morning the rate they would convert each other’s currency into gold at the close of business that day. This provision enabled the US stabilisation fund, which hitherto had refused to sell gold to non-gold standard countries, to engage in transactions with the EEA and the Bank of England. The operation of this ‘24 hour gold standard’ helped to diminish very short-term volatility in exchange rates, but the fact that countries were allowed to alter their pegged rates at only 24 hours’ notice meant that there was still plenty of scope over time for significant changes in exchange rates. This scope was fully exploited by France. Although the franc had been given a variable gold parity after its devaluation in September 1936, the French authorities chose, over the next nine months, to loosely peg it to the floating pound rather than to the gold linked US dollar.9 The peg was set initially at Fr105. This was lowered to Fr110 by May 1937, but then on 29 June 1937 the French government informed the other signatories of the Tripartite Agreement that it was scrapping the upper and lower gold parity limits for the franc. Henceforth, the franc was to become a managed currency, entirely divorced from gold (see Figure 4.1). The French franc/sterling rate—which was retained as the lodestar of French exchange rate policy—eased to Fr130 in the wake of this announcement. It did not remain there for long. Between July 1937 and May 1938, it weakened progressively from Fr130 to Fr178, in response both to faltering French net exports and to rising international political tensions. The franc’s slide was hardly a good advert for the Tripartite Agreement, even

Off gold and into the bank 1931–39

63

though—in keeping with the spirit of the Agreement—the French did intervene from time to time to moderate its slide.

Figure 4.1 Exchange rate volatility after leaving the gold standard (source of data: The Economist).

During the trials and tribulations of the French franc, the US dollar/sterling rate fluctuated in a fairly narrow $4.88−5.02 range. The behaviour of this exchange rate at least accorded closely with aims and objectives that had been sought by Britain, France and the United States in September 1936. However, the franc settled down after May 1938, and up until the German occupation of France, it operated with a virtually fixed

The foreign exchange market of London

64

rate against sterling, of around Fr178. It became, in effect, a member of the sterling bloc. The newfound stability in the French franc was paralleled by an underlying uptrend in the US dollar, and between May 1938 and August 1939, it strengthened from $4.96 to $4.68. The Bank of England supported sterling throughout this period, but then withdrew abruptly from the market on 25 August, as the British currency came under intense pressure after the announcement of the German—Soviet Pact.10 Sterling tumbled immediately to $4.35, but its days as a free currency by then were numbered and, following the outbreak of war on 3 September 1939, the UK authorities assumed tight control over the London exchange market and established an official US dollar/sterling rate of $4.03. Floating brings only limited joy The interval between sterling’s departure from gold, and it being pegged at $4.03, should have been a happy time for the exchange market. After all, spot trading should have been boosted by increased exchange rate volatility, whereas forward trading should have been stimulated by the expectation, and also by the realisation, of sudden sharp movements in exchange rates. Both of these things did in fact take place with the result that turnover on the London market picked-up during the 1930s. In turn, this permitted a recovery in brokerages from the low levels that had prevailed at the end of the previous decade.11 If times were not hard, they still could have been a lot better. Dealers normally feast on exchange rate volatility. But, during the 1930s, turnover on the market failed to rise as much as might have been expected in response to the intermittent currency crises of the period. This had something to do with the slump in world trade and slide in global stock prices that blighted the first half of the decade. However, it had something also to do with the institutional and financial changes that were sponsored by the inhospitable international economic environment of the time. One institutional development to have an adverse impact on the London exchange market was the formation of the sterling bloc. It did so by reducing the number of currencies in which dealers were able to trade profitably. The origins of the sterling bloc (it only acquired the title of sterling area in 1940) can be traced back to September 1931, when a group of countries chose to fix their currencies against sterling at the time of the latter’s departure from gold. The founder members were the British colonies along with Egypt, Estonia, Iraq and Portugal, but others soon were to be attracted to the shelter provided by this informal arrangement.12 Australia and New Zealand had left the gold standard before Britain, but both of these Dominions eventually decided to end their independent floats by setting fixed exchange rates against sterling (in both cases at 20 per cent below their old 1:1 gold standard parities). Australia did so in December 1931, and New Zealand followed suit somewhat later in January 1933. Canada—in view of its close economic and financial ties with the United States—saw little reason to enter into sterling’s orbit, but South Africa (which had remained on gold for some time after Britain, and had seen its pound appreciate against sterling) elected to devalue and to enter the sterling bloc with a 1:1 fixed rate against the British pound in December 1932.

Off gold and into the bank 1931–39

65

It was not just the Dominions that found it attractive to tie their currencies to sterling, which during the 1930s remained a key international currency, despite strong and rising competition from the US dollar. The pound’s global role—it continued to be used to finance around 50 per cent of world trade—provided ample justification for a number of foreign countries, beyond those who had signed up as founder members in 1931, also to join the sterling bloc. Among those subsequently obtaining membership were the four Scandinavian countries (in 1933), Japan (1933), Argentina (1934) and France (1938). Foreign exchange dealers had little reason to look with any favour on the sterling bloc. While the participating countries were free to alter their sterling parities, few chose to exercise this option (Argentina, which on two occasions devalued the peso’s official rate against sterling, was the main exception to this rule). The sterling bloc hit dealers’ pockets not only because the parities between the participating currencies were so stable, but also because there was scarcely any fluctuation in exchange rates around these parities. Looking back on this period, a League of Nations report commented: …exchange relationships within the sterling area were on the whole remarkably stable. Central banks usually maintained fixed buying and selling rates on sterling with a very small range between them, so even the fluctuation that used to occur in gold standard currencies between gold import and export points were partly or wholly eliminated.13 The widespread adoption of exchange controls also made life difficult for currency traders. Such controls spread like wild fire across continental Europe and Latin America as countries sought to husband their foreign currency resources in the face of dwindling export earnings and diminishing capital receipts. One of the first to move in this direction was Germany, which in July 1931 adopted a partial transfer moratorium on foreign shortterm debt repayments.14 This temporary measure, however, was to be just an appetiser for the veritable banquet of controls and regulations it and others were to introduce over the rest of the decade.15 During the early 1930s, many countries in Eastern and South Eastern Europe resorted to clearing agreements to organise the repayment of their commercial and financial debts. Such arrangements were deadly for currency traders, because they obviated the need for regular currency trading. Bilateral clearing arrangements sought to canalise payments between the participants through designated accounts, which invariably were maintained at their respective central banks. Clearing hurts spot trading To understand the basic principles involved, consider a hypothetical clearing arrangement (covering all current payments) between creditor country (A) and debtor country (B). When B sells goods to A, its exporters will receive payment in local currency from the clearing account at their own central bank, whereas when B buys goods from A its importers will make payment in local currency into the same account. These flows will be matched by offsetting transactions in country A. Two key points are worth noting. The first is that settlement takes place outside of the

The foreign exchange market of London

66

foreign exchange markets. The value of the goods being traded will be equated by a notional exchange rate agreed between the two participating countries. This may be the normal market rate, but it also may be a purely arbitrary rate selected by the debtor country. The second point to note is that clearing both equilibrates and rations commercial transactions between the two partner countries. Most clearing arrangements are also prescriptive. That is to say, at least one of the parties (usually the debtor country) will indicate how the money in its clearing account is to be spent. This is well illustrated by the partial clearing arrangement that was agreed between Germany and three of its trading partners in 1932. Under the so-called Reemtsma agreement, German purchases of tobacco from Greece, Turkey and Bulgaria were settled up to 75 per cent by frozen German claims on these three countries.16 Germany also adopted clearing arrangements to deal with many of its own creditors, as it sought to regularise its external debt repayments after the July 1931 moratorium. However, by 1934, the breadth and depth of German exchange control had been widened to embrace not just the settlement of its past financial obligations, but also the whole of its current trading activities. Clearing arrangements, payment arrangements (which were similar to clearing arrangements except that transactions were settled via the exchange markets) and a bewildering array of blocked mark accounts formed the main elements of this control. While Germany remained notionally on the gold standard, the use of the gold reichsmark was severely restricted and confined largely to approved transactions under bilateral payment agreements. Its use was permitted, for instance, under the 1934 AngloGerman payments agreement. Under this agreement, British current payments to Germany, which were made in free exchange, were canalised into special accounts, with the subsequent deployment of the funds in these accounts being prescribed by the Reichsbank. Just over half were reserved to cover imports from the United Kingdom, with the rest being largely used to settle commercial debt repayments and bond interest payments to UK residents.17 British creditors were rather lucky because, in the majority of cases, foreign claims on Germany were not settled in free exchange, but were ensnared in blocked mark accounts. Blocked marks came in many shapes and sizes, including: 1 Registered marks, that were used to make debt repayments to foreigners under the standstill arrangements that followed the 1931 moratorium. 2 Aski-marks, that were used to finance trade between Germany and Latin America. 3 Credit marks, that were used to make repayments on German external debts that were not covered by standstill arrangements. 4 Security marks, that were created from the sale of securities repatriated to Germany. Blocked marks traded at a discount to the gold reichsmark with the size of the discount varying in accordance with the rules governing the deployment of the blocked funds. Registered marks arguably were the best of this bad bunch, because they could be used to cover expenditures by foreign tourists in Germany and, under certain circumstances, also the purchase of goods from Germany (however, only goods that could not be profitably sold at the free rate of exchange were eligible to be bought with registered marks). Registered marks tended to trade at a discount of 20–50 per cent, whereas the

Off gold and into the bank 1931–39

67

discount on security marks, which could only be used to finance investments in Germany, usually was well above 50 per cent. Multiple exchange rates, arising from blocked or restricted accounts, were commonplace elsewhere in continental Europe (e.g. Hungary, Greece, Yugoslavia, Romania), and also in Latin America. Many of these accounts were so highly regulated that it was impossible to trade the currencies covered by them in London. However, there were exceptions to this general rule. Registered marks, for instance, were quoted and traded in London, and so too were the free rates (applied to financial transactions) adopted by some of the Latin American countries. Be that as it may, multiple exchange rates still impeded the proper functioning of the London foreign exchange market, even if they were less bad for business than the clearing arrangements, which during the 1930s, Britain had signed with countries such as Italy, Spain and Turkey. Forwards impeded by controls While the exchange rate volatility uncertainty that characterised the 1930s provided a powerful stimulus to forward exchange trading in London, the market was prevented from realising its full potential due to the stifling influence of European exchange controls. The pernicious effect of these controls is vividly illustrated by the disappearance of the forward market in lire following the adoption of comprehensive exchange controls and clearing arrangements by Italy in the mid-1930s. Dealers must be given free and unfettered access to banking deposits in a currency for it to be successfully traded on the forward market.18 However, such access was denied in all too many European countries, during the 1930s, by exchange controls. Banks simply were unprepared to engage in forward deals when they were unable to arrange suitable cover. As the Bank of England noted in 1938: …no matter how close the relations may be between banks in two centres, the bank in the free centre generally refuses to undertake any forward commitment with the bank in the tied centre. This is the reason why it is a waste of time to examine the possibility of developing a forward market in reichsmarks and lire…19 Exchange controls expunged forward trading throughout most of Central, Eastern and Southern Europe. Indeed, during the 1930s, the forward market was largely, although not exclusively, limited to trades involving the currencies of the principal international creditor nations (United States, Britain, France, Netherlands, Belgium, Switzerland and Canada). Unsurprisingly, due to this concentration of activity, the biggest forward markets were to be found in London, New York, Paris and Amsterdam.20 Turbulent conditions on the currency market undoubtedly spurred trading in forward exchange, by encouraging companies to cover their future foreign currency obligations. Forward exchange, however, also had been widely used, during the previous decade, by speculators seeking to profit from the currency disturbances of that time. It appears that time had not dulled their enthusiasm for dabbling in this market, because it was reckoned by the Bank of England that, during the mid-1930s, no more than 10 per cent of the

The foreign exchange market of London

68

turnover in forward exchange was attributable to genuine foreign trade requirements.21 While inter-bank trading in support of commercial transactions would have accounted for part of the remaining turnover, the Bank believed that a significant share also was attributable to the activities of speculators. Banks involved in foreign exchange trading set limits on the trades—both spot and forward—they undertake with other banks, in order to control their exposure to the potential losses that may arise from the failure of a counterparty to complete its side of a transaction on the due date. The willingness of one bank to grant a foreign exchange dealing line to another, and the size of the limit attached to the line, will be heavily influenced by the grantor’s assessment of the credit standing of the grantee. Risks do exist in spot trading (a bank may fail before it completes its side of the transaction), but the very short time horizon involved between the initiation and completion of a spot deal means that these ought to be easier to manage than those involved with forward trading— where the contract may be outstanding for up to six months, or even longer. If a counterparty goes bust before the maturation of a forward contract, it will be unable to deliver the funds required to complete its side of the deal. This will provide the other party to the contract with sufficient reason also to withhold payment. However, the frustration of the contract will leave the sound bank with an unplanned currency exposure that it will need to cover, but it may only be able to do so at a loss. Lines and limits for forward deals are set to minimise the risk of such losses. Unsurprisingly, close scrutiny was paid to such lines, during 1931, as banks in continental Europe—including the Credit Anstalt in Austria and the Darmstadter in Germany—started to fall like ninepins. While the British banking system remained remarkably stable during this period, this did not stop its members from being tarred with the same brush as their continental European counterparts. US banks, worried by the deteriorating financial situation in Europe, began to cut their dealing lines with European banks, irrespective of their country of origin. This had an unfavourable impact on the London forward exchange market. US banks were key participants in this market, something that was to be expected in view of the high share of forward turnover accounted for by the US dollar/sterling rate. During 1931– 32, US banks axed their forward dealing lines in Europe, other than with banks they judged to be of the highest credit standing. In the United Kingdom, they were prepared to deal only with the clearing banks, who by that time had become more inclined to act as market makers.22 US banks, however, were not alone in favouring the clearers. Other foreign banks and many British companies also acted in the same way. Indeed, by January 1932, the Bank of England was being urged to consider ways, ‘…of remedying the present tendency of giving the Clearing Banks a monopoly of [forward] exchange business’.23 Those who suffered most from this ‘tendency’ were institutions with a traditionally close involvement in the London foreign exchange market, such as the British merchant banks and the British owned overseas banks. Credit worries continued to undermine the forward market throughout 1931–33, although the focus of attention shifted during this period from Europe to the United States. In early 1933, the United States—which already had suffered from widespread banking failures over the previous two years—was gripped by a major financial panic,

Off gold and into the bank 1931–39

69

and US banks (who by then had become more liberal in granting dealing lines to British banks) received a dose of their own medicine, when they were turned down as acceptable names by the London market. Fortunately, this impasse did not last for too long. The passage of the US Banking Act of 1933, which amongst other things provided for the insurance of bank deposits, helped to restore confidence and, by 1934, business on the London forward exchange market no longer was being impeded by the cancellation of dealing lines.24 Between 1934 and 1936, trading benefited from the uncertainty surrounding the parities of the gold bloc currencies. This proved to be an exceptionally good period for the forward market, both in London and elsewhere. For instance, by 1935–36, forward trades were accounting for as much as 34 per cent of the total foreign exchange transactions (in the major currencies) undertaken by US banks in the United States.25 The instability in the French franc in the wake of the Tripartite Agreement also was good for business but, from mid-1938 onwards, activity reverted to a more humdrum level. Old Lady assumes leading role Dealers in both spot and forward exchange had to contend, after September 1931, with a dramatic increase in the role and importance of the Bank of England on the London market. This resulted from the operational changes that took place in the implementation of economic and financial policies in the post-gold standard era. Under the gold standard, the Bank had little direct involvement in the foreign exchange market (its support for sterling during the dying days of $4.86 was an exception to this general rule). Any influence it had over the exchange rate resulted indirectly from its Bank rate decisions, and from its transactions in the gold market. There had been periods before 1931, of course, when the rules of the gold standard either had been ignored (1914–18), or had been suspended (1919–24). However, during these earlier periods, the Bank’s activities had had little impact on the London market. This is because, during the First World War virtually all the intervention to underpin the exchange rate had been undertaken in New York, whereas during the floating regime of the early 1920s, the Bank had neither the means nor the inclination to operate in the foreign exchange market. The situation was very different from September 1931 onwards. The Bank was confronted by two immediate tasks following the departure from gold. The first was to secure the foreign exchange needed to repay the short-term debts that the Treasury and the Bank had incurred in the United States and France. The second was to oversee the exchange regulations that were in force between September 1931 and March 1932. The successful completion of these two tasks, far from leading to a diminution in the Bank’s role, was to be followed by its even more active involvement on the London market. This arose both from the emergence of the exchange rate as a key policy objective and from the establishment of the EEA to facilitate the achievement of this aim. The latter gave the Bank of England, for the first time, the firepower it needed for sustained intervention on the London market. In turn, sustained intervention made the Bank an important consumer of the services provided by the dealers and brokers supplying the

The foreign exchange market of London

70

market. This provided it with a good reason, and also endowed it with sufficient muscle, to influence the procedures and practices of market participants. The Bank of England’s foreign exchange department, which had been established in the late 1920s, had grown in size and importance in step with the Bank’s increasing involvement in the market. This department—leadership of which passed to George Bolton following the death of Robert Kay in January 1936—was charged with executing day-to-day transactions in the market, with managing the Bank’s relationships with foreign exchange dealers and brokers, and with policing the activities of market participants. In keeping with other market practitioners, the Bank maintained lists of dealers and brokers with whom it was prepared to do business. The Bank preferred to engage in foreign exchange transactions with British owned banks, probably because it was able to monitor their creditworthiness more easily than that of foreign owned banks. One of its earliest lists of approved counterparties included the big five clearing banks, the larger merchant banks and a handful of British overseas banks. The only ‘outsiders’ were four Canadian banks.26 It is good practice for a bank to transact with a wide range of exchange brokers, in order to reduce the scope for one or more of its dealers to solicit personal financial reward by directing business to a specific brokerage firm. The Bank abided by this rule, and (in 1936) 17 of the 30-odd brokers serving the London market were included on its approved list (Table 4.1). All of the big names—including Harlow & Jones, Astley & Pearce, Godsell & Co and M.W.Marshall & Co—were approved by the Bank to act on its behalf.27 The Bank’s dealers also were allowed to transact with four further firms, but only after referral, whereas nine firms were specifically excluded from doing any business with the Bank. Possessing a reputation for engaging in dubious or nefarious practices was one of the surest ways of landing up on this blacklist. The foreign exchange department was responsible for day-to-day operations in the London market. Policy related issues, however, were handled elsewhere. Intervention tactics were decided at a daily meeting of key Bank of England officials (which included a representative from the foreign exchange department), whereas strategic issues—such as the appropriateness of any given exchange rate target—were discussed at a joint Bank—Treasury exchange committee, which met on Friday afternoons.28 The initial membership of this committee comprised two Bank officials (the Deputy Governor

Table 4.1 Brokers approved to deal with the Bank of England 1936 Astley & Pearce Aria, Alexander & Co Ltd Belier, M. Brocke & Sandiford Flindt & Duke Fulton, Charles & Co Godsell & Co Ltd

Off gold and into the bank 1931–39

71

Gooding & Hodgson Harlow & Jones Ltd Hodge & Lea Lawrence & Co Martin, R.P. & Co Marshall, M.W. & Co Meyer, Edward B. Quin (Gerald) Cope & Co Scaramanga, S.P. Souch, Jefferey & Spillan Ltd Source: BoE C43 (114). Four other brokers were approved but only after referral and for deals with a first-class counterparty. The Bank’s dealers were expressly forbidden from using nine other firms.

and one other member of senior management), two Treasury representatives, one merchant banker and one clearing banker. A more formal market structure The deeper involvement of the Bank of England in the foreign exchange market created the need for improved channels of communication between it and other market participants. In September 1931, it faced the immediate task of disseminating information to banks’ foreign exchange dealers about the Treasury’s newly introduced exchange controls. To help it perform this task, the banks duly formed the London Foreign Exchange Managers’ Committee on 23 September.29 Unlike the informal Dealers’ Association that had existed during the 1920s, this new Committee was established with the blessing and full approval of banks operating in the London market. The Committee was chaired by A.W.Gurney of National Provincial, and contained ten other dealers to represent the London market. Four were drawn from the other big clearing banks (Barclays, Lloyds, Westminster and Midland) with the rest coming from British Overseas Bank, Samuel Montagu & Co, Guaranty Trust Co, Société Générale, Canadian Bank of Commerce and Swiss Bank Corp. While the Committee had been established to facilitate the implementation of the September 1931 exchange controls, it did not disband when these controls were lifted in March 1932. By that time, it had become, according to the Bank, ‘…such an essential part of the market organisation that [it] carried on as an advisory and sometimes executive body’.30 One of the Committee’s earliest and biggest successes came in July 1932 when, ‘…it organised the exchange brokers and in so doing prevented the growth of corruption and unfair practices which had been an unpleasant feature of the market between 1919 and 1927’.31 The London Foreign Exchange Brokers’ Association (FEBA) was given a similar title to the previous brokers’ organisation, which had been dissolved—amid some acrimony—during the lean trading times of 1929. The Bank, which had long held a jaundiced view of the broking community, both encouraged and supported the

The foreign exchange market of London

72

establishment of this body, in the hope that it would keep the more wayward brokers in line. In keeping with the Bank’s wishes, membership of the FEBA was made mandatory for all brokers operating in the London market. As a quid pro quo the banks agreed to channel their transactions through members of the Association and to eschew direct dealing in London.32 In the event, the banks were less than diligent in fulfilling their side of the bargain, and direct dealing between banks was destined to remain a bone of contention between dealers and brokers for a few years still to come. All 32 survivors of the late 1920s carnage in the broking community joined the FEBA, which was then promptly closed to new members. There were more brokers than needed by the London market, and the aim of this provision was to ensure that their numbers would shrink whenever firms went out of business or merged (as it turned out only two firms fell by the wayside between 1932 and 1939). Members of the FEBA were obliged to abide by its rules on good conduct and to enforce the fixed brokerage charges negotiated between it and the Foreign Exchange Managers’ Committee. Relations between these two bodies—other than on the controversial issue of direct dealing—seem to have been quite close. If anything they were too close for the good of the London market. This is because the banks and brokers colluded in an arrangement under which deals were struck at fixed spreads between buying and selling rates that were wider than the margins prevailing in continental European centres. The banks, especially the clearing banks, favoured this arrangement because of the profits they were able to make by, ‘…dealing with customers at the fixed margin in London and covering in between in other centres’.33 In turn, this worked to brokers’ advantage because the profits the banks gained from the arrangement made them more willing to accept high brokerage rates. The loser, of course, was the London market itself. Uncompetitive practices in the City meant that business was diverted to Paris, Brussels and Amsterdam. This was not a big problem so long as turnover continued to increase in London, but it became a matter of serious concern from late 1936 onwards, as business slowed in response to reduced exchange rate volatility. The matter eventually would be sorted out between the dealers and the brokers, although the London Foreign Exchange Managers’ Committee was destined not to take part in these future negotiations. The Committee was given a makeover in September 1936, when it was reconstituted as the London Foreign Exchange Committee (FEC). While the old Committee had won applause for organising the brokers, for setting market rules (such as on late payment) and for enforcing standards of practice, it also had attracted criticism. Banks without a seat on the Committee accused it of failing to represent their views and of failing to communicate adequately with the market; whereas the Bank of England felt that the foreign exchange managers who sat on the Committee were too far down the corporate ladder either to take important executive decisions, or to be sure of automatic approval of their views by senior management.34 Those unhappy about being excluded from the Committee appear to have spent some time bending the Governor’s ear on this matter, because it was Montagu Norman who wrote, in June 1936, to the Chairman of the Committee of London Clearing Banks (CLCB) demanding reform of, ‘…the existing self-appointed committee’.35 Two

Off gold and into the bank 1931–39

73

important changes distinguished the FEC—which came into being three months after the dispatch of the Governor’s letter—from its predecessor. First, its membership was widened to include Martins and also Glyn, Mills & Co (to represent the smaller clearers); English, Scottish and Australian Bank (to represent the Australian banks); Bank of Scotland (to represent the Scottish banks) and the Mercantile Bank of India (to represent the Eastern banks).36 Second, the head of the CLCB (Lord Waddington from Lloyds Bank) was appointed chairman of the Committee, in order to give it executive clout. Criticism of the Committee was not entirely stifled by these reforms, and complaints continued to rumble on about its members being privy to information that was not disseminated to outsiders. However, the market had much bigger things to worry about during 1937. Turnover on the foreign exchange markets declined in the wake of the Tripartite Agreement, and this made traders more sensitive to the business that London, due to its uncompetitive practices, was losing to other European centres. Something had to give and, in February 1937, after protracted and difficult negotiations, the Brokers’ Association and the Exchange Committee, acting with the full support of the Bank of England, rewrote the rulebook of the London market. The main features of the accord were noted in a letter sent, on 22 February 1937, by the secretary of the FEBA to the Bank of England.37 In this letter, it was noted that brokerages were to be slashed by around a third (or from 30s to 20s per $100,000, in the case of the US dollar, and from 1s 6d to 1s per Fr100,000, in the case of the French franc), and that the practice of maintaining a fixed spread between buying and selling rates was to be abandoned in favour of a ‘free quote’. The latter move elicited an early and dramatic response in the market. On 23 February, the day the new arrangements became operative, ‘…the spread for French francs was reduced from franc, or over 3 centimes to 1 centime, or in some instances 2 centimes. The spread for dollars contracted from cent, or 0.125 cent to 0.01 cent, though it widened subsequently to 0.03 cent, even at the lower rate it was less than one fourth of its previous figure’.38 The combination of lower spreads and brokerages was intended to dissuade London based banks from covering their positions in continental centres, and the resulting expansion in turnover on the London market was intended to compensate brokers for cutting their commission rates. Neither the banks nor the brokers were particularly happy with these arrangements. The clearing banks felt that narrower margins would undermine the profitability of the foreign exchange business they conducted with corporate customers, whereas the brokers felt that they would not attract enough additional business to offset the reduction in brokerages. Both sides had been forced to make concessions for the good of the London market. The brokers, however, felt that they had given more than the banks to secure the accord, and they now pressed the latter to fully meet the pledge they had made, in 1932, to boost brokers’ revenues by avoiding direct dealing in the London market. Most banks, in fact, had refrained from direct dealing. But some had not. According to the Bank of England, ‘…the chief offenders [in respect of direct dealing] were Samuel Montagu & Co, Guaranty Trust Co New York and the Central Hanover Bank & Trust Co’.39 Bank officials were reluctant to allow this issue to remain on the table for fear of giving discontents amongst the brokers an excuse to question the continued existence of

The foreign exchange market of London

74

their Association, the maintenance of which was a matter of some importance to Bolton and his colleagues. Accordingly, the Bank brought pressure to bear on the three offending banks, ‘…who, while not convinced, were persuaded to fall into line with the wishes of the majority’.40 Following this intervention, the CLCB advised the market that all direct dealing was to cease from 1 June 1937. This restrictive rule was to remain in force for over forty years. The Bank had long used a mixture of nods, winks and arm-twisting to influence the behaviour of participants in the domestic money and banking markets. The elevation of the exchange rate as a key policy target and the related expansion in the foreign exchange activities of the Bank meant that it was almost inevitable that, during the 1930s, foreign exchange dealers and brokers would become the recipients of the same sort of treatment. The bank’s requests to the market were devoid of legal backing, and this meant that they were not always fully observed. Those who did comply inevitably lost out to banks that were less in awe of the Bank’s authority. When the Exchange Committee was reconstituted the hope was expressed that: …it will be possible to obtain a more uniform interpretation and application of the various unofficial embargoes that concern the activities of foreign exchange departments. As it is, many of those who abide by the requests of the authorities about speculative forward exchange dealing, forward dealing in gold, dealing in gold coins at a premium etc. cannot help feeling that the business they relinquish swells the profits of their rivals.41 There is no firm evidence to suggest that this hope was fulfilled. In the role as headmistress of the London exchange market, the Old Lady attached a higher priority to seeking orderliness and tidiness than to encouraging competition. The Bank supported the establishment of the Brokers’ Association and of the two Exchange Committees, because these organisations served as useful channels of communication, and because—by setting trading rules and maintaining standards of behaviour—they contributed to the smooth running of the market. The Bank, however, seemed to be little concerned by the uncompetitive practices that were a feature of the London market during the 1930s. It tolerated the maintenance of fixed spreads for far too long, even though this practice was damaging to London’s position as a foreign exchange centre, and it fully supported the establishment of the Brokers’ Association as a closed corporation, even though it could have urged the market to rely on natural forces, rather than a ban on new entrants, to cut capacity in the broking community. The Bank, of course, was deeply involved in cobbling together the deal that eventually did away with fixed spreads. However, the ban on direct dealings, that it used to win the support of brokers for the 1937 accord, merely had the effect of replacing one restrictive practice with another. Apart from sorting out the dealers and brokers, the Bank was engaged in another and more portentous task in 1937. It began to develop contingency plans for the exchange market to be adopted in the event of war.42 Exchange controls formed the centrepiece of these plans, and preparations for their adoption were undertaken, amid great secrecy, by a small team of foreign exchange and legal experts, led by Harry Siepmann.43 Siepmann,

Off gold and into the bank 1931–39

75

who had joined the Bank in 1926 as an Advisor to the Governors, was the most senior Bank official with responsibility for currency matters. Ironically, his team (which included George Bolton) imported many of their best ideas from Germany. This applied especially to the payment agreements that would be used, during the Second World War, to facilitate British trade with neutral countries. The preparatory work undertaken on exchange controls indicates that the authorities had no intention of allowing the London exchange market to operate with the same degree of freedom in a future conflict as it had enjoyed during the First World War. This became only too apparent on 4 September 1939, or the day after war was declared, when the Treasury issued regulations requiring UK residents to sell to its agent (the Bank of England) not only their current holdings, but also their future receipts of key ‘designated’ currencies. Free market trading in these currencies was scrapped and those entitled to buy and sell them were obliged to do so with the Bank of England at fixed official rates. The London foreign exchange market, other than a small compartment dealing in the Dominion and colonial currencies, and a few minor foreign currencies, was shut at the stroke of a civil servant’s pen. It was to remain closed for a further twelve years.

5 War and peace 1939–51 Britain declared war on Germany on Sunday 3 September 1939 but, after being suspended for just one day, foreign currency dealings were resumed on Tuesday 5 September. This brief interruption stood in marked contrast with the lengthy six weeks seizure in foreign exchange trading that had followed the outbreak of war in 1914. The speedy resumption in trading in 1939 owed much to the meticulous contingency planning that had been conducted by the Treasury and the Bank of England over the previous two years. Owing to the protracted build-up to the Second World War, the authorities had had plenty of time to think about the policies they would adopt in the event of a conflict. Many of these policies were implemented during the first two days of the war so paving the way for business to resume on the 5 September. However, it was scarcely business as usual. Extensive exchange controls restricted the currency dealings of UK residents, whereas trading in designated currencies was transferred from the open market and into the Bank of England. The dirigiste structure unveiled in 1939, which was added to over the next five years, was intended to meet the needs of the wartime economy. In the event, it was to blight the financial landscape for many years thereafter. The London exchange market did not re-open until the end of 1951, non-resident owned sterling did not become fully convertible until 1958 and exchange controls were not lifted until the end of 1979. Preparations for war When developing their contingency plans in 1937–39, the authorities recognised—based on their experience during the First World War—that the overriding financial requirements in any future conflict would be (a) the need to secure adequate gold and foreign currency resources to cover the import of munitions and other essential supplies, and (b) the need to maintain a stable, but defensible, exchange rate against the US dollar, and other key currencies, in order to prevent the cost of imports from being inflated by currency depreciation. The first step towards concentrating the nation’s foreign assets had been taken on 6 January 1939, when £350 million of gold was transferred from the Issue Department of the Bank of England to the Exchange Equalisation Account.1 This move was made for purely practical reasons—the EEA needed additional resources to sustain its ongoing support for sterling on the exchange markets—but it carried with it an important implication for the future. This was that all of the country’s gold holdings would be available to pay for imports in the event of war. During the First World War the Treasury had been unable to lay its hands on the Issue Department’s gold, because the country had remained nominally on the gold standard

War and peace 1939–51

77

with domestic convertibility. However, the legal right of individuals to convert paper money into gold sovereigns at the Bank of England was removed when Britain came off the gold standard in April 1919, and it was not restored when the country returned to gold in 1925–31 (under the 1925 Gold Standard Act, the Bank was obliged to sell gold only in the form of gold bars of a minimum weight of 400 troy ounces). The abrogation of domestic convertibility meant there was little reason for gold to lie idle in the Issue Department, but it was not until after the establishment of the EEA, in 1932, that thought was given to pressing it into active service, and not until seven years later that the first step was taken in this direction. The January 1939 gold transfer to the EEA was regularised subsequently by the 1939 Currency and Bank Notes Act.2 Having already mobilised part of the Issue Department’s gold, the Treasury wasted little time in laying its hands on the remainder, worth £279 million, when war broke out.3 This transfer boosted the net reserves of the EEA to the equivalent of $2,455 million at the beginning of September 1939.4 In striking contrast, therefore, with the situation in August 1914, the Treasury entered the Second World War with a sizeable war chest of foreign assets at its disposal. Almost all of these assets were held in the form of gold—the EEA ultimately settled its foreign currency transactions in gold—and most of this yellow metal was shipped to New York and Ottawa for safekeeping during August and September 1939.5 Despite this healthy starting position, by early 1941 the Treasury had almost exhausted the means of paying for munitions and essential supplies in North America, and it was only the introduction of generous US assistance, in the form Lend-Lease, that enabled Britain to maintain its imports at a high level during the rest of the war.6 By the spring of 1939, ‘the regulations to be applied for exchange control purposes on the outbreak of war were more or less in the final form in which they eventually appeared’.7 This implies that by that time the decision already had been taken to set a fixed rate for sterling against the more important international currencies. George Bolton gives an interesting insight into how the authorities came to select $4.03 as the level that was eventually to be used for the pivotal US dollar/sterling rate.8 Those working on this issue in the Bank took $4.80 as a starting point—this was roughly the mid-point of the range within which this rate had traded since the stabilisation of the international currency markets in May 1938—and then made an allowance for inflation over the period up to the end of 1943 (the Bank clearly was not counting on a quick war). This methodology produced a rate of $4.00 and a proposal to use this rate in wartime was sent by Bolton to the Governor of the Bank of England. Norman’s response revealed a subtle understanding of the psychology of the exchange markets. He wrote to Bolton: I accept your proposal and will advise the Chancellor of the Exchequer, but the rate must not be but $4/£1 $4.03/£1 A round figure such as 4 would be very difficult to break and could become a figure of tribal significance; a broken figure does not look so final…9 In the event, the $4.03 rate would remain unchanged until the devaluation of 18 September 1949.

The foreign exchange market of London

78

Comprehensive exchange controls did not feature in the initial war plans drawn up by the Bank of England. While Siepmann’s team had recognised that there would be a need to conserve foreign exchange during wartime, they had hoped that this could be achieved without extensive or detailed regulations. By July 1938, a tentative scheme had been agreed, which drew heavily on the limited measures that had been adopted previously, either during the First World War, or after the departure from gold in 1931. Under this scheme, it was envisaged that on the outbreak of war: a The Treasury would take powers to requisition securities expressed in foreign currency. b An appeal would be made to the public not to purchase foreign exchange except for (1) normal trading requirements, (2) existing contracts and (3) reasonable travelling and other personal purposes. c British subjects would be required to offer for sale to the Treasury foreign exchange not required for these purposes.10 While these measures, due largely to the third item noted above, would have endowed the authorities with somewhat greater powers than they had possessed during the 1914–18 war, it was decided, after the Munich Agreement of September 1938, that stricter controls would be in order, and the original plans were substantially strengthened over the following six months. The final blueprint was drawn up and agreed by March 1939. The Bank now was almost ready for war. Only one task remained, and this was completed over the summer of 1939. During this period, the Bank printed three month’s supply of exchange control forms, which were sent to the Committee of London Clearing Bankers in readiness for future use.11 Exchange control management Powers to issue and enforce exchange control regulations were vested in the Treasury, but it chose to delegate most of these powers to the Bank of England. In turn, the Bank chose to delegate some of the tasks bestowed on it to commercial banks it appointed as authorised dealers. Despite this devolved structure, the implementation of exchange controls still required the creation of a substantial bureaucracy within the Bank. It also required the helping hand of an executive steering committee. The latter was established just after the outbreak of war, and was composed of the Deputy Governor of the Bank of England (Basil Catterns), or an alternative; one representative of the Treasury (Ernest Rowe-Dutton); one representative of the clearing banks (A.W.Gurney of National Provincial) and one of the Bank (Harry Siepmann).12 The first reference to this committee was made in a memorandum of 5 September, which stated that: Day-to-day administration will be controlled by the Bank of England and an internal committee will be set up in the Bank of England which will meet daily to approve the day’s transactions and consider any questions that may be referred.13

War and peace 1939–51

79

While this committee had broad oversight over the regulations, significant changes to them usually required direct negotiations between high-ranking officials in the Bank of England and the Treasury. In terms of enforcing the controls, the donkey work was undertaken by a new exchange control section established in the Cashier’s Department, and to parallel functions created in the authorised banks. The most immediate need at the outbreak of war was to find suitable people to staff this section—which was given the informal, but rather Orwellian, title of ‘Control’ within the Bank. An obvious starting point was to take in those City workers, such as foreign exchange dealers and brokers, stockbrokers and commodity brokers, whose livelihoods would be put at risk during the war. Attention had been given to this issue even before the war started. During 1939, or at the time when the Bank was completing its preparatory work on exchange controls, George Bolton had approached J.K.Jones (Chairman of the Foreign Exchange Brokers’ Association and partner of the brokers Harlow & Jones Ltd), and the two of them drew up a list of brokers who would be approached with an offer of employment in the Bank at the outbreak of war.14 Around 75 out of the 125 staff and partners of the member firms of the Brokers’ Association were included on this list. Bolton’s cynical view of the broking fraternity comes out clearly in his recollections of this selection process. In his memoirs he notes that staff and principals of foreign exchange broking firms were offered jobs in exchange control, ‘…excepting those who had either served or should have served prison sentences’.15 The need for foreign exchange brokers virtually disappeared following the Bank’s takeover of dealings in the designated currencies (the remaining open market trading in the Commonwealth and minor foreign currencies only generated sufficient work to sustain three or four broking firms), and so the offer of a job in the Bank came as a godsend to those engaged in this line of work. The Bank was not a big payer, and partners of broking firms mostly were taken on at £700 p.a., or well below the income to which they had previously been accustomed. However, poor pay was better than no pay, and those selected for employment in exchange control fared a great deal better than those who had been blackballed by Bolton and Jones. One such unfortunate was reduced to sending a begging letter to the Bank. On 12 September 1939, C.Platonoff, who had run a broking firm before the war, wrote to the Bank: The suspension of the foreign exchange market has resulted for me in a sudden and complete disappearance of income while I still have to meet my current commitments. In consequence, unless given a little assistance, I shall be faced with complete ruination.16 Bolton turned a deaf ear to this plea. The threat of bombs and fear of invasion forced the Bank to develop disaster relocation plans for its dealing and exchange control operations. In mid-1940, concern about invasion was much on the Bank’s mind and contingency arrangements were made to decentralise its activities to the regions using the offices of the clearing banks for this purpose.17 The progress of the war obviated the need to activate these arrangements, but

The foreign exchange market of London

80

the plan to provide emergency cover in case the Bank’s dealing room was bombed was implemented as soon as war was declared. The offices of four foreign exchange brokers (Harlow & Jones, Meyer & Co, M.W.Marshall & Co and Souch Jefferys & Spillan) were taken over by the Bank as subexchange offices, ‘…for a definite purpose associated with the possibility of air raids’.18 The Control delegated a number of rather mundane tasks to the staff retained by these four offices in order to keep them busy. These included relieving ‘the Bank Exchange Section of routine enquiries’ and supplying ‘the commercial banks and authorised dealers of rates of exchange’.19 In the event, the Bank experienced only minimal bomb damage during the Blitz, and so the need failed to arise for its dealers to decamp to these offices. With the exchange control section in the Bank becoming more efficient the decision was taken to close two of these sub-offices, and the two survivors were left with little more to do than recording and tabulating the Bank’s daily dealings.20 The staff of the exchange control section grew in leaps and bounds during the first two years of the war. From just 78 on 4 September 1939, the section’s headcount climbed to 343 by March 1940, before shooting up (in response to a significant widening in the scope of the controls) to a peak of 1,330 by September 1941.21 There were bound to be teething problems in bringing so many outsiders into the Bank, and it did not take too long for complaints to be levelled at this rapidly expanding section. On 5 October 1939, the staff officer of the exchange control section was obliged to inform his flock that, ‘Complaints have been received from several banks that members of their staffs have received discourteous treatment from this office’.22 The minutiae of the exchange control regulations were contained in (F.E.) notices that were sent out to the banks on a regular basis. However, due to the complexities of these regulations, it was recognised early on that other lines of communication also would be needed between the Control and the market. The London Foreign Exchange Committee, which had been in existence since September 1936, was pressed into service to meet this need. On 5 September 1939, the Bank noted: The London Foreign Exchange Committee will be required to sit daily and to appoint a full time Deputy Chairman and Secretary. It will be their duty to act as a buffer between the Bank and the commercial banks and to analyse and select queries and complaints for submission to Exchange Control.23 The existing deputy chairman of the Exchange Committee, A.W.Gurney (who also sat on the Bank’s steering committee) assumed this full time position, and he remained in this role until 1943, when he was succeeded by F.C.Ellerton of Barclays Bank. Using the Foreign Exchange Committee as a communications channel between the Bank and the market did not please everyone. The authorised banks, in particular, believed that—compared with other financial institutions—they deserved to receive not only more information, but also better treatment, from the Bank, in recognition of their frontline involvement in enforcing exchange controls. The banks had authority to approve run-of-the-mill visible trade transactions, although anything more complicated had to be referred to the Bank. The chairmen of the clearing banks always had easy access to the Governor, or Deputy Governor, but those lower down the ladder felt that they should

War and peace 1939–51

81

have greater direct contact with the Bank. This matter was not fully resolved until midway through the war, when the Bank decided that, ‘Where we have occasion to address communications to the Authorized Dealers we will do so direct, but where we wish to make communication to the market in general, we will do so through the Foreign Exchange Committee’.24 Exchange control regulations The legal basis for the exchange control regulations issued during the war was provided by the Emergency Powers (Defence) Act 1939.25 As it turned out, the first in a long line of Defence (Finance) Regulations to be issued under this Act was actually announced a few days before the start of the conflict. On 25 August 1939, or on the same day as the EEA withdrew its support for sterling on the exchange markets, a regulation was passed providing for the future requisitioning of specified foreign securities and calling for the immediate registration of securities, ‘…the principal, interest or dividend of which was payable in the currencies of Argentina, Belgium, Canada, France, Holland and the Dutch East Indies, Norway, Sweden, Switzerland and the United States’.26 The importance of the currencies mentioned in this initial regulation became only too apparent on 4 September, when a regulation was issued requiring UK residents to sell their existing holdings and future receipts of these designated currencies, as well as their holdings of gold bullion and coin, to the Treasury. Other measures introduced during the first few days of the war: • Required residents to conduct all of their foreign currency transactions through authorised dealers (who were appointed by the Bank of England, on behalf of the Treasury). • Made the Bank of England the sole market maker in the designated currencies. • Imposed restrictions on the purchase, sale and lending of foreign currencies by UK residents. • Required residents to obtain exchange control approval before purchasing foreign currency. • Defined an area, later to be known as the sterling area, within which transactions could be conducted freely, but across which they were subject to control. This area initially consisted of the British Commonwealth countries, other than Canada, Newfoundland and Hong Kong. Countries belonging to this arrangement had to maintain the same sort of outward exchange controls as the United Kingdom so as to prevent transfers arising from intra-area transactions on current and capital account from leaking into outside financial markets. Early exchange control policy was influenced by three guiding principles. The first was that there should be no control over non-resident holdings of sterling, since the authorities were keen not to jeopardise London’s leading position as an international financial centre. The second was that approval to acquire foreign currency generally should be given for current account transactions. The third was that capital outflows should be tightly controlled and largely banned.

The foreign exchange market of London

82

The noble aim of preserving the City’s international reputation soon had to give way to the more mundane objective of securing foreign currency to pay for vital war supplies. A key weakness of the initial exchange controls was that they failed to fully capture the foreign currency proceeds of British exports. Such exports were mostly invoiced in sterling and, between September 1939 and July 1940, importers were able to obtain, at bargain basement rates, the sterling they needed to pay for British goods on the ‘free’ exchange markets in New York and Zurich. Non-residents seeking to withdraw their balances from the United Kingdom, only were able to do so by selling sterling abroad, and heavy sales by them invariably caused the free sterling rate to trade well below its official rate in London (something which was not overlooked by the German propaganda machine).27 Indeed, at one stage in May 1940, the free market rate for US dollar/sterling in New York was standing at a hefty discount of 20 per cent to the official rate of $4.03.28 The authorities—who had come under attack in the financial press for their pusillanimity in dealing with this issue—eventually began to tighten the controls. However, their initial response did little to assuage the critics. On 8 March 1940, the Treasury announced that henceforth exports of whisky, furs, jute, jute manufactures, tin and rubber (all of which were good earners of hard currency for the sterling bloc) to the United States, most South American countries, Switzerland, the Belgian Empire and the Dutch Empire would have to be paid for in the relevant foreign currency or with sterling bought from the Bank of England at the official rate.29 This step soon was assailed by The Banker, which observed, ‘…the recent measures covered a mere fraction of British exports instead of covering all of them’, and that ‘…at the same time as reducing the demand for sterling, the Government ought to have taken steps, as a matter of elementary common-sense, to reduce also the supply by stopping some of the innumerable loopholes in the exchange restrictions’.30 Stung by continued criticism and by a further slide in the free US dollar/sterling exchange rate (which increased the incentive for importers of British goods to buy the sterling they required in New York, rather than in London, thereby diminishing the inflow of hard currency into the British reserves), the Treasury eventually took decisive action during the summer of 1940. In June, it extended the 8 March measures to cover all sterling area exports to all countries. And in the following month it negotiated bilateral payments arrangements with the United States and Switzerland, which—following the occupation of Belgium and the Netherlands—were left as the only neutral countries with hard, or fully convertible, currencies. These arrangements involved channelling commercial and financial transactions between Britain and these countries through Registered Accounts opened in the names of either US or Swiss banks. In the case of the United States, for instance, all authorised payments between that country and the sterling area had to be made either in US dollars, or in sterling from a Registered Account maintained with a bank in the United Kingdom. Payments of sterling by UK residents into such an account were, ‘…subject to the same conditions as were in force regarding applications for foreign exchange. In this way, operations on the accounts were confined to approved current transactions, and capital transactions were practically eliminated’.31 The effect of this measure was to canalise future payments flows between the sterling

War and peace 1939–51

83

area and the United States through the official exchange market, thereby stemming the flow of sterling entering the free market in New York. Registered Accounts were announced on 17 July 1940, and the efficacy of this step can be gauged by the fact that by the middle of the following month the free sterling rate was being quoted at par with the official rate. The recovery in the free US dollar/sterling rate, however, had started some time before the introduction of Registered Accounts. From a low of $3.19 in late May, or just after the capitulation of the Low Countries, this rate had strengthened to around $3.75 by the middle of June. The earlier weakness in this rate had stemmed from sales of non-resident owned sterling on the free markets in New York, Zurich, Lisbon and elsewhere. Its recovery to $3.75 owed much to the Treasury’s decision to block one of the channels feeding the supply of sterling onto the free market. On 13 May, the Treasury shattered the myth that it was business as usual in the City, when it required non-residents to obtain a licence before selling a sterling security. And from 23 May, ‘these licenses were given only if the sale was made on a UK stock exchange and the proceeds reinvested in a sterling security of the same category as the one sold…’.32 It was becoming clear that full sterling convertibility was a luxury that Britain no longer could afford in wartime. Indeed, further steps to restrict the rights of non-resident sterling holders were to be taken over the next six months. This applied even to the owners of Registered Accounts. While holders of Registered sterling were allowed to convert it either into US dollars (in the case of US Registered Accounts), or into Swiss francs (in the case of Swiss Registered Accounts), they were not allowed to convert it into any other foreign currency, or to transfer it to any other type of foreign owned sterling account. Around the time that the Registered Account scheme was launched, the Treasury extended and deepened a similar scheme it had initiated the previous year. Towards the end of 1939, the Treasury had negotiated bilateral payment arrangements with Argentina and Sweden, both of which were categorised as soft currency neutral countries. In common with the deals struck with the United States and Switzerland, these earlier arrangements had involved canalising payments between the sterling area and the neutral country concerned through accounts, called Special Accounts, maintained with British banks. Special Account arrangements, however, possessed two distinguishing characteristics. First, the signatories agreed to conduct their current transactions with the sterling area exclusively in sterling, with any conversions that might be required between their own currency and sterling taking place at a fixed rate agreed with the British authorities. Second, the signatories gener-ally agreed to retain any surplus in their Special Accounts in sterling. Registered Account holders, in contrast, had the right to convert any surplus back into their own currency. During the course of 1940, new Special Account arrangements were signed with a number of countries, including Romania, Brazil and Portugal; whereas, in 1941, a comparable type of payments arrangement, also involving the use of restricted sterling accounts, was negotiated with twelve Central American countries. Apart from implementing these various payments arrangements, the authorities took two further steps to plug the holes in the exchange control barriers. The first was to

The foreign exchange market of London

84

impose restrictions on any outstanding sterling balances held by non-residents, prior to the introduction of the above arrangements. Such balances were swept into Old Sterling Accounts, which were opened on a country-by-country basis. No new payments of sterling could be credited to these accounts, and the existing balances could be disposed of only through sales to a national of the same country as the holder (such transactions sustained, albeit at a minimal level, trading in sterling on the free market), or through the settlement both of old sterling debts and of certain invisible payments to the sterling area. The second additional step was taken in November 1940, and involved the diversion of certain non-resident funds, arising from legacies, real estate sales and corporate divestitures, into Blocked Sterling Accounts, the monies from which could only be invested in British government securities. By the second half of 1940, the exigencies of war had overcome any desire the government previously might have had to protect sterling’s international role and reputation. As The Banker poignantly observed in August 1940, ‘…the authorities have now realised that the best way of safeguarding London’s position as an international financial centre is to win the war…’.33

War demoralises the London market The harsher exchange control regulations introduced during 1940 not only dehydrated overseas markets in free sterling, but they also exerted further downward pressure on turnover on the London foreign exchange market. Activity in London already had been badly hit by the virtual cessation of capital flows, resulting from the introduction of the initial exchange controls, and by the diminution in British exports resulting from the diversion of domestic output to the war effort. However, the introduction of Special Accounts, as distinct from Registered Accounts, exacerbated this downtrend by converting a significant chunk of Britain’s dwindling overseas trade onto a sterling-only basis. The volume of foreign exchange business in London dwindled still further after the introduction of Lend-Lease, because this arrangement not only resulted in the bulk of Britain’s imports from the United States being put on the slate, but also served indirectly to further weaken British exports. It did so in two ways. On the one hand, the ‘free’ supply of imports from the United States reduced the need to export, and allowed the government—which had introduced an export licence system in 1940—to accelerate the diversion of resources from exports to munitions production. On the other hand, it was a condition of Lend-Lease that none of the materials so received could be used in the production of British exports.34 By 1943, in response to these negative influences, British exports (f.o.b.) had contracted to only £240 million, compared with £564 million in 1938, or the last full year of peacetime. Exchange control regulations segmented foreign exchange trading in London into three sectors, each containing a distinctive group of currencies. The first contained the designated currencies (which, a few weeks into the war, were to be officially reclassified as the ‘specified’ currencies); the second contained the non-specified foreign currencies and the third contained the sterling area currencies. Under the devolved exchange control

War and peace 1939–51

85

system adopted by the authorities, the banks were given a front line role in monitoring and sanctioning basic exchange transactions. In keeping with this approach, the right to serve as an intermediary in supplying and receiving the specified foreign currencies, and/or to act as a principal in transacting the other foreign and Commonwealth currencies, was limited to those banks approved as authorised dealers by the Bank of England. At the outbreak of war, the Bank issued three lists of authorised dealers, giving the names of those banks appointed (A) to deal in all foreign, colonial and Dominion currencies, (B) to deal in certain colonial and Dominion currencies, (C) to deal in certain foreign currencies.35 The first of these lists was the most important, because it described the banks that were entitled to deal in, or perhaps more accurately to distribute, all of the specified currencies.36 The initial A list contained the names of the Bank of England, and of 24 UK commercial banks, including the ‘Big Five’ clearing banks. In fact, to be more accurate, the list contained the names of 19 commercial banks, plus an addendum with the names of five other institutions. Those belatedly added to this list were the five main northern Irish banks (Belfast Banking Co Ltd; National Bank Ltd; Northern Bank Ltd; Provincial Bank of Ireland Ltd and Ulster Bank Ltd).37 These banks also did business south of the border and it was only after eleventh hour negotiations with the Eire government, on the exchange control arrangements to be put in place in southern Ireland, that the British authorities became confident that granting the northern banks authorised status would not create a loophole in British exchange controls. Not enfranchising the Irish banks (even the Bank of Ireland’s northern branches were added to the A list late in 1939, and two other southern based Irish banks were admitted in May 1940) would have proved administratively inconvenient later in the war, given that Belfast was to become an important staging post for dollar laden GIs arriving in Europe. The decision to limit the A list just to English, Scottish and Irish commercial banks was taken largely for practical reasons. According to The Economist, the joint stock banks had been selected, ‘…for administrative convenience, since their enormous network of branches covering the whole country obvi-ously will be of great assistance in working a system of control which necessarily involves a great deal of attention to detail’.38 The specified currencies accounted for the bulk of transactions on the London market and the commercial banks certainly were better placed, by virtue of their extensive branch networks and sizeable workforces, to handle this high volume business, on behalf of the Bank, than were say the British merchant banks. UK owned banks were preferred to handle the specified currencies, because the authorities would have had no reason to question either their commitment, or their loyalty, to the British war effort (apart from the commercial banks, certain British overseas banks subsequently were given authorisation to deal in one or other of the specified currencies). Considerations such as these made the Bank reluctant to allow the branches of banks with their headquarters in other jurisdictions to deal in the specified currencies, and only a few exceptions were made to this rule. As noted above, banks from Eire were admitted to the A list during 1951–52, They were the only non-UK banks allowed to deal in all foreign currencies, including the specified currencies. Other outsiders allowed to deal in the specified currencies generally

The foreign exchange market of London

86

were authorised only to transact in the currency of their own home country. From the outset, the branches of five Canadian banks (Bank of Montreal, Bank of Nova Scotia, Canadian Bank of Commerce, Dominion Bank and the Royal Bank of Canada) were authorised to deal in the Canadian dollar. In 1940, Banque du Congo Belge was authorised to deal in the Belgian Congo franc. US banks, however, had to wait until well into the war before they were given dispensation to deal in the most important of the specified currencies. It was not until 23 October 1943, that F.E.183 was issued granting the right to the London branches of six US banks (Bank of America National Trust and Savings Association, Bankers Trust Company, Central Hanover Bank & Trust Company, Chase National Bank of New York, Guaranty Trust Company of New York and the National City Bank of New York) to deal in the US dollar. Banks as commission traders The British merchant banks might have been miffed at not being appointed as authorised dealers, but it is doubtful that their profits were much affected by their exclusion from the A list. Throughout the war, the Bank of England was the sole trader in the specified currencies, and the only way banks were able to make any money from dealing in these currencies was by levying a commission charge on their customers. A regulation issued by the Bank of England on 5 September 1939 stated: All bankers should obtain their remuneration on their transactions with their customers by a uniform scale of commission to be agreed between the banks. An authorised bank who deals with a bank not so authorised will make no charge to the non-authorised bank.39 It was subsequently agreed that this commission should be levied at a rate of per cent with a 1s/-minimum. When the initial exchange control regulations were published, the public were asked,‘…to deal direct with their usual bankers, who will pass on the offers, if necessary, to the right quarter’.40 Given that the merchant banks, as well as other non-authorised banks, were able to obtain commission-free foreign exchange from the authorised banks, and were entitled to impose the same commission rate as the latter (of per cent) on transactions with their customers, it does not seem that they were put at much of a commercial disadvantage. Indeed, there were only two things that gave them any cause for complaint. The first was that the authorised dealers benefited from a commission of per cent paid by the Treasury each time they dealt in a specified currency with a non-authorised bank. The second was that authorised dealers were able to present themselves abroad as the most direct port of call for foreigners wishing to transact in the specified currencies on the London market. Neither of these factors, however, greatly disadvantaged the nonauthorised banks, because much of the per cent commission received by the authorised dealers was gobbled up by exchange control expenses incurred on behalf of the nonauthorised banks, and because the bulk of transactions, by nonresidents, in the specified

War and peace 1939–51

87

currencies was conducted, at least during the first twelve months of the war, on free markets abroad. Patriotism did little to stop the public from venting its anger at certain aspects of the wartime foreign exchange dealing arrangements. The per cent commission levied on transactions in the specified currencies was a particular source of acrimony. During the early days of the war, compulsory sales of these currencies to the Treasury dominated activity on the London market. Many individuals, however, were aggrieved that they should have to pay the banks a commission for the privilege of complying with the Treasury’s requisition order. Complaints were levelled at the banks, and the fear of possible legal action soon gave rise to serious concern not only in banking parlours, but also in the corridors of power. In a letter to Basil Catterns, the Deputy Governor, A.W.Gurney of the Foreign Exchange Committee observed, ‘One argument put forward is that the banks are agents of the Treasury and as such should receive their remuneration from the Treasury and not from the public, and it is impossible to refute this’.41 The authorities, however, refused to give any ground, even though they too harboured doubts about the legitimacy of the arrangement. On 11 October 1939, Catterns wrote to Ernest Rowe-Dutton at the Treasury: The charging of commission by the Banks on requisitioned holdings is a thorny subject—personally, I am inclined to agree with you it would have been better had we undertaken to remunerate the Bankers directly ourselves—but I think it would be most unfortunate to go back on our decision.42 The decision did stand and, despite further criticism from their customers, the banks continued to charge commission on both purchases and sales of the specified currencies throughout the war, and for some time thereafter. Treasury scoops foreign exchange profits Exchange control regulations concentrated the country’s holdings of the specified currencies in the hands of the Treasury. The Bank of England, acting on behalf of the Treasury, was given the sole right to trade in the specified currencies, and UK residents seeking to transact in them had to do so via authorised dealers. Working balances in these currencies were placed by the Bank of England with the authorised dealers who, in turn, were allowed to transfer these funds, which remained owned by the Control, to their overseas correspondents in order to clear day-to-day dealings. Indeed, as agents of the Control, the authorised dealers served as little more than conveyor belts moving the specified currencies between the public and the Treasury’s coffers at the Bank of England. Fixed central rates were set for these currencies, and fixed (but adjustable) buying and selling rates were set around these central rates. All of these rates had to be sanctioned by the Treasury. The spread between the Bank’s buying and selling rates generated substantial trading profits, and these were paid straight over to the ultimate owner of the

The foreign exchange market of London

88

specified currencies—the Treasury. Extremely wide dealing spreads were set initially for the specified currencies. In the case of the US dollar/sterling rate, the Bank announced—when the market re-opened on 5 September 1939—that its buying rate for dollars would be $4.06, and that its selling rate would be $4.02. This spread of 4 US cents, or 400 points, compared with a normal peacetime inter-bank spread of 13 points, or less. Business on the London foreign exchange market was largely one-way during the first few days of the war, as UK residents surrendered their holdings of the specified currencies to the authorities. The Treasury was keen to keep the cost of requisitioning these currencies to a minimum, and this explains why it instructed the Bank to set its buying rate further away, than its selling rate, from the relevant central rate (of $4.03 in the case of the US dollar). The big rush to sell the requisitioned currencies to the Treasury was over by the middle of September and, on 14 September, the Bank announced a narrowing in its dealing spreads. From that date, the US dollar/sterling rate was quoted at $4.02−$4.04. The Treasury, however, won no applause for acceding to this limited act of largesse. Even at 2 cents the Bank’s dealing spread was abnormally wide and it imposed a hidden tax, ‘…on traders in the export and import markets and fell with a particular severity on firms with a large foreign exchange turnover’.43 The dealing profits made by the Bank of England were a ‘nice little earner’ for the Treasury who had good reason to protect this source of income. According to Sir Richard Hopkins of the Treasury: We have to meet very considerable expenditure incurred not only by the Bank itself, but also by the Government Departments, including, particularly, the Customs, in running Exchange Control, and I feel it is not improper to look upon revenue derived from the spread as counter balancing this expenditure.44 Parenthetically, it is worth noting the reference to the Customs in the above letter, because it draws attention to the key wartime role played by that department in safeguarding the nation’s foreign exchange resources. Import licensing was introduced in September 1939 (export licensing followed in March 1940), and it fell to the Customs to check that goods flowing through the port had the appropriate licence. Indeed, in terms of visible trade, ‘…exchange control was subsidiary to physical control’.45 During the first two months of the war the Bank’s dealing spreads generated £500,000 for the Treasury.46 This proved to be more than enough to cover not only the expenses of running exchange control, but also of paying the per cent commission to authorised dealers, to remunerate them for dealing in the specified currencies with non-authorised banks. The Treasury showed little embarrassment at receiving this excess income and initially resisted pressure, from the Bank, for a recalibration in its dealing spreads. However, by the end of December, it was persuaded to change its mind as the cumulative profits yielded by these spreads climbed to £1,000,000.47 The Treasury had incurred significant start-up costs in establishing exchange control and the recognition that the expenses of running the Control would not remain so high in the future contributed to the softening in its stance. On 8 January 1940, it sanctioned the publication of new Bank of England dealing rates. In the case of the pivotal US dollar/sterling rate,

War and peace 1939–51

89

the dealing band was narrowed from $4.02−$4.04, to . This 100 points dealing spread was to remain in force until 1947. Spot transactions accounted for the bulk of the dealings undertaken in the specified currencies. The establishment of rigidly fixed exchange rates for these currencies diminished both the need and the demand for forward cover. The Bank, however, was still prepared to provide forward quotes. According to Harry Siepmann, ‘Throughout the war it has been our practice to deal in forward specified currencies at rates very close to the “spot” quotations and, in the case of our “forward” purchases most of our rates have been the same as for “spot” delivery’.48 The Bank clearly had absolute faith in the central rates established for the specified currencies. The only sector of the London foreign exchange to function almost normally during the Second World War was the one trading the sterling area currencies. Open market interbank trading was maintained in these currencies for both spot and forward delivery. Trading between two sterling area currencies was not restricted by exchange controls, but this freedom did not provide dealers with much of a bonanza, because the extremely low volatility in sterling area exchange rates limited the scope for banks to make big profits from trading these currencies, and because much of British trade with this area was conducted in sterling. While this sector was little affected by the imposition of wartime rules and regulations, it was forced to accept one important administrative change. Banks dealing in the sterling area currencies had to be authorised by the Bank of England. This move provided the authorities with the machinery for checking the flow of funds from Britain to the rest of the sterling area, and so the means for detecting any flows seeking to exploit chinks in the outward controls imposed by the other member countries of this area. Virtually all of the banks that had engaged in this line of activity before the war were included on the B list of authorised banks. However, unlike the A list banks, which were authorised to deal in all currencies, those on the B list were given only limited freedom. Each B list bank was given authorisation to deal only in certain of the colonial and Dominion currencies. For instance, approval was given to the Netherlands Bank of South Africa only in respect of the South African pound, and to the Bank of Adelaide in respect of the Australian pound and currencies of Mandated Territories. In contrast, Barclays Bank (D.C. & O.) was granted a wider remit covering the South African pound, the Palestine pound and the currencies of those colonies in which it had branches carrying on a banking business. Limited authorisation also was given to London based banks and branches to deal in certain foreign currencies. Ten currencies, or groups of currencies, were originally noted on the C list. These included the Chinese dollar, the escudo and Portuguese Empire currencies, the Greek drachma, the Romanian leu, the Central and South American currencies and the Japanese yen. Additions and deletions were made during the course of the war. For instance, the Italian lira was added in late 1939 (when the London offices of Italian banks were authorised to deal in this currency), but was removed in June 1940 when Italy became an enemy country, and the Japanese yen was removed in December 1941 when Japan declared war on Britain. A key addition was the US dollar, which was included in October 1943, when six US owned banks were authorised to deal in this currency in London.

The foreign exchange market of London

90

In the same way as banks on the B list, many of those on the C list were authorised to deal only in one currency. Thus, the Imperial Bank of Iran was restricted to dealing in the Iranian rial, and the National Bank of Egypt was limited to the Egyptian pound. Some, however, were given greater leeway. For instance, the Bank of London and South America was allowed to deal in all Central and South American currencies, whereas the Ottoman Bank—which had other rights resulting from its inclusion on the B list—was authorised to deal in the Turkish pound, the Greek drachma, the Egyptian pound and the Iranian rial. Certain banks on the C list were given authorisation to deal in one or more of the specified currencies (the currencies in question—not all of which were given this classification at the start of the war—were those of Argentina, Belgian Congo, Portugal, Netherlands East Indies, Panama, Philippines and the United States).49 Banks so authorised, as already has been mentioned, served as little more than agents of the Bank of England. This did not apply to banks authorised to deal in one or more of the nonspecified foreign currencies. Inter-bank trading was allowed between these currencies and sterling, and banks operating in this sector sought to earn a crust by spread trading, by running an open position and, in some instances, by charging their customers a commission. However, trading in these currencies was inhibited by exchange controls imposed in Britain and abroad. These controls not only curbed capital flows, but also prevented much, if any, forward trading in these currencies. Approved current account transactions did generate moderate turnover in these currencies during the first year of the war, but the negotiation of Special Account arrangements subsequently reduced this to a minimal level, by putting much of Britain’s overseas trade onto a sterling-only basis. The rigours of peace The war in Europe ended in May 1945, but there was to be no peace dividend for the London foreign exchange market. It was to remain shackled by restrictive rules and practices for much of the early post-war period. Exchange controls that had been imposed to prosecute the war were now retained to defend the battered peacetime economy. Britain had emerged from the war in an impoverished state. The rundown of its export industries had contributed to a severe deterioration in its current account deficit (which totalled £870 million in 1945, compared with only £55 million in 1938), whereas heavy purchases of supplies both from the rest of the sterling area and from the Special Account countries had sponsored a massive build-up in external sterling liabilities, which had risen to £3.6 billion by the end of 1945. Against this, Britain’s official holdings of gold and convertible currencies were equal to only £610 million at the end of 1945. Through British eyes, the parlous state of the nation’s external finances provided ample justification for maintaining the wartime panoply of controls. Indeed, even before the conclusion of hostilities, the Treasury had begun to extend and renew the network of bilateral payments and monetary agreements that had been started in 1939, thereby reinforcing sterling’s status as a largely inconvertible currency. In October 1944, the Treasury negotiated a monetary agreement with the recently

War and peace 1939–51

91

reinstated Belgian government. This agreement, which set the pattern for comparable arrangements negotiated with other newly liberated European countries, called for (a) the establishment of a fixed exchange rate between the Belgian franc and sterling, (b) the Bank of England to hold the equivalent of £5 million in Belgian francs as a working balance, and (c) the National Bank of Belgium to hold up to £5 million plus the outstanding sterling holdings of the Belgian monetary area at the date of the agreement.50 Any holdings above these levels were to be settled in gold. The operation of the Belgian arrangement, and of similar ones to follow, was slightly less restrictive than the sterling payments arrangements that either were inaugurated or renewed with ‘soft’ currency countries after 1945. These sterling arrangements were the successors of the wartime Special Account arrangements, since they placed all transactions with the country concerned on a sterling basis, and provided for the foreign signatory to accumulate net sterling balances. There was no provision for automatic transferability to other countries or for convertibility into US dollars. Following the Second World War, as the US dollar became the most favoured means of international exchange, the ‘hardness’ of other currencies was judged by the ease with which they could be converted into the former. Sterling scored poorly on this count. The funds canalised through the post-war monetary and payments agreements, which covered a substantial part of British trade, were not eligible for conversion into dollars (although in the case of the monetary agreements, there was at least an element of ultimate convertibility through the gold settlement). However, approved current account transactions with the United States could be paid in dollars—or from sterling credited to US Registered Accounts. And a small step towards a more liberal and multilateral approach was taken in July 1945, when US Registered Accounts and Central American Accounts (the latter had been introduced in 1941 in respect of twelve countries in Central and South America) were grouped together as American Accounts.51 Following this move, sterling could be transferred freely between the accounts belonging to the countries included in this grouping. The low level of sterling convertibility diminished the allure of London as a centre for foreign currency dealings and, during the early post-war years, the main focus of attention was centred on the free markets of New York, Zurich and Tangier. Britain, however, came under strong international pressure to forsake its dependence on bilateralism and to introduce sterling convertibility, at least for current account transactions. Britain had been one of the original signatories of the 22 July 1944 Bretton Woods Agreement that set out the road map for the post-war international monetary system. Apart from authorising the creation of the International Monetary Fund, this Agreement also called for the establishment of a regime of fixed but adjustable parities, and for the achievement of current account convertibility after a transition period of up to five years, timed to start from the launch of the IMF (which actually took place on 1 March 1947). Earlier and stronger pressure for convertibility came from another quarter. The LendLease lifeline upon which Britain had become so dependent was abruptly severed following the installation of Harry S.Truman in the White House in May 1945. This placed Britain in dire economic straits, because the neglect of its export industries during the war meant that it did not have the means of producing the exports that were now

The foreign exchange market of London

92

needed to cover its imports of essential supplies. In the end, it was obliged to go cap in hand to the United States. Following lengthy negotiations, a sizeable $3,750 million loan was secured in December, which became available on 15 July 1946, after the completion of US legal niceties.52 This loan came with a number of strings attached, including one that required sterling to be made convertible within a year of its commencement.53 The United States was a vociferous cheerleader for convertibility, because it believed that a multilateral payments system not only would serve its own best interests, but also those of the world economy. Beggars cannot be choosers and Britain was obliged to comply with the conditions set by the United States, even though its war-weakened economy was in no fit state to accept the rigours of convertibility. In order to fulfil its commitment to the United States, the Treasury introduced a number of changes to Britain’s exchange control regulations during 1946–47. The most important of these changes was made in February 1947, when: …a Transferable Account Area was established, confined to countries which were prepared to ensure that third country transfers through accounts of their residents were made only for current payments. By July 1947, seventeen countries had been included in this area, and nineteen (including the Central American countries) in an American Account Area. Sterling could be freely transferred for current transactions between these thirty-six countries and to— but not from—the sterling area.34 The countries belonging to the Transferable Account area included Argentina, the Belgian monetary area, Canada, the Netherlands monetary area, Italy and the Portuguese and Spanish monetary areas. The concessions made by the Treasury were deemed to satisfy the convertibility clause in the US loan agreement, even though they did not make sterling fully transferable on a worldwide basis. Britain was forced into convertibility of non-resident owned balances for current account purposes, at a time when only the United States had the productive capacity to supply the goods that were needed to rebuild the war-ravaged economies of Western Europe. In consequence, the countries in the Transferable Account area wasted little time in converting their eligible sterling balances into dollars to pay for imports from the United States. Their actions imposed an unbearable strain on Britain’s gold and convertible currency reserves, and on 20 August 1947, the government—which had spent all but $400 million of the $3,750 million US loan—was compelled to announce the suspension of sterling’s external convertibility.55 From that date, Transferable Account countries no longer were entitled to use sterling to make payments to American Account countries. While sterling remained convertible for current transactions within the Transferable Account area, concern that this might lead to an unwanted build-up in the sterling holdings of certain countries led to a number of departures from the area, with those leaving (such as Canada, Portugal and Italy) subsequently entering into new bilateral arrangements with Britain.

War and peace 1939–51

93

Liberalisation of currency dealings Currency traders received an unexpected bonus from the ill-fated rush to make sterling convertible. Recognition that such a move would sponsor a rise in the volume of sterling traded on the global currency markets encouraged official moves to improve the competitiveness of the London market. The wide dealing spreads maintained by the Bank of England in the specified currencies deterred non-residents from trading in London. The biggest deterrent was presented by the 1 cent dealing spread quoted by the Bank on the US dollar/sterling rate.56 While action was taken to address this problem at the beginning of 1947, an even earlier step had been taken by the authorities to relax the shackles that had been imposed on the market during wartime. In July 1945, the Bank announced a sizeable expansion in the number of banks authorised to deal in all foreign currencies, including the specified currencies. The A list was expanded to cover 78 names, and all the principal British banks, including the merchant banks, as well as those Dominion and Colonial banks with offices in London were granted full authorisation. In addition, more foreign banks were added to the C list, and were granted the right to deal in London in the currency of their own home country. Banks authorised to deal in the specified currencies continued to serve, at this time, as commission agents on behalf of the Treasury, but their position was to change on 13 January 1947 with the introduction of measures that liberalised dealings on the London market. During early deliberations on this move, the Bank’s Deputy Chief Cashier, Frank Hawker, had written to Siepmann: UK banks are already allowed to sell dollars against American sterling at and to buy dollars at against credit of sterling to an American Account. Until we are in a position to allow UK banks to deal in between the official rates, the bulk of the business will go to New York.57 Steps to treat this problem were included in the package of measures adopted by the authorities in early January. The key elements of this package comprised: • A narrowing in dealing spreads on the specified currencies. • The right of authorised banks to marry up their transactions, both spot and forward, in the specified currencies during each working day, and to settle only their net position at the end of the day with the Bank of England. • The withdrawal by the Bank of England of the working balances it had previously maintained with the authorised banks. • The scrapping of the per cent commission previously paid by the Treasury to authorised dealers for handling the specified currency requirements of non-authorised dealers.58 While these measures fell a long way short of restoring to the London foreign exchange market the freedom it had enjoyed in pre-war years, they at least marked an important

The foreign exchange market of London

94

first step towards creating more normal trading conditions. For the first time since 2 September 1939, banks were given (limited) powers to act as principals when trading the leading international currencies. Inter-bank trading was not permitted, but the banks were allowed to pocket the dealing profits they made by marrying up their own customers’ transactions during the course of the working day. Authorised dealers would have been on to a really good thing had they been able to pocket the wide dealing spreads previously enforced by the Bank of England. However, a narrowing of these spreads formed an integral part of the liberalisation process. In the case of some of the specified currencies (such as the Swiss franc, Dutch guilder and Belgian franc) official spreads were already at a near normal level and so only token changes were made. The biggest changes were made in the buying and selling rates for the Canadian dollar (which were recalibrated from C$4.02–$4.04 to and for the US dollar (which were recalibrated from

) ) to

Prior to the announcement of the new cent dealing spread for the US dollar, Harry Siepmann wrote to Ernest Rowe-Dutton at the Treasury that this concession, ‘…would go some way, although admittedly not all the way, to reversing the attraction of non-resident business from London to New York’.59 The 13 January measures attracted praise in the press, but received only lukewarm applause from the banks. Many felt that their intra-day dealings in the specified currencies would not provide sufficient profit to compensate for the loss of the per cent commission, for the withdrawal of the Bank of England deposits, and for the revised commission charges they were obliged to introduce on customer trades in the specified currencies. Ever since the outbreak of war a flat per cent commission had been charged on such trades. However, the authorities believed that once banks were allowed to make a turn in trading in the specified currencies it was no longer appropriate for them to be compensated for handling the currency requirements of non-authorised dealers, or to be allowed to mulct their bigger customers with a flat Accordingly, on 13 January: Instead of a general charge of

per cent commission charge.

per cent a graduated scale of commission came

into operation—under which per cent is charged on the first £20,000, per cent between £20,000 and £100,000 and per cent on all amounts in excess of £100,000.60 In order to profit from the new dealing arrangements, banks needed a critical mass of multinational customers who could be depended on to do a good two-way business in foreign exchange, and who also could be relied upon to provide foreign currency deposits to substitute for those withdrawn by the Bank of England (certain multinationals, such as the oil companies, were granted exchange control permission to hold working balances in the specified currencies). The big clearing banks attracted such customers, but many of the smaller British banks were not so fortunate, and they gained less from the new arrangements, because their modest foreign exchange trading flows gave them only limited scope to marry-up customer transactions during the day, and because their

War and peace 1939–51

95

inability to attract sizeable foreign currency deposits from their customers obliged them to ‘borrow’ their working balances from the Bank of England via a foreign currency swap with an attendant sterling cost. Banks that felt cheated by the liberalisation measures pleaded with the Bank of England to lengthen the period for marrying-up transactions from one day to a week, so as to give them more time to attract offsetting customer purchases or sales of the specified currencies. This plea fell on deaf ears, but a different step affecting the London foreign exchange market was to be taken later in 1947. On 1 October, the wartime exchange control regulations were placed on a peace footing with the passage of the 1947 Exchange Control Act onto the statute book (the ubiquitous F.E. notices were now to be replaced by the equally voluminous E.C. notices). The regulations were kept largely unchanged, although an important operational change was introduced and announced in the first general E.C. notice to be issued under the new Act. The old A, B and C lists of authorised dealers were scrapped, and were replaced by a single list containing the names of 111 banks (a reduction on the 140 or so institutions that had participated in the London market before the war) (see Table 5.1). The British, Commonwealth and foreign banks included on this list were authorised to deal in all foreign currencies, and so this notice did away with the segmentation of foreign exchange dealers that had been in place in London since the outbreak of the Second World War. A normal foreign exchange market was slowly coming into view, although it would take a further four years before the Bank was willing to relinquish its role as the market maker in the specified currencies. Hopes that the 1947 liberalisation measures would attract non-resident foreign exchange business to the City were never very realistic given that, even after 13 January, the pivotal US dollar/sterling rate still was quoted with a wider spread in London than in New York. In addition, the level of activity on the London market also was adversely affected by another factor. This was the use of so-called cheap sterling to settle foreign purchases of goods and services from Britain and the rest of the sterling area (the members of which were designated as the Scheduled Territories under the 1947 Exchange Control Act).

Table 5.1 E.C.notice of authorised banks 1947

E.C. (GENERAL) 1. NOTICE TO BANKS AND BANKERS. EXCHANGE CONTROL ACT, 1947. This Notice is one of an administrative tenet issued by the Bank of England to draw attention in convenient form to the law contained in the Act and Treasury Orders made thereunder, and (by virtue of powers delegated by H.M.Treasury under Section 87 of the Act) to give certain exemptions, permissions, consents, authorities and directions (including directions imposing certain requirements on bankers and others under Section 84 of the Act). It should be construed accordingly. Reference in this Notice to the United Kingdom should be read to include the

The foreign exchange market of London

96

Isle of Man and the Channel Islands. AUTHORISED BANKS. 1. Offices in the United Kingdom of the banks listed in paragraph 2 have been appointed as Authorised Banks and may exercise the authority set out below, within the limits laid down from time to time in Notices issued by the Bank of England. Authorised Banks should refer to the Bank of England all applications which do not fall within the scope of their authority. i To act as Authorised Dealers in all foreign currencies. ii To approve applications on Forms E and Forms T.2 for the purchase of such currencies. iii To approve applications on Sterling Transfer Forms and Forms T.2 for the transfer of sterling to the account of a person resident in any country outside the Scheduled Territories. iv To approve applications on Forms E.2 in respect of credits. v To open Blocked Sterling Accounts. 2. The list of Authorised Banks is as follows: Afghan Bank of Montreal National Bank, Ltd. American Bank of New South Wales Express Company Inc. AngloBank of New Zealand Palestine Bank, Ltd. AngloBank of Nova Scotia Portuguese Colonial and Overseas Bank, Ltd. Bank of Scotland Banco de Bankers Trust Company Bilbao Bank of Banque Belge pour 1’Etranger Adelaide Bank of (Overseas), Ltd. America National Trust and Savings Banque de I’lndo-Chine Association Bank of Banque du Congo Belge Athens Bank of Banque Italo-Belge Australasia

War and peace 1939–51

97

Bank of Barclays Bank (Dominion, Colonial and Overseas) British West Africa Ltd. Bank of China, London Agency Bank of India Barclays Bank Ltd. Ltd. Bank of Baring Brothers & Co., Ltd. Ireland Belfast Banking Co., Ltd. Bank of London and South America, Ltd. Blydenstein & Co., B.W. Brandt’s Sons & Co., Wm. Martins Bank Ltd. British and French Bank (for Mercantile Bank of India, Ltd. Commerce and Industry) Ltd. Midland Bank Ltd. British Linen Bank Montagu & Co., Samuel. British Mutual Bank, Ltd. Morgan Grenfell & Co., Ltd. Brown Shipley & Co. Moscow Narodny Bank, Ltd. Canadian Bank of Munster and Leinster Bank Ltd. Commerce Central Hanover Bank and National Bank Ltd. Trust Company Chartered Bank of India, National Bank of Australasia, Ltd. Australia and China Chase National Bank of the National Bank of Egypt City of New York Clydesdale Bank Ltd. National Bank of India, Ltd. Commercial Bank of National Bank of New Zealand, Ltd. Australia, Ltd. Commercial Bank of National Bank of Scotland, Ltd. Scotland, Ltd. Commercial Banking Co, of National City Bank of New York Sydney, Ltd. Commonwealth Bank of National Provincial Bank Ltd. Australia Comptoir National Netherlands Bank of South Africa d’Escompte de Paris Co-operative Wholesale North of Scotland Bank Ltd. Society Ltd., Bankers

The foreign exchange market of London Coutts & Co. Credit Foncier d’Algerie et de Tunisie Credit Lyonnais District Bank Ltd. Dominion Bank Eastern Bank, Ltd. English, Scottish and Australian Bank, Ltd, Erlangers Ltd, Gibbs & Sons, Antony Glyn, Mills & Co. Grindlays Bank, Ltd. Guaranty Trust Company of New York Guinness, Mahon & Co. Hambros Bank Ltd. Hibernian Bank, Ltd. Hoare & Co., C. Hongkong and Shanghai Banking Corporation Imperial Bank of India Imperial Bank of Iran Ionian Bank, Ltd. Isle of Man Bank Ltd. Japhet & Co., Ltd., S. Kleinwort, Sons & Co. Lazard Brothers & Co., Ltd. Lloyds and National Provincial Foreign Bank, Ltd. Lloyds Bank Ltd. BANK OF ENGLAND, 1st October, 1947.

98

Northern Bank Ltd. Ottoman Bank Prague Credit Bank Provincial Bank of Ireland, Ltd. Queensland National Bank, Ltd. Reserve Bank of India Rothschild & Sons, N.M. Royal Bank of Canada Royal Bank of Scotland Samuel & Co., Ltd., M. Shroder & Co., J.Henry Seligman Brothers Society Generale de Credit Industriel et Commercial Societe Generale pour favoriser le developpement du Commerce et de 1’Industrie en France Standard Bank of South Africa Ltd. Swiss Bank Corporation Ullmann & Co. Ulster Bank, Ltd. Union Bank of Australia, Ltd. Union Bank of Scotland, Ltd. Westminster Bank Ltd. Williams Deacon’s Bank, Ltd. Yorkshire Penny Bank, Ltd.

Following the suspension of convertibility in August 1947 many countries, especially those belonging to the Transferable Account Area, were piling up excess sterling balances arising from their current account transactions with the United Kingdom, which now could no longer be able to be used to buy goods from the United States. However, a number of clever wheezes soon were being employed to acquire US goods with Transferable, and also with Bilateral, sterling. The funds that were utilised in this way were given the moniker of cheap sterling. Commodity shunting was one of the routes that was used. This involved the use, say,

War and peace 1939–51

99

of Dutch Transferable sterling to buy Malayan rubber for delivery in Rotterdam, the reexport of the rubber to the United States, the swift unloading of the rubber at a discounted price in New York, and the simultaneous employment of the dollar proceeds to buy coveted US goods that could readily be sold at premium prices in Europe and elsewhere.61 Commodity shunting, apart from reducing the sterling area’s dollar receipts, also reduced the volume of trading between the US dollar and the sterling area currencies. However, another type of cheap sterling business did pass through the exchange markets, but the dubious channels used ensured that this business was undertaken not in London, but in free markets in New York and elsewhere. This sort of transaction involved the sale of, say, Transferable sterling for dollars, at a discount to the official rate, to a US resident with the seller using the proceeds to buy US goods to sell at premium prices in Europe. Another leg, however, had to be added to this transaction in order to circumvent UK exchange controls. US residents were not allowed to receive sterling from a Transferable Account, and so the sterling due to them was used directly either to buy goods from, or to settle payments to, sterling area residents. Cheap sterling had a big impact on the potential turnover on the official exchange markets. In the late 1940s, it was guessed that at least one third of US purchases of goods from the sterling area were being paid for with cheap sterling.62 Reducing the flow of sterling to the Transferable and Bilateral Account countries, by correcting Britain’s current account deficit, was judged by the authorities to be the most effective way of blocking this loophole in the exchange control regulations. Things started to go their way, during 1948, when the current account swung into surplus. However, this improvement proved to be only short-lived, and a sharp slowdown in the US economy in 1949, by weakening global economic activity, pushed the UK current account back into deficit. This deterioration reinforced a long held official view that sterling was overvalued, at least against the US dollar, and contributed to the decision to devalue sterling from $4.03 to $2.80 on 18 September 1949 (the Bank narrowed its dealing spread at the same time, by setting its selling rate at and its buying rate at This constituted a nominal devaluation of 30 per cent, but the competitive advantage gained by Britain was significantly eroded by a spate of copycat moves elsewhere in the world. Virtually all of the sterling area countries devalued in tandem with sterling, and so too did the Netherlands and the Scandinavian countries. France, West Germany, Belgium and Italy also devalued, but by a lesser amount. This chain reaction served to reduce sterling’s effective depreciation to less than 10 per cent. Exchange control regulations forbade UK residents from using forward exchange, except for hedging genuine commercial transactions. However, those eligible to take out forward cover in the specified currencies were able to do so at fixed standard rates set by the Bank of England. The Bank merely added a charge of 1 per cent p.a. to its spot dealing rates (applied both to purchases and sales), when meeting requests for forward exchange. This mode of operation came under critical review in the aftermath of the 1949 devaluation. Just over a year after this event, a Bank official exclaimed: This system takes no account of supply or demand or of the differential in interest rates between London and foreign centres. The result is that in times of

The foreign exchange market of London

100

stress when sterling or foreign currency is under pressure the E.E. Account takes the full risk without adjusting its forward quotations.63 The market was too tightly controlled in 1949 for the Bank to have taken much of a hit from the devaluation of sterling. However, this event underlined the risks the Bank was taking in making the forward market and, during 1950, Bolton came round to the view that forward trading should be returned to the open market.64 While the government was not yet willing to be so bold, the case for re-opening the market in the specified currencies, and not just for forward deals, was given an unexpected fillip towards the end of 1950 by a development on the other side of the Atlantic. On 30 September 1950, the Canadian government—which was struggling to curb speculative capital inflows and to combat an accelerating inflation rate—decided to float the Canadian dollar. This placed the Bank of England in a bit of a pickle. Continuing to make the market in this (floating) specified currency would expose it to the risk of potential trading losses. Neither the Bank nor the Treasury had any appetite for this risk and so after a few days of deliberation a free market was established in London for the Canadian dollar, although not for the other specified currencies, on 10 October 1950. The market was developed by a number of the authorised banks and by those brokerage firms (all three of them!) that still had active switchboards.65 The banks were: …allowed to claim a commission from their clients and to make a traing profit on their operations. They must report their positions monthly to the Bank of England, who will presumably keep a motherly eye on them, but they are not required to settle outstanding positions with the Bank.66 Within two weeks banks in London were quoting the Canadian dollar/sterling rate with a relatively fine cent dealing spread, which The Banker claimed was, ‘…an eloquent tribute to the survival of London’s pre-war expertise’.67 The successful re-opening of the London market in the Canadian dollar provided a compelling argument for freeing the whole of the market from its wartime shackles. The Bank anyway was keen to unlock these fetters, because it feared that its rigidly fixed dealing rates were presenting too much of a target for currency speculators. When the Bank took its case, in late 1951, to the newly elected Conservative government, it found itself knocking on an open door and plans were quickly put in place to re-open the London market by the end of the year.

6 Regaining lost ground 1951–72 On 17 December 1951, London based foreign exchange dealers regained the right to do something from which they had been barred for over twelve years. This was to make a market in the leading international currencies. For the first time since 2 September 1939, they were allowed to conduct interbank transactions and to run positions in key currencies, such as the US dollar and the Swiss franc. The re-opening of the market in the specified currencies marked an important step towards ridding the London foreign exchange market of its wartime shackles. However, there was still some way to go before it was able to trade with anything like the freedom of the pre-war days. During the 1950s, turnover in London was reduced by the inconvertibility of sterling, by Bank of England rules curbing banks’ arbitrage transactions within Europe, and by exchange control regulations that crimped the demand of UK residents for foreign exchange.1 Further deregulation, however, took place during the course of the decade with the biggest change coming on 27 December 1958, when sterling was made convertible on non-resident accounts (that is non-residents were given the unrestricted right to convert sterling into any foreign currency of their choosing). Despite the retention of domestic exchange controls, the conditions now were in place for London to challenge for its old position as the leading international currency centre. The resumption of convertibility in Western Europe was followed by a significant acceleration in activity on the global exchange markets. The demand for foreign exchange was boosted by rising world trade volumes, by increasing levels of foreign direct investment (especially by US multinational companies), and by the needs of operators in the newly formed and fast growing Eurocurrency market. Turnover also was stimulated by sporadic bouts of speculation against the IMF regime of fixed but adjustable parities. Speculation provoked a number of currency realignments during the 1960s and early 1970s. While a last ditch effort was made to shore-up the old regime with the Smithsonian agreement of December 1971, the decision to float sterling, in June 1972, opened a hole in the edifice of fixed exchange rates that many others soon were to climb through. A revitalised market Foreign exchange activity had not been entirely expunged in the City during, and immediately after, the Second World War. As noted in the previous chapter, a modest volume of trading had continued to take place both in the Commonwealth currencies, and in the minor foreign currencies, throughout the period between 1939 and 1951. Dealers also had been given limited rights to act as principals in trading the specified currencies from 13 January 1947 onwards. They had also been allowed to make a market in

The foreign exchange market of London

102

Canadian dollars since October 1950. The measures adopted on 17 December 1951, therefore, did not exactly resurrect foreign exchange trading in London. What they did do was to breathe new life into key activities that had been lying dormant since September 1939. In terms of the specified currencies, the measures provided for the: • Resumption of inter-bank trading within the London market. • Widening of spreads between official buying and selling rates. • Running of open positions by banks. • Resumption of arbitrage operations in US and Canadian dollars. • Cessation of official quotations for forward transactions.2 The freeing of forward transactions in the specified currencies arguably was the most important of these concessions, if only because it was the need to adopt this change that had persuaded the authorities to re-open the wider market in the specified currencies. Under arrangements that had been introduced during the war, the Bank had provided forward cover at a fixed cost of 1 per cent p.a. Following the devaluation of sterling in 1949, the Bank had been keen to withdraw this facility, which it believed invited speculative activity against sterling (given that operators were able to sell forward without moving the market against themselves). Its request to liberalise forward dealings had been rejected, in 1950, by the Labour government, but the election of the Conservatives, in October 1951, created a political environment more conducive to change.3 One of the first moves of the new government was to re-activate monetary policy in order to deal with the inflationary consequences of the Korean War. Since the early days of the Second World War, monetary policy had been put into deep freeze with the government relying on fiscal policy and direct controls to manage the economy. Bank rate had been lowered to 2 per cent, from 3 per cent, on 26 October 1939, and it was to remain unchanged at that level until 8 November 1951, when Rab Butler, the new Chancellor of the Exchequer, sanctioned an increase to per cent. Fixed forward exchange rates and flexible domestic interest rates are inappropriate bedfellows, and recognition of the distortions that this combination would have created eased the government’s decision to re-open the forward market. If the status quo had been maintained, the Bank could have been left in the invidious position of raising interest rates to protect sterling, while at the same time providing operators with a cheap exit route via the forward market. Having made a convincing case to re-open the forward market, the Bank then argued that a wider liberalisation of currency dealings would help to diminish speculative pressure against sterling.4 The existing US cent spread between the Bank’s spot dealing rates was much narrower than the+/−1 per cent band that Britain was entitled, under IMF rules, to set around its $2.80 parity rate. The rigidity in the Bank’s dealing rates meant that UK residents suffered little or no penalty when they sought to speculate against sterling by accelerating their import payments and slowing their export receipts (such ‘leading and lagging’ was hard to banish even with comprehensive exchange controls). It was claimed that by providing some scope for sterling to appreciate, between the floor and ceiling of an IMF parity band, would make operators think twice about engaging in

Regaining lost ground 1951–72

103

this practice whenever sterling was weak. In the event, the Treasury decided not to exploit the full leeway allowed under IMF rules. When the market re-opened, the Bank announced that its old dealing spread of would be replaced by intervention points, set at 0.7 per cent either side of sterling’s $2.80 parity, or at $2.78 and $2.82. Comparable adjustments were made for the other specified currencies. Authorised dealers were allowed to deal both with their customers and with other banks in London between these limits, they were allowed to set their own dealing spreads, and they were no longer obliged to cover their net positions with the Bank of England at the end of each day. Concentrating the nation’s foreign currency holdings in the coffers of the Bank of England had been one of the primary aims of the exchange controls adopted in 1939 and, between 1939 and 1951, UK residents had been obliged to use authorised dealers to sell their holdings of the specified currencies to the Bank. Even though the government still was active in procuring British imports, there no longer was such a compelling need, by the early 1950s, to continue with this wartime requirement.5 Following the reopening of the London market, UK residents were obliged only to sell their holdings of the specified currencies on the official market, whereupon they would land up in official coffers only in the event of Bank of England intervention on the exchange markets. A fettered opening Those dealing in the market, on 17 December 1951, would have noticed some things in common, but also many things quite different, to the way in which it had operated before the Second World War. The key similarities, in regard of the specified currencies, were the existence of a forward rate that was freely determined by market forces, of inter-bank trading both in spot and forward exchange, and of position taking by market principals. Despite these attributes, the re-opened market was distinguished in a number of important ways from the pre-war model. Most of these distinguishing characteristics arose from the 1947 Exchange Control Act. Whereas before 3 September 1939, any bank with an acceptable name had been able to enter the London market as a principal, entry now was limited to authorised dealers sanctioned by the Bank of England. In order to be granted this status, a bank had to convince the Bank of England that it was not only technically competent but also knowledgeable of British exchange control regulations. These requirements could have been used as a means of restricting entry into the London market, but the Bank did not use them in this way, and—largely due to a dramatic rise in London’s foreign bank community—the number of authorised dealers increased sharply between 1951 and 1972. By the end of that period, there were over 200 authorised dealers in London, compared with only 111 in the late 1940s.6 Prior to the Second World War, the only limits imposed on banks’ open positions were set by their own senior management. These were applied for prudential reasons, and the extent to which dealers were allowed to go long or short depended on the risk tolerance of their bosses. When the market reopened, dealers were allowed to run open positions, but now they were obliged to maintain these within limits set by the Bank of England, as

The foreign exchange market of London

104

well as by their own management. The limits imposed by the Bank may have served indirectly to curb reckless behaviour, although it was noted some years later that, ‘…the control of banks’ position in foreign currency is mainly designed to protect the official reserves…’.7 Exchange control arrangements, at least initially, also impinged on the ability of London based banks to conduct arbitrage operations with foreign centres. While banks were free to engage in inter-bank transactions within the London market, they were prohibited—with two important exceptions—from dealing with banks abroad. From the outset, banks were granted the freedom, ‘…to deal in US and Canadian dollars in the respective centres and to resume arbitrage transactions, both spot and forward, in those two currencies’.8 However, the same dispensation was not immediately made in respect of the European currencies, with the result that, ‘…spot rates in London differed materially from rates in the corresponding foreign centre…’.9 The restoration of normal trading relationships between the European currencies was delayed until the introduction of further liberalisation measures during the course of the 1950s. Between 1939 and 1951, the ability to interpret the exchange regulations distributed by the Foreign Exchange Committee replaced the ability to read the market as the principal skill needed by currency traders. The market became institutionalised during this period and those with a central role in enforcing the wartime regulations (mainly the FEC and the clearing banks) found it hard to re-adjust to the rigours of open market trading. In particular, the clearing banks proved resistant to giving up some of the perks they had enjoyed under the old regime. Commissions were a case in point. Commissions had been introduced at the outbreak of the war to compensate authorised dealers for their work in distributing the specified currencies. The scale against which these were levied had been lowered in January 1947, when banks had been granted limited rights to act as principals in trading the specified currencies, and logically they should have been scrapped altogether once the market re-opened in 1951. They were not and—apart from becoming a future source of acrimony between the clearing banks and the foreign banks operating in London—they stood out as another distinguishing feature of the post-war market. The existence of a fixed exchange rate (something that had been absent between 1931 and 1939) and the enforcement of exchange controls on the exchange transactions of UK residents also distinguished the new currency landscape. Despite the changed environment, the London market performed extremely well at its re-opening. George Bolton was fulsome in his praise. Writing to the Governor, he exclaimed: In my opinion the Authorised Banks and the Brokers have done amazingly well in view of the short notice we gave them, their lack of equipment and the shortage of expert staff, to have developed a market which operates smoothly on narrow dealing margins and without the facility (except in New York and Montreal) of arbitrage in foreign centres.10 However, there was still room for improvement and Bolton stressed, ‘…the necessity to increase the number of foreign exchange brokers from the inadequate number of four which exists at the moment…’.11 Most of the brokers had gone out of business during the

Regaining lost ground 1951–72

105

war, with their employees either entering the Bank to work in exchange control or moving into other pursuits. The four that had managed to scrape a living during and after the war—by broking both the sterling area currencies and the non-specified currencies— were R.P.Martin & Co, Astley & Pearce, M.W.Marshall and Quin Cope.12 During the winter of 1951–52, the Bank played a leading role in reviving the brokerage function in London.13 The moribund Foreign Exchange Brokers’ Association was dissolved and a new grouping was formed with the same name but with a new constitution. Old hands (including Charles Fulton & Co, Godsell & Co and Woellwarth & Co) were persuaded to return to the market, but only in limited number. The Bank considered that there had been far too many brokers in London before the war, and it now seized the opportunity to restrict the membership of the new Association. Mergers and amalgamations were actively encouraged and only eight or nine firms were given the nod to serve the market during the 1950s and 1960s, compared with 30 in the late 1930s. In order to ensure adequate coverage, currencies were divided up and allocated between its member firms by the Brokers’ Association.14 The widely traded US dollar was allocated to every firm, the main European currencies to four or five, and the lesser currencies to just one or two. The newly constituted Foreign Exchange Brokers’ Association (FEBA), the FEC and the Bank of England wasted little time in reviving many of the market’s pre-war rules and practices. A code of practice was agreed for dealers and brokers (a matter still very close to Bolton’s heart), rules were established on the settlement of payment errors, and value dates were agreed for each currency traded in London. These measures contributed to the smooth working of the market, but the Bank and its allies in the dealers’ and brokers’ organisations all too willingly re-imposed the restrictive practices of the pre-war days. Fixed brokerage rates were negotiated between the FEBA and the FEC, and the banks agreed both to eschew direct dealing in the London market and to use only brokers who were members of the FEBA. In addition, the Bank—ever mindful of conflicts of interest—instigated a new rule that banned any bank from owning a foreign exchange brokerage firm.15 These practices did little to enhance the appeal of the London market— brokerage rates, for instance, were kept higher than on the Continent—and the fact that, despite the obstacles put in its way, the London market eventually regained much of the ground that it had lost during the war said much about the wider allure of the City as an international financial centre. Easing the shackles The history of the market between 1951 and 1958 is dominated by the progressive relaxation in exchange controls, which culminated in the restoration of full non-resident convertibility at the end of 1958. Following the abortive attempt at convertibility in 1947, non-resident owned sterling had been segmented into different types of account (American, Transferable, Bilateral, Blocked, Other Countries and Scheduled Territories) each being subject to differing levels of restriction on transfers. For instance, sterling held in an American Account could be freely transferred between

The foreign exchange market of London

106

the 16 countries belonging to this area, whereas transfers between the 27 countries belonging to the Bilateral Account grouping (covering countries such as Argentina, Canada, Belgium, France and West Germany) were not permitted, unless specifically authorised by the UK exchange control authorities. Transfers between, as distinct from within, the different account areas were heavily circumscribed and, in the case of the sterling area (i.e. the Scheduled Territories), payments to the outside world only were allowed for purposes approved by exchange control. Within Western Europe, many countries belonged to the Bilateral Account area, but some (such as the Netherlands and Spain) were Transferable Account countries. This led to a highly fragmented cross-border payments system. However, in July 1950, a bold initiative had been launched to lower the barriers between the European countries. This was the creation of the European Payments Union, or EPU. The EPU had been set up under the aegis of the Organisation for European Economic Co-operation (which had been established to administer the American post-war Marshall aid programme for Europe, and was the forerunner of the current Organisation for Economic Co-operation and Development), to facilitate a means of multilateral settlement between its 14 European member countries.16 The EPU obviated the need for the bilateral payment arrangements that Britain had previously maintained with many of the Western European countries. Under the EPU, Britain’s net balances—arising largely from current account transactions—with the other member countries were reported monthly to Union’s fiscal agent, the Bank for International Settlements, where offsetting claims and liabilities were consolidated to produce a net position vis-à-vis the EPU as a whole. Up to agreed limits, outstanding balances were financed by credit, but beyond these limits they had to be settled in gold or US dollars. The EPU made an important contribution to the post-war liberalisation of trade and payments, and not just within Western Europe. Britain joined the EPU not in its own right, but as the leader of the wider sterling area. In consequence, the mechanism provided for current account convertibility not only within Europe, but also between Europe and the sterling area. When the London market re-opened on 17 December 1951, the EPU was in full swing and was providing multilateral settlement of European balances, albeit only on a monthend basis. The exchange rates quoted in London, however, barely reflected this arrangement, given that banks were prevented from engaging in bilateral, let alone in multilateral, arbitrage with other European centres. The desire to bring the daily operations of the London exchange market into line with the month-end multilateralism of the EPU, informed the authorities’ decision to progressively grant the market more freedom. Various steps were taken, including: • In early 1952, authorised banks were allowed to deal, spot and forward, in certain specified European currencies in the respective centres. • In May 1953, authorised dealers were allowed to resume spot arbitrage in the major European currencies. • In October 1953, forward arbitrage was permitted in most European currencies for periods up to three months. • In April 1956, forward arbitrage was allowed for periods up to six months.

Regaining lost ground 1951–72

107

• In June 1956, non-residents were allowed to buy and sell any specified currency in London so long as settlement was made against the appropriate external account.17 These piece-meal measures provided the London market with a limited degree of freedom. However, it would have enjoyed far greater leeway, if the Conservative government had implemented a top-secret plan, drawn up by Bank of England and Treasury officials, called Robot. The gist of this plan, which was formulated during the winter of 1951–52, was to secure immediate convertibility of non-resident sterling by floating the pound. However, there was no political appetite, at the time, for such a bold move and this ensured that it soon was kicked into the long grass.18 The resumption of spot arbitrage in the major European currencies arguably was the most important of the concessions that actually were introduced in the early 1950s. Apart from bringing European cross-rates more into line, the arbitrage scheme was expected to: …provide an automatic means of multilateral settlement by enabling a large proportion of the EPU ‘offsetting’ to be done day by day between the different exchange markets. The net position of any countries in EPU should not be altered but the gross deficits and surpluses to be settled at the end of the month should be reduced. In short, a further step towards normal.19 The inauguration of the European arbitrage scheme, on 18 May 1953, led to, ‘…the most active day’s busines…in the London market for a long time. Most of the business took place in guilders, French francs, deutsche marks and Swiss francs, probably in that order of importance’.20 The arbitrage scheme applied only to the European currencies, and it was not until the establishment of full convertibility, at the end of 1958, that arbitrage was permitted between the European currencies and the US and Canadian dollars. However, even before the restoration of convertibility, further measures were to be taken that served to lower the barriers segmenting the London foreign exchange market. In March 1954, the previous mishmash of external accounts was replaced by a new and simpler regime. This change was produced by enlarging the Transferable Account area to include most of the countries that were not otherwise members either of the sterling area, or the American Account area, or the Canadian dollar area. Sterling could be transferred freely within these areas, but (at least in theory) it could only be transferred between them with exchange control approval. In practice, holders of Transferable sterling were able to sell it for US dollars—at a discount to the official rate—on the free markets of New York and Zurich. In the mid1950s, the free market discount on Transferable sterling became deep enough to promote a renewed expansion in cheap sterling transactions.21 Such transactions diminished the hard currency earnings of the sterling area and a decisive new policy initiative was launched, in early 1955, in order to kill off this unwanted activity. From 24 February onwards, the Bank of England began to intervene in New York and Zurich to keep the free market sterling/US dollar rate at a discount of no more than 1 per cent to the official rate.22 Two effects flowed from the decision. First, it put paid to operations in cheap sterling in overseas markets. Second, it provided back-door convertibility between sterling and the US dollar, given that the Bank now was supplying resources from the official reserves to

The foreign exchange market of London

108

provide holders of Transferable sterling with US dollars in overseas markets. It took a few years longer to establish formal convertibility. In UK eyes, this was achieved on 27 December 1958, when all sterling held outside of the sterling area was consolidated into External accounts and was made freely convertible into any currency. At the same time, the EPU was dismantled and most of the Western European countries also joined Britain in making their currencies convertible. Despite these steps, it took a couple of years more for the convertibility of sterling to be given the formal blessing of the IMF. While import licensing had largely disappeared by 1958, a few restrictions still remained on imports from the dollar area. Such discriminatory measures violated Article VIII of the IMF Agreement and so had to be lifted before the IMF would deem sterling to be fully convertible.23 That did not take place until 15 February 1961. The vice of the exchange control measures that were enforced until the end of the 1950s was that they deflected trading in sterling from London to free exchange markets abroad. This changed with the restoration of convertibility. The consolidation of nonresident owned balances held outside of the sterling area, other than those in Blocked Accounts, into a single regime of External Accounts eliminated the regulatory need for non-residents (mostly holders of Transferable Accounts) to trade sterling in New York and Zurich. Henceforth, the decision on where to trade sterling would be based on commercial considerations and not on the need to circumvent UK exchange controls. Convertibility brought the bulk of trading in sterling back into the official market. However, there were a couple of exceptions to this general rule. After 1958, sterling continued to be traded, albeit on only a comparatively modest scale, on two irregular markets. The first (and least important) of these was the ‘security sterling market’. The second was the ‘investment currency market’. The origins of the security sterling market can be traced back to the blocked sterling balances that had been created in 1940, when the authorities were struggling to stem the outflow of foreign owned funds to New York. These balances were invested in UK securities. The rules governing these balances had been eased in 1953, when permission was granted for them to be transferred between residents of the same country or monetary area.24 This had encouraged the development of markets in security sterling in foreign centres. The bulk of such trading took place against the US dollar and at a rate that almost always was at a discount to the official rate. Such activity continued up until April 1967, when security sterling finally was unified with External sterling. Investment dollars at a premium The investment currency market differed from other irregular markets in three important respects. In the first place, its customers were UK residents. Second, it was located in London. Third, it was recognised by the Bank of England. Under the 1947 Exchange Control Act, UK residents were barred from entering the official exchange market to obtain foreign currency to finance overseas portfolio investment. The primary purpose of the Act, however, was to conserve the country’s exchange reserves, and the Bank was happy to sanction the investment currency market, because it provided UK residents with

Regaining lost ground 1951–72

109

scope to obtain funds for investment abroad in a way that did not impose a drain on official holdings of gold and foreign exchange. The market comprised a distinct pool of foreign currency assets available to UK residents wishing to invest abroad. Prices were set freely by the interaction of supply and demand. The funds traded in this market were described initially either as switch dollars, or as security dollars, but eventually they became better known as investment dollars.25 Despite this label, currencies other than the US dollar were traded in this market. Investment dollars were not quoted as an outright rate, but rather were expressed as a percentage of sterling’s IMF par rate against the US dollar (cross-rates were used to imply quotes in terms of other currencies). Strong demand ensured that investment dollars always traded at a premium to the official sterling/US dollar par rate. Fluctuations in the so-called dollar premium exerted an important influence on the prices that UK residents had to pay for foreign securities for three decades after the Second World War. The pool of assets traded on the investment currency market had its origins in those UK owned hard currency securities that had avoided being requisitioned and sold by the Treasury during the Second World War. Included among these securities were Australian government US dollar bonds, a few US company shares, some Canadian dollar holdings and the guilder issues of the two big Anglo-Dutch multinationals, Unilever and Royal Dutch/Shell.26 By the late 1940s, exchange control regulations allowed UK holders of foreign securities to sell them to: …other residents for settlement in sterling. Residents were also allowed to switch most foreign currency securities into quoted investments payable in the currency realised, or alternatively to sell (via dealers) the foreign currency capital proceeds of their portfolio investments to other residents.27 The proceeds were converted at the investment dollar rate. A further change was introduced in 1954, when permission was granted for the sales proceeds of non-dollar securities to be reinvested in quoted foreign securities of any kind. In contrast, the proceeds of US and Canadian securities still had to be reinvested in similar North America assets. This 1954 rule provoked a split in the investment currency market, with separate quotes being provided for ‘hard’ investment dollars (applied to transactions in North American securities) and for ‘soft’ investment dollars (applied to transactions in nondollar securities). The former invariably were quoted with a slightly bigger premium than the latter, which is hardly surprising given the global clamour for the US dollar during the 1950s. However, the distinction between North American and other foreign securities became less important as more currencies became convertible after 1958, and eventually the two compartments of the market were merged in May 1962, following which only a single rate was quoted for investment dollars. The pool of assets within which UK residents had to bid in order to obtain the funds for portfolio investment abroad was not entirely static. Apart from underlying changes in the value of the assets held in the pool, the size of the investment currency market also was determined by inflows and outflows ordained by the authorities. Prior to the mid-1960s, the movements were largely in one direction, and the pool was

The foreign exchange market of London

110

allowed to expand by the inclusion of foreign capital items due to UK residents such as, ‘…legacies under wills, compensation granted by the German government to refugees who had established residence in the United Kingdom, payments to UK shareholders of companies in liquidation, e.g. Mexican Eagle etc….’.28 Admitting new classes of assets into the pool would have kept the investment dollar premium lower than it might otherwise have been. The reverse would have been true when the demands of residents needing foreign currency were diverted from the official market to the investment currency market. This is precisely what happened during the 1960s, as the British government responded to recurring sterling crises, by forcing more of the UK demand for foreign currency into the investment currency market. In July 1961, the rules governing the availability of foreign exchange for direct investment were tightened, and from May 1962 companies that were unable to buy exchange in the official market for this purpose were allowed instead to satisfy their needs in the investment currency market. This added to the demand for investment dollars, which was strengthened still further from April 1964, when UK residents wishing to buy properties outside of the sterling area were required to use investment dollars. A far more important, and also far more unpopular, measure was introduced the following year, when action was taken to strengthen the official exchange rate by shrinking the investment dollar pool. In April 1965, the Bank of England announced the adoption of the infamous 25 per cent surrender rule, which required a quarter of the proceeds of sales of all foreign currency securities to be sold on the official market, so leaving only 75 per cent available either for reinvestment or for encashment at the premium rate. Trading investment dollars was a profitable pastime for the handful of dealers who specialised in this line of activity. Around six financial institutions served as the main principals in this market, and they were exempt from the 25 per cent surrender rule on transactions passing through their books. Dealing spreads were wider than in the official market. Compared with a typical

of a US cent spread between buying and selling rates

for cable, the dealing spread for investment dollars was in the range of cent.

to

of a US

Post-war trading conditions Between 1951 and 1972, turnover on the London foreign exchange market was boosted both by rising levels of international direct investment (which was more leniently treated under UK exchange controls than portfolio investment), and by the vigorous expansion in global trade. Post-war economic reconstruction in continental Europe and Japan imparted a powerful stimulus to international trade and, after increasing from $59 billion in 1950 to $118 billion in 1960, the value of world exports climbed even more rapidly to reach $382 billion by 1972. This created plenty of scope for dealers to earn a decent living just by taking a turn on regular commercial foreign exchange transactions. In theory, the IMF regime of fixed parities should have provided less scope for making a profit by running open currency positions. The maximum 1 per cent limits set either side of these parities offered only limited room for currencies to fluctuate on a day-to-day

Regaining lost ground 1951–72

111

basis and, while parity adjustments were permitted, the whole ethos of the IMF was directed towards maintaining stable exchange rates.29 As things turned out, this ideal was achieved only during the 1950s. Thereafter, the currency markets were plagued by recurring crises that in the end were to lead to the demise of the Bretton Woods system. IMF parities were expressed in terms of the US dollar, which official holders were entitled to convert into gold at a fixed price of $35 an ounce. The dollar was intended to serve as the anchor of the post-war international monetary system. It proved to be a solid anchor during the 1950s. The world remained short of dollars for most of this decade, as Europe and Japan turned to the United States for the goods and capital they needed to rebuild their war-ravaged economies. This problem had contributed to the British led devaluations of 1949, which—in view of the number of currencies involved—amounted more to a dollar revaluation than to a series of bilateral parity adjustments. These adjustments, however, cleared the air and the international monetary system, as had been hoped by its designers, proved to be fairly stable over the following ten years. During the 1950s, there were to be only localised outbreaks of turbulence. Most of these were centred on sterling, which came under intermittent pressure in response to balance of payments difficulties (1951–52), to rumours that its parity might be abandoned in favour of a floating exchange rate (1955), to the Suez crisis (1956), and to general speculation against the European currencies (1957).30 These attacks, however, were resisted and sterling survived the 1950s with its $2.80 parity intact. Indeed, the only leading cur-rency to be realigned during that decade was the ailing French franc, which was devalued in 1957 and again in 1958. However, cracks began to appear, by the end of the 1950s, in the previously solid foundations of the Bretton Woods system. These were to widen during the following decade and to provoke an increasing number of parity adjustments. The root cause of the problems that developed during the 1960s was the deteriorating international economic position of the United States. The dollar shortage of the early post-war period was replaced by a glut as the United States failed to generate a big enough current account surplus to offset its ever rising levels of investment and military expenditures abroad. In conjunction with underlying improvement in Germany’s international competitiveness, and with Britain’s continuing balance of payments difficulties, this set the stage for the mounting tensions that developed between the two reserve currencies and the increasingly favoured German mark after 1960. The altered fortunes of the dollar are highlighted by the sharp decline that occurred in the US gold reserves between 1951 and 1972. From a high of over $22 billion in 1951, US official gold holdings edged down to $18 billion by 1960, before slumping to only $11 billion by 1972. In 1951, foreign central banks could not lay their hands on enough dollars, but during the second half of this period some of them were actively seeking to convert part of their dollar holdings into other reserve assets such as gold, the German mark and the Swiss franc. International money managers started to behave in a similar fashion. Throughout the 1960s and early 1970s, there were episodic outflows of funds from the US dollar (and also from sterling) into the strong continental European currencies and gold. The first such episode occurred in 1961, when money poured into Germany amid speculation about a revaluation of the mark to correct the sizeable German current account surplus.

The foreign exchange market of London

112

Concern about the inflationary consequences of these inflows led the Adenauer government to ignore the uncharacteristic opposition of the Bundesbank and to force 31 through a modest per cent revaluation of the mark. This move was immediately mimicked by the Dutch guilder. This move did little to clear the air and continued mistrust of the dollar found its reflection in a strengthening in demand for gold on the London market. This market had re-opened in March 1954 and, following the restoration of convertibility, in 1958, access to it was allowed for all residents outside of the sterling area. The free market price of gold had been kept in line with the official price by gold supplied by the Bank of England and the US authorities. However, as demand intensified during 1961, it became necessary to augment the supply of gold reaching the market. Responsibility for stabilising the free gold price was bestowed on a broad syndicate made up of the central banks of Belgium, France, Germany, Italy, the Netherlands, Switzerland, United Kingdom and the United States. The so-called Gold Pool came into operation in November 1961. Focus on sterling During the mid-1960s, sterling was dragged back into the limelight by Britain’s weak current account position. The tendency for the current account to slide into deficit whenever the economy was expanding at anywhere close to its trend rate fomented the view that sterling was overvalued. However, when the Labour government assumed power in 1964, it categorically rejected the idea of devaluation and instead resorted to a hotchpotch of measures that were aimed at supporting the $2.80 parity, while at the same time avoiding an unwanted increase in unemployment.32 Measures adopted between 1964 and 1966 included the instigation of official support for sterling in the forward market, the imposition of tighter exchange controls and the adoption of a temporary surcharge on imports of manufactured goods. With only modest exchange reserves (of around $2.5 billion) at its disposal, the Bank of England was obliged to resort to external borrowing to sustain its intervention not only in the forward, but also in the spot, market. Use was made both of short-term borrowings under the reciprocal swap facilities agreed between central banks in 1961, and under Britain’s stand-by facility with the IMF. Sterling struggled through 1966 and most of 1967 with its parity still intact, but some other currencies shared a different fate. The mid-1960s witnessed a series of exchange rate realignments in the developing world. Trading the currencies of the developing, or emerging, nations was not such a popular activity in the 1960s, as it was to become twenty years or so later. However, those specialising in this sector of the market, such as the Commonwealth banks and the British overseas banks, would have had the opportunity to make, but of course also to lose, money by running open positions in these currencies. During 1966–67, there were a number of maxi devaluations by countries seeking to compensate for years of waning international competitiveness. India started the ball rolling in June 1966, when it devalued the rupee by 36 per cent. This was followed by devaluations by Brazil (18 per cent in February 1967), Argentina (29 per cent in March 1967) and Peru (31 per cent in September 1967).

Regaining lost ground 1951–72

113

These realignments, however, served as little more than appetisers for the big event of 1967. This was the 14.3 per cent devaluation of sterling, from $2.80 to $2.40, that was announced on 18 November. Sterling had encountered intermittent pressure over the previous three years, but this suddenly intensified after the first quarter of 1967, in response to (a) higher import costs emanating from the effects of the June war in the Middle East, (b) rising US short-term interest rates, (c) slower exports to the faltering economies of the European Economic Community (EEC), (d) surging domestic credit expansion, (e) rising wage costs after the 1966 pay freeze and (f) poor October trade figures in the wake of unofficial dock strikes in Liverpool and London. The reasons that persuaded the government to drop its earlier opposition to devaluation were summarised by the Bank for International Settlements (BIS) in its 1968 Annual Report. According to the BIS: As the drain on official reserves and available borrowing facilities showed a relentless momentum, the authorities were faced with the problem of whether to devalue or to continue to struggle to maintain the existing parity. In either case further restrictive measures and borrowing facilities would be needed: but it must have been thought that, with a reasonable devaluation, the chances were better that less foreign debt and less sacrifice of economic expansion would be needed.33 Sterling’s devaluation proved to be anything but cathartic for the currency markets. During 1968, operators turned their attention to other currencies judged to be in need of realignment. The currencies of countries with weak balance of payments (United States and France) came under heavy selling pressure, whereas the German mark attracted strong demand in response to Germany’s high and rising current account surplus. Mounting tensions in the currency markets found their reflection in strong demand for gold on the London market, and eventually forced the leading central banks to abandon their efforts to hold the market price of gold at $35 an ounce. On 15 March, the Gold Pool was dismantled, and the market gold price was allowed to find its own level. By the end of May it had climbed to $42 an ounce. Despite further crises, including the temporary closure of the main European currency markets, including London, for three days in November, the leading currencies miraculously finished 1968 with their parities still intact. However, this proved to be only a temporary remission. Tensions between the French franc and the German mark continued into 1969, and intensified following the resignation of President de Gaulle in April. The franc was supported for a little while longer, but in August the French government bowed to the inevitable and endorsed an 11.1 per cent devaluation. This move excited hopes that Germany would similarly acquiesce to a realignment of the mark. Money flooded into Germany and, following elections at the end of September, the newly formed Social Democrat led government (which was less wedded than its predecessor to the old DM/US dollar parity of 4.00) ordered the Bundesbank to cease its intervention on the exchange markets. The mark was allowed to float upwards, before being formally revalued by 9.3 per cent on 24 October.34 This parity was not destined to survive for long. A farther significant widening in the

The foreign exchange market of London

114

US basic balance of payments deficit contributed to an upsurge in demand for the hard continental European currencies. Eventually, the inflow of money into Germany became a flood and, on 5 May, the German Bundesbank withdrew from the market, which was then temporarily closed. On the same day, as a result of similar, though lesser pressures, the Austrian, Belgian, Dutch and Swiss authorities stopped buying dollars. After some days of deliberation, the Swiss franc was revalued by 7.07 per cent and the Austrian schilling by 5.05 per cent, with effect from 10 May. Simultaneously, the Deutschmark and guilder were allowed to float.35 Dealers who had feared that the IMF regime of fixed but adjustable exchange rates would turn currency trading into a mere spread-taking process now were being confronted with the sort of volatility that few would have anticipated when the London market re-opened in 1951. There was even more excitement to come. In August 1971, a Congressional sub-committee hinted at the need for a realignment of the dollar to correct the growing deterioration in US international trade and competitiveness.36 This encouraged a number of central banks to convert some of their excess dollar holdings into gold. While the US Treasury had stopped supplying gold to meet private demand after the Gold Pool was disbanded in 1968, it was still obliged to satisfy central bank needs at the official price of $35 an ounce. The US gold reserves fell by over $1 billion during the first two weeks of August and, faced with the prospect of further heavy losses, President Nixon announced the suspension of the convertibility of the dollar on 15 August. This announcement was followed by what was now becoming an all too common event, namely the temporary closure of the main European exchange markets. When they re-opened on 23 August, all but one of the European countries allowed their currencies to float (they joined the Canadian dollar which, after observing a fixed exchange rate for eight years, had resumed its float in June 1970). The one exception was France. It kept its old parity, but only for commercial and official transactions. Henceforth, financial transactions were to be undertaken at a separate and floating rate. Belgium had adopted such a two-tier exchange rate regime in May 1971. A bold, but ultimately unsuccessful, attempt was made to rescue the Bretton Woods system with an agreement that was cobbled together at the Smithsonian Institute in December 1971. This agreement endorsed: • A 7.9 per cent devaluation of the US dollar brought about by a symbolic increase in the official price of gold from $35 to $38 an ounce (the convertibility of the dollar into gold was not restored). • Modest 1 per cent devaluations against gold by Italy and Sweden. • The retention of unaltered exchange rates in terms of gold by Britain, France and Switzerland. • Revaluations in terms of gold by the Belgian franc (2.8 per cent), the Dutch guilder (2.8 per cent), the German mark (4.6 per cent) and the Japanese yen (7.7 per cent). • Adoption of wider limits of up to +/−2.25 per cent either side of newly established parities. Under the Smithsonian agreement, sterling’s parity against the US dollar was revalued by 8.6 per cent (the reciprocal of the dollar’s 7.9 per cent devaluation), or from $2.40 to

Regaining lost ground 1951–72

115

$2.6057. Limits of $2.6643 and $2.5471 were set either side of this parity. Despite sterling’s significant revaluation against the dollar, its parallel devaluations against the hard European currencies and the Japanese yen meant that it exited the Smithsonian Institute showing only a modest 3 per cent overall appreciation.37 It was not to retain this gain for long. The events that led up to the pound’s subsequent fall from grace started on 1 May 1972, when the currencies of the three EEC applicant countries (Britain, Denmark and Ireland) joined the colourfully named European currency snake. This arrangement had been launched the previous month by the EEC, as a first step towards an ill-fated attempt to establish a monetary union by 1980.38 Participation in the snake required Britain to keep the movement between sterling and the other European member currencies within a narrower band than otherwise would have been allowed under the Smithsonian arrangements. Sterling survived for a mere six weeks in the snake, something that made its subsequent 23 month sojourn in the Exchange Rate Mechanism (the successor of the snake) in 1990–92 look almost like a feat of endurance. The sterling crisis of mid-1972 was sparked off by the prospect of an imminent dock strike and by concern about the expansionary bias of domestic economic policies. Despite the provision of $2.6 billion of support from the other members of the snake, massive speculative selling forced the British authorities both to withdraw sterling from the snake and to abandon its $2.6057 parity. Sterling was allowed to float on 23 June 1972. Down the road, this meant that London foreign exchange traders, for the first time since the summer of 1939, would have to ply their trade with a permanently floating, and also potentially volatile, base currency. London dealers confront the future Such currency turmoil was scarcely on the minds of authorised dealers when the London market re-opened in December 1951. At that time, there were over 111 authorised dealers serving the market. However, the majority of these banks were only minor and occasional participants, and business was largely concentrated in the hands of a dozen or so major players. In 1953, Roy Bridge, who by that time was responsible for the Bank of England’s day-to-day foreign exchange operations, singled out the Big Five clearing banks, Samuel Montagu, National City Bank of New York, Société Générale, and the Commercial Bank of Scotland as key members of this active group.39 Bridge, however, also criticised most of the clearing banks for not doing enough to aid the post-war recovery of the London market. When the market re-opened in 1951 authorised banks were permitted to run open positions within limits set down by the Bank of England. Central bankers normally are scornful of speculation, so it is rather unusual for a central banker to castigate dealers for being too risk-averse. Yet, in 1956, Bridge observed: If there is any criticism to be levelled at the London market it is not that there is too much speculation in foreign exchange but there is too little to ensure a broad

The foreign exchange market of London

116

market at all times. The market is made by the private and the foreign banks; the clearers, who used to make the market before the war, are in most cases not now allowed by their own general management to use even the modest limits that were given to them in 1951.40 The clearers had served as the main dealers in the specified currencies between 1939 and 1951 and, when the market re-opened, they found it hard to discard the civil service mentality that they had developed during that period. The key strategic strength of the clearing banks anyway lay in their large UK corporate and commercial customer base. This generated a high volume of customer transactions for their foreign exchange departments, and most of them were content to earn a steady and risk-free living by taking a spread and earning a commission on these transactions. The merchant and foreign banks had fewer UK corporate and commercial customers than the clearers and this forced them to take a more aggressive approach than the latter to drum up foreign exchange business. A clash between these two approaches became an increasing possibility, and this duly occurred in 1954. Many of the merchant and foreign banks wanted to scrap commissions on foreign exchange deals, in order to attract more overseas business to London, and some were actually breaking the rules of the London market by rebating commission to their customers.41 The clearers, in contrast, were unwilling to give up this revenue source. After a heated debate, it was eventually agreed, in May, that a reduced commission scale should be introduced with importantly a flat rate of £6/5s being charged on deals in excess of a low ceiling of £5,000. This move largely satisfied the non-clearers, because it substantially cut the commission on the higher value deals, often undertaken for multinational companies and for other financial institutions, which were their metier. Birth of the Eurocurrency market The role and importance of foreign banks in trading foreign exchange in London increased dramatically, from the mid-1950s, in response to the birth of the Eurocurrency banking market (which—since the creation, in 1999, of the euro as the single currency of the EMU member countries—is increasingly referred to as the international banking market so as not to confuse it with the totally separate domestic banking market of the euro-zone). The origins of the Eurocurrency market, in which currencies are deposited and lent outside of their country of origin, can be traced back to 1955, when the Midland Bank—faced with tight monetary conditions—widened its domestic funding operations by bidding for dollar deposits in London for the purpose of swapping into sterling.42 In 1956, the supply of Eurodollars was enlarged when Middle Eastern and Eastern European countries, fearing that the US government might impose a freeze on their financial assets in the United States in the wake of the Suez and Hungarian crises, transferred some of their dollar deposits from New York to Europe.43 The expanding pool of Eurodollar deposits soon was put to work. In 1957, the Bank of England (responding to one of sterling’s regular bouts of weakness) banned the use of sterling in financing trade between two non-sterling area countries. Bankers soon turned

Regaining lost ground 1951–72

117

to Eurodollars to fill this void. This cemented London’s role as the dominant Eurodollar centre, and the market subsequently entered into a period of vigorous expansion during the 1960s, in response to a series of restrictive US measures aimed at stemming the outflow of capital from the United States. These measures not only stimulated the growth of the Eurocurrency banking market, but also fostered the formation of the Eurobond market. The latter—in which bonds are underwritten and sold in more than one country—came into being in mid-1963, when the US government imposed an Interest Equalisation Tax on foreign stock and bond issues on the US domestic capital market. Foreigners wishing to raise capital without paying this impost were forced to look elsewhere for their funds, and eventually they turned to London where the first Eurobond issue was arranged in July 1963. Additional US restrictions on capital outflows, including the 1965 Voluntary Foreign Credit Restraint Programme and the 1968 Mandatory Foreign Investment Programme, provided a further stimulus to the development of the Eurocurrency and Eurobond markets. And in 1969, the former received another big boost from heavy borrowing by US banks. Under the Federal Reserve’s Regulation Q, a ceiling was imposed on the interest US banks were allowed to pay on domestic time deposits. US Treasury bill rates rose above this ceiling during 1969, and banks compensated for the ensuing run-off in their domestic deposits by siphoning funds from the Eurodollar market. Most of these US restrictions either were eased or were removed by the early 1970s, but by then the Eurocurrency and Eurobond markets had developed a momentum of their own. They had also broadened their base by intermediating currencies other than just the dollar. The subsequent and, even part of the earlier, growth of these two markets can be attributed to the competitive edge they possessed over their domestic counterparts. Being less highly regulated (there were no reserve requirements or deposit insurance charges in the Eurocurrency market), and running with lower operating costs (Eurocurrency banks and Eurobond issuers did not suffer the high overheads of institutions operating in the retail markets), they were able to offer depositors better rates and borrowers finer terms than domestic markets. From a zero base in the mid-1950s, the footings of the Eurocurrency banking market edged up to $10 billion by 1963, before climbing rapidly to $146 billion by 1972.44 Over 30 per cent of these deposits were placed with banks in London, a far bigger share than in any other centre, with the rest being distributed across banking markets in continental Europe, Canada and Japan. Within London, the share of deposits expressed in currencies other than the US dollar (mostly German marks, Swiss francs and Dutch guilders) rose from 14 per cent in 1963, to 19 per cent in 1972. The emergence of London as the leading centre for Eurocurrency lending and Eurobond issuance owed much to the low entry barriers faced by foreign banks wishing to set up shop in London, to its location in a convenient time zone that overlapped with part of the working day in Asia and North America, and to the allure of its already wellestablished international financial infrastructure. The fact that these markets were separated by exchange controls from the UK domestic financial markets also meant that their progress was unaffected by the measures that the authorities frequently were required to take to defend the wayward pound. The development of the Eurocurrency and Eurobond markets imparted a powerful

The foreign exchange market of London

118

boost to foreign exchange trading in London. This applied even though straightforward transactions in these two markets do not give rise to any demand for foreign exchange. Foreign exchange traders are kept totally out of the picture when, for instance, Eurodollar deposits are transformed into Eurodollar loans, and US dollar holders invest in Eurodollar deposits or Eurodollar bonds. However, there are indirect links between the foreign exchange market and the Euromarkets, and it was through these that the former benefited from the co-location of the latter in London. These benefits were realised in two main ways. In the first place, the foreign exchange market gained from an explosion in the City’s foreign bank population. Between 1961 and 1972, the number of foreign banks operating in London increased from around 80 to 215.45 While these newcomers entered London primarily to participate in the Eurocurrency market, involvement in the foreign exchange market was considered by them to be both a necessary and natural adjunct of this primary activity. Even those without a big customer base were able to generate revenues for their foreign exchange departments by engaging in proprietary trading. Foreign banks, or at least those that obtained authorised status, boosted the number of principals participating in the London foreign exchange market, and this served both to expand its turnover and liquidity and to improve its competitiveness relative to centres abroad. The second way in which the foreign exchange market gained was through the demand for its services that was indirectly generated from the activities of those wheeling and dealing in the Euromarkets. For instance, foreign exchange transactions would have been triggered when US dollar holders deposited in Euromarks, when Belgian residents invested in Eurodollar bonds, and when non-US borrowers converted their Eurodollar loans and bonds into domestic currency. Transactions such as these had important implications for currency trading in London, because they involved the exchange of nonsterling currencies by non-residents and so were unaffected by British exchange control regulations. As the leading Euromarket centre, London captured a significant volume of business in transactions involving the exchange of one foreign currency for another. This boosted turnover on the London foreign exchange market and helped to compensate for the main disadvantage it suffered compared with Frankfurt, Zurich and New York, or its main overseas rivals. Whereas turnover on these three markets benefited from sizeable inflows and outflows of domestic capital, exchange controls severely restricted the freedom of UK residents to export capital abroad. Official exchange was made available for direct investment (albeit on terms that varied with the state of the balance of payments), but it was not provided either for short-term capital outflows or for portfolio investment. However, the business London dealers gained by trading the US dollar against the continental European currencies meant that they were not unduly penalised by the restrictions surrounding sterling. Adopting the US dollar as a key working currency also provided authorised dealers with some wriggle room under the limits set by the Bank of England on their open positions (both spot and forward) in foreign currencies relative to sterling. These limits, which had to be met at the end of each working day, seem to have been faithfully observed by the banks. In 1957, Roy Bridge, commenting on returns the Bank had

Regaining lost ground 1951–72

119

recently received, noted they contained no irregularities and exclaimed, ‘This is most satisfactory and confirms that we have indeed been right in believing that we could rely on the members of the foreign exchange markets to play the game’.46 The key thing about these dealing limits is that they applied only to positions against sterling, and this gave banks freedom to run open positions, that added to the depth of the London market, between two non-sterling currencies. However, they did not have unlimited freedom, for two reasons. In the first place, the senior managers of banks would have set their own prudential limits on this sort of activity. In the second place, the Bank of England kept a watchful eye on these foreign currency positions. Authorised dealers had to, ‘…report on a monthly basis their positions in respect of one foreign currency against another…’ and these positions were monitored ‘…to ensure that individual banks do not enter into imprudent exposures on individual currencies’.47 Despite these constraints, trading involving two non-sterling currencies not only developed rapidly during the 1960s, but also provided the business platform that eventually would allow London to reclaim its position as the world’s biggest foreign exchange centre. Deepening forward market Forward exchange traders derived significant benefit from the advent of the Eurocurrency market. Such traders must have unrestricted access to foreign currency deposits in order to ply their trade. The Eurocurrency markets not only provided them with deposits in all the major currencies (Paris was the principal centre for Eurosterling deposits), but did so on better terms than domestic markets. Access to the Eurocurrency market was not restricted by exchange controls, and Eurocurrency interest rates were ‘clean’ in that they were not distorted either by reserve requirements or by deposit insurance charges. In view of these attributes, forward exchange traders increasingly sought to cover their deals by using deposits taken from the Eurocurrency market rather than from domestic banking markets.48 In some domestic markets, competition from public sector borrowers makes it hard for banks to raise deposits with maturities much beyond six months. This constraint does not apply in the Eurocurrency markets, and deposit rates in some currencies are quoted for periods of up to two years, or even longer. The availability of these longer-term deposits facilitated a significant lengthening, starting in the 1960s, in the maturity of forward exchange contracts. Hitherto, these had rarely extended much beyond six months. However, by 1968: For US and Canadian dollars and the major European currencies, forward rates are quoted for periods up to (and occasionally beyond) a year, and there is a regular quotation for two year forward dollars. Periods longer than those normally quoted can be negotiated; e.g. forward US dollar deals occasionally take place for as long as five years.49 UK residents were barred, by exchange controls, from using forward exchange for speculative purposes. They were allowed only to cover normal commercial transactions,

The foreign exchange market of London

120

and they did this with traditional forward contracts, and also with newly created ‘option forward’ contracts. The latter gained popularity in the post-war period by offering companies greater flexibility in covering their exchange exposures. Under a traditional forward contract currencies only are exchanged at the maturity of the contract. In contrast, under an ‘option forward’ the contract can be completed on any day over a stated period (say any time within one month of its initiation), or between two specified future dates (say any time during the last two months of a three month contract). Non-residents were granted unrestricted access to the forward exchange market in London, and many did so both for financial and speculative purposes. They used forward exchange especially to cover their short-term investments in UK financial instruments. When the cost of forward cover was less than the relevant differential between (higher) British and (lower) foreign interest rates, they tended to expand their holdings of these instruments, and vice versa. The importance attached by foreigners to variations in this covered margin did not pass unnoticed in Threadneedle Street. During sterling’s trials and tribulations in the mid1960s, the Bank intervened on the markets to cheapen the cost of forward cover, and so enhance the allure of sterling assets to distrustful foreigner investors. Its purchases of forward sterling turned it into one of the best customers of the forward market. It has been estimated that, by late 1967, the Bank had outstanding forward contracts that were equal to more than £2 billion.50 Its foray into the forward markets proved to be a costly venture because, following the devaluation of sterling in November 1967, the EEA was hit with a £356 million foreign exchange translation loss. During the 1960s, it was not just the forward market that was affected by the development of the Eurocurrency market. The impact of the latter also was felt in the brokerage community. In 1967, the Foreign Exchange Brokers’ Association opened its doors to brokers serving the Eurocurrency market and changed its name to the Foreign Exchange and Currency Deposit Brokers’ Association (FECDBA).51 The initial membership of the FECDBA comprised the eight foreign exchange brokers that previously had belonged to the FEBA plus three currency deposit brokers. In contrast with foreign exchange traders, dealers in the Eurocurrency market were not obliged to use the services of brokers in the London market, and a significant amount of business was undertaken on a direct basis. However, with so many new names entering the Eurocurrency market, many banks still found it convenient to employ brokers when searching for suitable counterparties. Unlike currency deposit dealers, foreign exchange dealers continued to be bound by the earlier agreement that banned direct dealings in London, other than for deals involving either very small amounts, or ‘exotic’ currencies that were inadequately covered by the foreign exchange brokers. This ban, however, was not always strictly observed.52 Some of the foreign banks accused the brokers of maintaining inflexibly wide margins in the less widely traded currencies, and claimed that they could only engage in profitable arbitrage transactions with foreign centres by executing the London leg of any deal via a direct trade with another bank. When the FECDBA was established, a fresh attempt was made to secure compliance with this ban. Banks were reminded by the Foreign Exchange Committee to conduct all

Regaining lost ground 1951–72

121

of their foreign exchange dealings in London via a member of the FECDBA. Direct dealings were permitted for Eurocurrency transactions in London, but banks electing to employ brokers for this purpose were required to use only FECDBA members. These restrictions were intended to reward brokers for belonging to an Association that, by upholding the same rules of probity as its predecessor, helped to maintain the high dealing standards that were so dear to the Bank of England’s heart. Having given FECDBA members a monopoly over the provision of brokerage on the foreign exchange and Eurocurrency markets in London, it was perhaps not unnatural for the FEC, acting on behalf of the banks, to demand something in return. What it obtained was the reaffirmation of a rule stopping brokers from passing either corporate names, or the names of banks overseas, on the London markets.53 Under this rule, companies were prevented from using brokers to shop around for the best deals in London, whereas brokers were barred from facilitating arbitrage deals between banks in London and abroad. This did little to ensure that the London foreign exchange market always quoted the best terms and the finest prices. The partial insulation of the market by exchange controls (authorised dealers had a largely captive domestic customer base) served to limit any business loss suffered as a result of London’s anti-competitive rules, and this helped to extend the latter’s life span. Indeed, it was only after the abolition of exchange controls, at the end of the 1970s, that these restrictive practices were finally placed on the bonfire of deregulation. Changes in market practices When the FECDBA was established in 1967, its members would have been obliged to work only a five-day week. It had not always been so. Prior to 26 September 1964, the market had been open on Saturdays. The move away from a six-day week had started on the Continent, and it was only after all of its European rivals had taken this step (the Swiss market was the last to act) that the decision was taken to follow suit. There was not much agonising over this decision. As The Banker noted, ‘Since the Swiss market went over to five-day working at the beginning of July, the volume of Saturday business in London has dwindled to almost nothing’.54 At this time, there was something else that dealers and brokers also would have been pleased to see the back of. This was the old pound that was divided into 20 shillings each of 12 pence. Converting the old pound into other (decimal) currencies was a tedious process, given that after the adoption of decimalisation in South Africa in February 1961 (when its pound was replaced by the rand), in Australia in February 1966 (when its pound was replaced by the Australian dollar), and in New Zealand in July 1967 (when its pound was replaced by the New Zealand dollar), Britain was left as the only significant country with a non-decimal currency. In 1960, Evitt advised those intending to take up foreign exchange trading that, ‘A thorough, almost an automatic, knowledge of the decimal system is…essential, as is an ability quickly and accurately to convert…shillings and pence into decimals of one pound, and vice-versa’.55 Britain’s conversion to a decimal currency, on 15 February 1971, at least spared dealers from having to engage in this

The foreign exchange market of London

122

bothersome exercise. Even before decimalisation, the process of undertaking foreign exchange calculations had been speeded up by the introduction of computers and electronic calculators. Computers, mainly the ubiquitous IBM 360, began to be introduced into banks during the 1960s. Mainframe computers were used initially to process customer accounts and general ledger data, and were not generally dedicated to serving the needs of foreign exchange departments. However, by the end of the 1960s, some banks were using computers both to record and revalue their foreign exchange positions.56 Mechanical calculators had been in use since before the First World War, but these were slow and cumbersome in comparison with the newfangled electronic calculators. Whereas a simple division on the former took approximately 30 seconds, it was performed in a fraction of that time on an electronic calculator. Speedier calculations, in conjunction with improved telecommunications, served to expedite overseas arbitrage transactions and to all but eliminate variances in spot quotations between London and centres abroad.57 The telex made a significant contribution to the improved communications between London and other foreign exchange markets. This service had been pioneered in the 1930s, but it only came into widespread use after the Second World War. The telex allows users to exchange written messages employing teleprinters connected to the public telephone exchange. It possesses many advantages as a means of communication over the cable, or telegram, being not only more convenient (teleprinters can be located within dealing rooms), but also cheaper and faster (messages are relayed almost in an instance rather than in minutes). Following the re-opening of the London market in 1951, these attributes ensured that the (tested) telex increasingly took over the traditional role of the cable for issuing and confirming dealing instructions with banks abroad. However, the telex also was used in another and more unique way. The location of teleprinters in dealing rooms and the speed with which messages were sent allowed the telex to be used as a conversational medium. Dealers could ‘chat’ with one another via telex messages, and this provided London dealers with indirect access to the tittle-tattle that their counterparts on the Continent picked up during the daily bourse sessions that were held, up until the mid-1980s, in many European centres. Ever since the closure of the Royal Exchange in 1920, London dealers had lacked a formal meeting place where they could discuss trends and swap gossip. In the pre-online information age, some felt that this kept traders in the City less well informed than their opposite numbers on the Continent. Direct contact between dealers working for different organisations was limited mainly to irregular meetings in pubs and wine bars. For instance, it was not unheard of, during the 1960s, for the chief traders of the leading banks to meet from time to time to discuss the prospects for sterling over a long liquid lunch. Coates Wine Bar in Old Broad Street was a popular venue for such gatherings. However, one quasi-official forum did exist for London foreign exchange dealers. In 1955, the Association Cambiste International (ACI) had been founded in Paris and— partly due to the efforts of Roy Bridge—a London branch of this umbrella organisation had been opened in 1956.58 The ACI (apart from fulfilling an important educational role) arranged both international and local gatherings for dealers, and these at least afforded

Regaining lost ground 1951–72

123

London dealers with the opportunity, albeit only on an occasional basis, to have direct contact and discussions with their counterparts from other banks in Britain and abroad. Even today, the annual meeting of the ACI—which nowadays also is described as the Financial Markets Association—counts as the main social event in the foreign exchange market’s diary. When the ACI met in 1972, its British based members would have been able to look back on a period of rapid growth, during which the London market had recaptured much of the ground that it had surrendered during and immediately after the Second World War. By 1972, it was challenging New York, Frankfurt and Zurich for the title of the world’s biggest foreign exchange centre. Some were convinced that London had already reclaimed that position. In its February 1972 edition, The Banker exclaimed, ‘London houses the biggest foreign exchange market in the world’.59 Given that The Banker was not alone in claiming the top spot for London, it may seem churlish to even question its opinion. However, early data on foreign exchange market turnover paint a rather different picture. In 1980, the Group of Thirty, a private think tank, published a report that included earlier foreign exchange turnover estimates (provided by national central banks) for four European centres.60 These figures need to be taken with a pinch of salt because, as admitted by the authors, ‘The official estimates…are no more than approximations…’.61 But for what it is worth, the reported data showed average daily turnover, for 1973, at $19−20 billion for Frankfurt, $5−6 billion for Zurich, $4−5 billion for London and $1 billion for Paris. Turnover data are extremely sensitive to the time when they are gathered and it may well be that the high total estimated for Frankfurt was exaggerated, in 1973, by the intense speculative activity in the German mark at that time. However, two other factors suggest that, in the early 1970s, London’s relative position may not have been too far away from that suggested by early survey data. In the first place, at that time, it was common for big dollar deals to be held back in London until the afternoon, or until they could be covered in the liquid New York market (such behaviour was hardly consistent with London’s alleged leadership role). In the second place, London would have benefited less than Frankfurt or Zurich from the upsurge in international demand for the German mark and Swiss franc that characterised this period. There is probably insufficient evidence either to definitively reject, or support, contemporary claims of London being—by the early 1970s—the top ranking foreign exchange centre. However, even if its ranking was unclear in 1972–73, events soon were to lift it into a position of undisputed dominance. During the rest of the decade, the London market benefited from the further rapid growth in international capital flows and the continued expansion in the Euromarkets. And at the end of 1979, its advance was further accelerated by the sudden abolition of British exchange controls. London’s share of global foreign exchange activity manifestly exceeded that of other centres by the end of the decade, and its dominance was to become even more pronounced over the remaining years of the twentieth century.

7 Innovation and deregulation 1972–86 A whirlwind of change swept through the London foreign exchange market in the decade or so that followed Britain’s adoption of a floating exchange rate in June 1972. Within nine months of sterling’s departure from its IMF parity, the creaking Bretton Woods system of fixed exchange rates finally collapsed and was replaced by a generalised regime of floating exchange rates. Floating exchange rates were introduced at a time of great economic instability and uncertainty, and this gave rise to bouts of exchange rate volatility that were every bit as intense as those that had been experienced during the 1930s, or the last time when floating had been the norm. In the early 1970s, dealers had little or no experience of working with floating exchange rates. However, they were soon made aware of the risks of trading in the new environment. In 1974, big foreign exchange losses were announced by a string of banks in Europe and the United States. In one or two cases, the losses were severe enough to bring down the banks concerned. While none of these trading debacles took place in London, the fall-out from them affected foreign exchange dealers throughout the world. High and variable inflation, during the 1970s, inspired the creation of new financial instruments aimed at protecting operators from the resulting instability in interest rates and exchange rates. This trend started in the United States, but spread to Britain by the early 1980s, with the commencement of trading in London in financial futures and options. Much of the financial innovation, which involved the creation of mathematically complex products, was enabled by an accompanying revolution in computer technology and telecommunications. London foreign exchange traders were confronted by a revolution of another kind at the end of the 1970s. This was the election of a Conservative government committed to deregulation and private sector enterprise. Within six months of assuming office, the Thatcher government stunned the City by scrapping the exchange controls that had shackled the exchange market since the start of the Second World War. The newfound freedom of UK residents to freely buy foreign exchange contributed to the rising tide of business undertaken in the City’s dealing rooms. In turn, this allowed London to lay undisputed claim to the title as the world’s biggest foreign exchange centre. From Bretton Woods to the Plaza Hotel There was little hint during the early days of sterling’s float of the frequent storms that were to beset the foreign exchange markets over the next two decades. Sterling depreciated by 10 per cent over the second half of 1972, but other currencies were surprisingly stable during this period. The calm did not last for long. Worries about a sharp deterioration in the US current account balance gripped the markets in the opening

Innovation and deregulation 1972–86

125

days of 1973, and persuaded operators to bale out of the US dollar and to step up their holdings of the Swiss franc, the German mark and the Japanese yen. Strong buying pressure forced the Swiss authorities to float their currency in January 1973. This move served to exacerbate an already tense situation, by giving rise to speculation that other currencies soon would follow suit. The dollar came under further attack and, following a crisis meeting of finance ministers, a last-ditch attempt was made to salvage the old order with a 10 per cent devaluation of the US currency on 13 February 1973.1 However, neither Japan nor Italy were prepared to play by the old rules (both countries floated their currencies), and the fact that the dollar soon fell to the bottom of its new parity bands, against those currencies still observing fixed rates, indicated that any remaining confidence in the Bretton Woods system had by now evaporated. The foreign exchange markets were closed on 1 March, and when they re-opened later in the month all of the leading currencies were set free to float. There was only one exception to this general rule. Bilateral parities and intervention margins continued to be maintained between the currencies of the remaining members of the European currency snake (Belgium, France, Germany, Denmark, Luxembourg and the Netherlands).2 On 12 March, as the snake currencies entered into their joint float against the US dollar, there were hopes that this arrangement would serve as an ‘islet of stability’ in the brave new world of floating exchange rates.3 However, the German decision to revalue the mark by 3 per cent before the launch of the joint float served as a forbidding omen of the problems that Europe would face, in the future, in aspiring to regional currency stability in the absence either of policy coordination or economic convergence. Between 1973 and 1985, the foreign exchange markets had to respond to two oil price shocks, to petro-dollar recycling, to the replacement of soaring inflation by rapid disinflation, to political upsets on both sides of the Atlantic, and to a sea change in US and British economic policies during the early 1980s. Events such as these kept foreign exchange traders on their toes although, even during these turbulent years, there were brief periods of relative calm with low exchange rate volatility. The opening months of floating, however, were anything but tranquil. Continued worries about the US current account position caused the dollar to fall sharply up until the outbreak of war in the Middle East in October 1973. Between March and October, it dropped from DM2.8360 to DM2.4133 against the German mark. This decline, however, was followed by a sharp four-month rally when the dollar recouped virtually all of its previous losses. Sentiment was improved both by the publication of better US trade figures and by the perception that, by being able to satisfy part of its own oil requirements, the United States would be less affected than the other industrial nations, by the oil price explosion that followed the conflict in the Middle East. This view changed during the course of 1974, as rising oil imports weakened the US current account. The Watergate saga (which culminated in the resignation of President Nixon in August 1974), also dented demand for the dollar, which fell to a new low of DM2.2767, by early 1975. The next couple of years, however, proved to be rather kinder to the US currency. The 1974–75 recession curbed import demand and propelled the US current account into sizeable surplus. This helped to lift the dollar off its lows, and so too did the inclination of the oil-producing countries to invest a disproportionate share of their external surpluses in dollar denominated assets. The dollar exhibited a modicum of

The foreign exchange market of London

126

strength between March 1975 and September 1977, a period in which it also became less volatile. Sterling did not share the same luck. Between 1975 and 1976, it fell steeply in response to lax domestic economic policies, soaring inflation and a yawning current account deficit. However, the extent of its decline was not always apparent to those whose eyes were glued to the widely publicised US dollar/sterling rate. In a world of floating exchange rates, the behaviour of cable no longer provided accurate information about the overall performance of sterling on the currency markets. For instance, between March 1973 and February 1975, sterling had exhibited only a modest decline from $2.4900 to $2.42932. During that period, however, the dollar had fallen sharply against most of the continental European currencies and the yen, and because sterling was unable even to hold its ground against the US currency, it had actually posted a bigger drop than the latter against the other leading currencies. The problem of accurately measuring changes in sterling’s value in a world of floating exchange rates was quickly tackled by the Bank of England, which developed a tradeweighted index of sterling’s movement against a basket of other important currencies. However, the fact that this ‘effective rate index’ (ERI) could not be bought or sold on the currency markets made it hard for the authorities to persuade either the press, or the public, to switch their attention from the highly visible US dollar/sterling rate. Between February 1975 and February 1976, sterling fell from $2.4292 to $2.0292. This sharp decline, however, was matched by a less pronounced depreciation in sterling’s effective rate index because, over the same period, the other European currencies and the yen also lost ground to the dollar, albeit at a somewhat slower pace than sterling. The steady depreciation in sterling’s ERI was not unwelcome in official circles, where it was regarded as an inevitable consequence of Britain’s high inflation rate. Two events soon gave dealers good reason to believe that the authorities were keen to see sterling fall even lower. On 4 March 1976, the Bank of England entered the foreign exchange market as a seller of sterling, whereas on 5 March, the Bank cut its Minimum Lending Rate (MLR) from 9.25 to 9 per cent. These actions set alarm bells ringing in the markets, although it is not entirely clear that they were undertaken to deliberately hobble the pound. There is some evidence to suggest that the Bank’s sales of sterling were conducted on behalf of the Nigerian authorities, and that the cut in MLR was made purely for domestic reasons.4 However, it is perceptions that count and within a week of the events of 4–5 March, sterling broke below $1 for the first time to reach a new record low of $1.91. That turned out to be just a brief resting place and, over the next seven months, the effective depreciation of sterling (its slide against the US dollar was matched by comparable falls against the other leading currencies) gathered such momentum, that the British government was forced to undertake conditional borrowing from the IMF in order to stop the rot.5 By the end of October, sterling was standing at $1.5350. Its earlier depreciation had been induced both by Britain’s weak economic fundamentals and by a raft of unsettling political and economic news. The latter had included the unexpected resignation of Prime Minister Harold Wilson on 16 March, the outbreak of labour unrest in September and the publication, on 25 October, of a Sunday Times article suggesting that the IMF would require a drop in the exchange rate to $1.50, as a condition for

Innovation and deregulation 1972–86

127

sanctioning a $3.9 billion standby loan.6 Sterling’s descent in 1976 was marked by moments of high drama. Steep intra-day falls were far from uncommon. For instance, sterling plunged by over 5 US cents during the first hour of trading on 8 March, and by US cents during the morning of 28 September (a move that persuaded Chancellor of the Exchequer Denis Healey famously to turn his car around at Heathrow airport and abort a trip to the Commonwealth Finance Minister’s meeting in Hong Kong). Britain eventually secured its IMF loan at the end of December, on terms that required fiscal and monetary restraint, but not the exchange rate target that had been rumoured by the Sunday Times. However, it had become clear two months beforehand that the Labour government would agree terms with the IMF, and sterling’s recovery had started from that time. Between the end of October and the end of December, sterling climbed from $1.5860 to $1.7030 against the US dollar, and from DM3.8062 to DM4.0162 against the German mark. Sterling’s earlier fall had taken it down to a manifestly undervalued level, and operators wasted little time in buying the ‘cheap’ pound to benefit from relatively high UK interest rates, once confidence had been restored in British domestic economic policies. This forced the Bank of England to change its tack in the currency markets. During 1976, the Bank had bought sterling in a vain attempt to arrest its decline. However, by early 1977, it began selling sterling for dollars, in order to replenish its depleted exchange reserves, and to prevent the desired improvement on current account from being jeopardised by excessive currency appreciation. Intervention held the pound just below $1.72 until mid-year, but as the US dollar started to weaken the Bank raised its intervention target slightly in July, to just above $1.74, in order to keep sterling stable in terms of its effective rate index. However, further dollar weakness forced the Bank to intervene on an increasingly grander scale just to keep sterling at $1.74. Such intervention soon resulted in an unwanted acceleration in UK money supply growth, and eventually this persuaded the Bank to withdraw from the market. Sterling closed the year at $1.9185. Benign neglect of dollar During the trials and tribulations of sterling, the British authorities had had little compunction about intervening to influence the behaviour of the exchange rate. The US authorities, in contrast, had a natural disinclination to operate in the exchange markets. Their attitude was shaped by both practical and theoretical considerations. The closed nature of the US economy (external trade accounted for a much smaller share of GDP in the United States than in the other industrial countries) served to significantly dilute the effect of gyrations in the dollar on domestic prices and employment. This diminished the sensitivity of US policy makers to the fortunes of the dollar, and the belief that, if left alone, it would ultimately find its right level on the currency markets also contributed to their preference for a policy of benign neglect towards the dollar (see Figure 7.1). When currencies started to float, the US authorities believed that any overshooting in

The foreign exchange market of London

128

exchange rates would be soon corrected by countervailing speculation. Undervalued currencies would be bought, and overvalued currencies would be sold, by profit seeking operators. In the event, behaviour in the markets did not quite conform to this idealistic model. Significant currency movements all too readily excited extrapolative expectations of further changes in the same direction. Traders came to trust the adage ‘the trend is your friend’, and devotees of technical analysis, or chartism, became a more powerful force in currency trading. In these circumstances, some form of policy action often was required to break an exaggerated trend in a currency. This point was underlined, in 1977–78, when the dollar fell out of bed. Between October 1977 and October 1978, the dollar fell from DM2.2537 to DM1.7395 against the German mark (the US dollar/sterling rate moved from $1.8396 to $2.0750 over the same period). The primary cause of the dollar’s plight was the weakness in the US current account promoted by relatively strong domestic demand. However, as noted by the BIS, ‘The crisis was essentially one of confidence…[what] was missing was an indication from the US authorities of their will to stem the dollar’s decline in the most direct way possible, by intervening in the exchange markets…’.7 It was only after the slide by the dollar threatened to imperil relations between the United States and the other industrial relations that the Carter administration abandoned its laissez-faire approach and took decisive measures to rescue its beleaguered currency. In November 1978, it embarked on an ambitious programme of foreign currency borrowing to finance direct intervention on the foreign exchange markets, whereas the Fed raised its discount rate by 1 percentage point with the avowed aim of supporting the dollar. These measures did the trick, and between October 1978 and May 1979 the dollar rallied strongly, from DM1.7395 to DM1.9076.

Innovation and deregulation 1972–86

129

Figure 7.1 Floating freely 1972–85 (source of data: Citibank).

Death of the snake During the dollar’s rally an important institutional change took place in Europe involving

The foreign exchange market of London

130

the replacement, on 13 March 1979, of the accident-prone currency snake by the European Monetary System (EMS). The snake patently had failed to serve, as its creators had hoped, as a safe refuge for the European currencies. Between 1973 and 1979, realignments involving one or more of the member currencies had taken place on nine separate occasions. That was not all. Britain and Italy left the snake within a year of its inception, whereas France, Denmark and the two associate members (Norway and Sweden) made either temporary or permanent exits.8 Of the last four, only Denmark was still an active member when, in an act of mercy, the EEC put the snake to the sword. The snake suffered from two key structural faults. The first was that there was no compulsion on the member countries to coordinate their policies. The second was that, in the absence of an effective alternative, the German mark served as the de facto anchor of the system. This last feature proved to be highly destructive because, whenever the US dollar was weak, demand tended to rise much faster for the fancied mark than for the other snake currencies, thereby exerting pressure on cross-exchange rate relationships within the snake. The Exchange Rate Mechanism (ERM) of the EMS sought to overcome this flaw by giving the European Currency Unit (ECU), a weighted basket containing all of the EEC currencies, an important role in the new arrangement.9 However, despite this move, the ERM still proved to be dominated by the German mark and, at least until the mid-1990s, it turned out to be no more of an oasis of stability than its predecessor. Britain alone of the then nine EEC countries chose not to join the EMS at the outset (a decision that served to break the historical 1:1 link between the Irish pound and sterling). This probably did the other countries a favour, because over the next couple of years sterling uncharacteristically became one of the best performing international currencies. Its popularity was boosted both by the election of a Conservative government committed to free enter-prise and to tough anti-inflation policies, and by the coincidence of booming North Sea oil production with soaring oil prices. Sterling posted across the board gains, and in terms of the US dollar it climbed to $2.4365 in October 1980, from the $0.0690 level at which it was standing in May 1979, when Mrs (now Lady) Thatcher first became Prime Minister. Sterling, however, was not to hold centre stage for long. The election of Ronald Reagan as US President, in November 1980, set the stage for one of the most spectacular gravity defying acts of the post-Bretton Woods era. Between the end of November 1980 and February 1985, the dollar soared almost without interruption from DM1.9620 to DM3.3425. The dollar’s strength proved even too much for sterling, which, from its high in October 1980, tumbled to within a whisker of parity (touching just below $1.04) in February 1985. Various factors contributed to the dollar’s surge. However, the dominant influence was the combination of lax fiscal policy and tight monetary policy adopted by the US authorities during the first half of the 1980s. Easy fiscal policies helped to propel the US economy into a rapid recovery from the double-dip recession of 1980–82, whereas tight monetary policies secured a sharp deceleration in inflation and an associated improvement in real returns on US assets. These factors boosted the dollar, and so too did the perception that the US economy—thanks to the pro-business policies of the Reagan administration—offered more profitable opportunities for investment than the hidebound

Innovation and deregulation 1972–86

131

economies of continental Europe and Japan. Those buying the dollar did so without fear of intervention from the US authorities. The proactive exchange rate policy that had been belatedly embraced during the Carter era was jettisoned by the new administration within weeks of taking office.10 Exchange rate intervention was to be forsaken and the dollar was to be allowed to find its own level. Dollar strength was regarded as a proud emblem of America’s economic success, whereas the accompanying deterioration on current account (a $9 billion surplus in 1981 was replaced by a $122 billion deficit by 1985) was dismissed as a matter of little consequence. However, by the mid-1980s, the grossly overvalued dollar was beginning to exact a heavy toll on US manufacturing industry, and mounting complaints from this sector eventually elicited a shift in Washington’s thinking on the exchange rate. Legend has it that this shift took place during the 22 September 1985 Group of Five meeting, at the Plaza Hotel in New York, which was attended by the finance ministers of the United States, Japan, Germany, France and Britain. In fact, it had occurred several months beforehand. It was at an earlier Group of Five meeting, on 17 January 1985, that the Reagan administration had first signalled its willingness to enter the exchange markets to wing the high-flying dollar. During this meeting, US Treasury Secretary Donald Regan had joined the other finance ministers in expressing a ‘commitment to work towards greater exchange market stability’.11 These words were quickly followed up by deeds. Over the next six weeks, the central banks of the biggest industrial nations engaged in heavy coordinated intervention to weaken the dollar. Central bank sales of dollars during this period amounted to $10 billion, with the US Fed’s contribution being an admittedly modest $700 million.12 Even though the Fed was only a minor player in this exercise, what really mattered was that it was involved at all. Intervention, along with a domestically driven cut in US interest rates, in May 1985, induced a sharp drop in the dollar. Between the end of February and the end of July, it fell from DM3.3425 to DM2.8055 against the German mark, and from $1.0800 to $1.4085 against sterling. However, the US currency showed signs of rallying during the late summer and it was this development along with the need to counter protectionist sentiment in the United States that led to the Plaza declaration in favour of ‘some further orderly appreciation of the main non-dollar currencies against the dollar’.13 Subsequent heavy intervention (of which the United States accounted for almost 25 per cent) induced a renewed fall in the dollar, which closed the year at DM2.4455 against the German mark, and at $1.4455 against sterling. Profits and risks with floating The period between 1972 and 1985 was a generally happy time for foreign exchange dealers. The widespread adoption of floating exchange rates not only stimulated the demand for forward cover from companies seeking to protect themselves from volatile exchange rate movements, but also increased the opportunities for successful proprietary trading. The foreign exchange market displayed two features during this era that appealed

The foreign exchange market of London

132

to dealers. One was the existence of pronounced trends involving a number of important currencies. The other was the existence of significant intra-day currency fluctuations that provided trading opportunities even for those dealers who were obliged, by internal rules, to close out their currency positions at the end of each working day. Short-term volatility was especially high between 1973 and 1974, and 1982 and 1985.14 High intra-day volatility presented dealers with opportunities, but it also exposed them to risks. Some banks found this out the hard way during the first of these two periods. Bank’s had suffered noteworthy foreign exchange losses during the Bretton Woods era, but these mishaps had been few and far between, partly due to the modus operandi of the market under fixed rates. Foreign exchange trading is a zero-sum game. If one dealer makes a profit trading foreign exchange, another dealer or dealers will have to have made a loss. Under fixed exchange rates, however, it will be possible for all dealers to make profits if the offsetting losses are absorbed by central banks. This commonly will happen when dealers are betting on a realignment of a fixed exchange rate. Central bank support for a currency with a fixed exchange rate tends to be the greatest when it is at its parity floor or ceiling. However, this is exactly the same time that dealers will have the greatest incentive to go short/long of a currency, given the windfall gains that will ensue in the event of a parity change. If such a change does take place, and central banks have been the only counterparties on the other side of the market’s sales/purchases of a currency, the offset to the profits garnered by dealers will be the losses incurred by central banks. Banks, in fact, had done rather well out of currency realignments during the Bretton Woods era. In turn, this had encouraged senior managers to set more ambitious profit targets for foreign exchange trading, and towards this end they had allowed their dealing rooms to run ever larger open positions.15 Exchange controls had limited this process in Britain, but banks in many other countries had been less well constrained. The altered characteristics of the exchange market after February 1973—including the diminished likelihood of central bank intervention and the increased prospect of intra-day currency volatility—ought to have made banks more risk conscious, but some acted in the opposite way as they sought to exploit to the full the greater trading opportunities presented by floating exchange rates. The chickens came home to roost in 1974. A combination of aggressive position taking (especially in the forward market), and lax internal controls that failed to detect irregular and/or fraudulent trades, caused a string of banks in continental Europe and the United States to suffer big foreign exchange trading losses. Included on this roll call were the Union Bank of Switzerland (with an estimated loss of $150 million); Westdeutsche Landesbank Girozentrale $108 million; Lloyds Bank International, Lugano Branch ($76 million); Franklin National ($46 million); and I.D.Herstatt, a mediumsized German private bank $160 million.16 These losses caused bank regulators and bank managers around the world to tighten foreign exchange dealing limits and to improve internal audit controls. However, it took time for confidence to be rebuilt and, from mid-1974 onwards, fear replaced avarice as the driving force on the global foreign exchange markets. This resulted in a sharp drop both in inter-bank trading and in total turnover. The slowdown lasted well into 1975,

Innovation and deregulation 1972–86

133

but—thanks to the absence of any further trading disasters—confidence began to improve and, by 1976, foreign exchange activity had rediscovered its earlier strong upward momentum. None of the publicised foreign exchange losses were booked in London, but even so the Bank of England felt compelled, in December 1974, to issue a circular to British banks reminding them to make sure that their own houses were in order.17 It did so partly because one of the mishaps (at Lloyds branch in Lugano) occurred at an overseas branch of a British owned bank, and partly because the exchange control limits imposed on the foreign exchange exposures of banks operating in London did not provide foolproof protection against reckless behaviour (if only because they did not apply directly to trades between two non-sterling currencies). In its circular, the Bank noted that the losses had taken place in an environment where, ‘Some general managements seem to have placed their dealers in an exposed position by looking well beyond the service element of the dealing function and imposing ambitious profit targets on them’.18 It then went on to remind banks of some good housekeeping rules, including adopting spot checks on dealing activities between regular audits, and banning dealers from issuing and receiving confirmations of foreign exchange trades (leaving this activity to a separate back-office function). Most of the banks involved in the dealing debacles of 1974 survived with their reputations tarnished but with their businesses intact. Two, however, did not. Franklin National, which was not just hobbled by foreign exchange losses, was declared to be insolvent (it was subsequently bought by European American Bank and Trust). And Herstatt was sent into oblivion by its losses. The manner of its demise, however, was to make this Cologne based bank one of the most notorious players ever to have participated on the global foreign exchange market. On 26 June 1974, the Bundesbank shut down Herstatt at 4.30 pm local time, or after the Frankfurt clearing system had closed for the day, but while the New York clearing still was open. The timing of the bankruptcy meant that the German mark side of Herstatt’s German mark/US dollar deals were settled, but the US dollar side was not. The total value of these unsettled trades was £380 million.19 Counterparties involved in these transactions, including some in London, initially had to write-off the full amount, although their losses were eventually pared by funds realised during the subsequent bankruptcy proceedings.20 The manner of these losses would prey on the minds of those managing foreign exchange dealing rooms for many years to come. Settlement risk—which after 1974 also became known as Herstatt risk—rose to the top of their worry list, and measures aimed at diminishing it were given close attention. One of the earliest solutions was to reduce the amount of money exposed to settlement risk through bilateral netting, a procedure agreed between two banks to match deals between themselves and only to settle any net balance at the end of the day. Subsequently, more ambitious arrangements involving multilateral netting were to come into play, but—as will be outlined in the next chapter—it took until the beginning of the twenty-first century for a definitive solution to be found to the problems highlighted by the failure of I.D.Herstatt.

The foreign exchange market of London

134

Demise of exchange controls That London based banks were not directly embroiled in the dealing debacles of 1974 can be attributed to a combination of luck, satisfactory internal procedures and the limits imposed on open positions (at least involving sterling) by exchange controls. At that time, few would have believed that these controls soon were to be consigned to the dustbin of history. Yet that is exactly what happened on 23 October 1979. Exchange controls were still very much a part of the British financial furniture in the mid-1970s. Indeed, two years before the Herstatt affair there had been a dramatic extension in their coverage. When the pound was allowed to float on 23 June 1972, virtually all the other members of the sterling area decided to sever their exchange rate links with sterling. This, in turn, persuaded the British authorities to redefine the Scheduled Territories to include only the United Kingdom, the Channel Islands, the Isle of Man, the Republic of Ireland and Gibraltar.21 Those countries evicted from the sterling area henceforth were regarded in the same way as other foreign countries and transactions with them were subject to the full force of British exchange controls. This applied especially to transactions on capital account. Not that this elicited any complaint from those British investors lucky enough to be holding securities payable in the currencies of the evicted countries, because the sterling value of these securities rose overnight as they became eligible for sale in the investment currency market, where they attracted the investment currency premium.22 During the sterling crisis of 1976, exchange controls were tightened a further notch (when a ban was imposed on the use of sterling finance for third country trade), but the subsequent improvement in the fortunes of the British currency led to a slight relaxation in the reins.23 The most important of these concessions was the abolition, on 1 January 1978, of the unpopular 25 per cent surrender rule in the investment currency market. Since its introduction in April 1965, this rule had resulted in the transfer of over £1.7 billion of foreign exchange from the investment currency market to the official market.24 Further relaxations—including the automatic clearance of foreign direct investments of up to £5 million—were sanctioned by the incoming Conservative government in the June 1979 Budget. However, pressure already was building within the government for abolition and, in conjunction with the underlying strength of sterling, this persuaded Chancellor of the Exchequer Geoffrey Howe to make his historic, and totally unexpected, announcement on 23 October. The abolition of exchange controls meant that for the first time since 2 September 1939, UK residents were granted the unrestricted right to buy and sell foreign exchange. Under exchange controls, approval to transact in the official exchange market had been readily given for current account transactions, whereas a fairly liberal approach had been taken towards sanctioning the use of this market for covering foreign direct investment. The main burden of the controls had fallen on portfolio investment and banking transactions. It is unsurprising, therefore, that it was through these two channels that the London foreign exchange market benefited the most from abolition. Within a couple of years of this move, the foreign currency deposits held by the UK private sector (mostly companies

Innovation and deregulation 1972–86

135

and financial institutions) had increased by the equivalent of £5 billion.25 An even bigger boost to foreign exchange market turnover was provided by the increased demand of British investors for overseas securities. The freedom of UK institutional investors to buy foreign securities without either paying the investment currency premium (which was eliminated with the lifting of exchange controls) or borrowing foreign exchange resulted in a step change in their portfolio preferences. Most sought to spread their risks by giving a higher asset allocation to foreign securities. Between 1978 and 1985, the overseas assets held by UK pension funds, insurance companies, investment trusts and unit trusts soared from £10.4 billion (7.8 per cent of their total assets) to £77.3 billion (16.4 per cent).26 Abolition of exchange controls was widely applauded in the City, although not everyone had cause to join in the celebrations. A whole cadre of City workers saw their jobs disappear overnight. In the Bank of England, an entire department employing 750 people was shut down.27 Exchange control departments in authorised banks shared the same fate. Many of the older workers took early retirement, but for the majority it was a matter of seeking alternative work in the City, or trying their luck elsewhere. Abolition also had a bearing on the structure of the London foreign exchange market. Under the 1947 Exchange Control Act, only banks anointed by the Bank of England as authorised dealers had been allowed to act as principals in the market. Those so appointed served as agents of the Bank of England in enforcing exchange controls. However, both the right of, and the need for, the Bank to confer this status passed with the removal of the 1947 Act from the statute book. Henceforth, entry was open to any institution that was able to negotiate dealing lines with established players. In the event, there was only a modest shift in the composition of those serving as principals in London. The main newcomers were some of the bigger US investment houses, who operated outside of the Bank of England’s ambit, and a scattering of multinational companies (the latter having set up in-house banks to handle their own treasury activities). The Bank of England had an important supervisory role over banks operating in the United Kingdom, which—in the wake of the secondary banking crisis of the mid1970s—had been codified and strengthened by the 1979 Banking Act.28 Hitherto, the Bank had relied heavily on exchange controls to exercise prudential supervision over the activities of banks engaged in the foreign exchange market. The abolition of these controls, therefore, placed the Bank in a bit of a pickle and, on the day of their removal, the Governor was obliged to write to the banks urging them to hold the line until new arrangements could be put in place.29 Following a lengthy round of discussions, the Bank eventually published its new provisions in April 1981.30 They established new limits on open positions that were set in relation to a bank’s adjusted capital base. A bank was allowed to maintain a net open dealing position in any one currency of up to 10 per cent of its adjusted capital base, and a net short open dealing position in all currencies taken together of up to 15 per cent of its adjusted capital base. Monthly returns were required of London based banks to ensure compliance with these rules. The limits imposed by the Bank were set as maxima, and senior managers within banks were free to establish tighter rules. Indeed, the Bank actually urged banks that were inexperienced in foreign exchange dealing to operate with more conservative guidelines.

The foreign exchange market of London

136

The new rules provided greater leeway than the old ones for banks to take position against sterling, but exerted greater formal control over positions taken in all foreign currencies (previously these had to be reported monthly to the Bank, but they were not subject to a formal official limit). Technology facilitates expansion The abolition of exchange controls contributed to the dramatic increase that took place in foreign exchange dealings during the 1980s. That the market was able to take this increased workload in its stride was due in no little part to the technological revolution that characterised this period. Online information systems, personal computers, computer based trading systems and data transmission services transformed the operating procedures of the market. Changes had taken place in the past but, even in the early 1970s, the way in which the market conducted its business would have been fairly familiar to a trader from the 1920s. The same would not have been true fifteen years later. The first innovation to hit the market was the Reuters Monitor service launched in 1973.31 Delivered through dedicated computer terminals it provided online quotations of money market and foreign exchange rates contributed by subscribing banks and brokers. Previously, such information had been obtained by telephone and telex as well as from Teletype services, but with the advent of floating rates the need arose for a more instant way of retrieving financial market prices. This was provided by the Monitor service, the launch of which could not have been better timed, because it coincided with a period of extreme turbulence that made speedy price discovery all the more important. Reuter terminals soon became a common fixture not only in banks’ dealing rooms and brokers’ offices, but also in the offices of corporate treasurers. This allowed companies to become better informed about dealing rates and, in turn, this helped them to exact finer foreign exchange quotes from their own banks. The Monitor service, which was improved in 1975 with the addition of a news retrieval facility, operated without a competitor until the introduction, at the end of the decade, of the Telerate service in Britain. This too supplied online price data, but (at least at that time) in a more sophisticated format than the former.32 Computer terminals also began to appear in dealing rooms during the 1970s. Big banks had employed mainframe computers to provide operational support for their dealing activities by the late 1960s. These machines, which sat outside of dealing rooms, had been mostly used to generate management reports, covering such things as brokerages, open positions and profits. Mainframes, however, were expensive (so putting them out of reach for many of the smaller foreign branch banks operating in the London market) and also had to be shared (so forcing dealing rooms to compete with other departments for computer time). The minicomputers and microcomputers (i.e. home or personal computers) that were developed in the 1970s did not suffer from these drawbacks, and they soon entered into dealing rooms and the back offices supporting them.33 The introduction of this new technology helped banks to cope with the burden of processing an ever-rising volume of foreign exchange transactions. Apart from management reports, computers now were

Innovation and deregulation 1972–86

137

being used also to generate confirmations and payment instructions. However, there was one weak link in the production process. This was that primary information on transactions still had to be keyed into computers from handwritten dealing slips. However, it did not take long for the achievement of end-to-end automation. This was realised in the early 1980s with the introduction, by the London branch of Citibank, of its Cititrader foreign exchange system.34 The novel feature of this system, which comprised a network of Apple II microcomputers housed in dealers’ desks, was that it allowed dealers to directly input transactional data through the use of an electronic pen and a digitising tablet sited underneath each desktop. This resulted in a faster and less error prone way of recording deals. Subsequently, other banks in London adopted comparable trading systems. Innovations in information technology also transformed the ways in which participants in the foreign exchange market communicated with one another. Ever since the First World War, the telephone, the telegraph and, from the 1950s, also the telex had been the principal channels of communication between banks. All three channels were used to book deals (the telephone being especially favoured for this purpose), with the last two also being used both to confirm transactions and to provide payment instructions. The cable and telex, however, soon were to be usurped by SWIFT in fulfilling these last two functions. SWIFT, which stands for the Society for Worldwide Interbank Financial Telecommunications, was founded in 1973, by 239 banks located in 15 countries, to provide a safe and secure computer network for transmitting payment related messages.35 The key feature of SWIFT is that the messages transmitted across its network are sent in a standard format that is computer-readable. The requirement for messages to be strictly formatted is important because it serves to diminish the likelihood of misunderstandings and errors, whereas the fact that messages are received in computer-readable form is consequential because it means that they can be automatically forwarded to other computer networks. SWIFT first went live in 1977. Initially, its coverage was confined to Europe, but over the next five years the service was extended to North America, the Far East and the Middle East. By 1984, the number of member banks had grown to 1084, and the number of live countries to 39.36 The ability to interconnect from SWIFT to other networks facilitated the automatic processing of foreign exchange deals from initiation to settlement. The latter became possible with the development of automated domestic payment and settlement systems. In the United States, most international dollar payments are settled through the Clearing House Interbank Payment System, or CHIPS. This system was automated in the mid-1970s, but it was not until some years later that an automated system was developed in Britain to settle high value transactions. This took place, in February 1984, with the successful launch of CHAPS (or Clearing House Automated Payment System). Without the use of computer-based systems to process and settle foreign exchange transactions, banks would have struggled to cope with the massive upsurge in foreign exchange volumes that occurred during the 1980s. Technological improvements not only allowed more business to be booked, they also altered the way in which business was done. This even applied to the negotiation of foreign exchange trades. Previously, inter-

The foreign exchange market of London

138

bank deals had been arranged by telephone, cable or telex. However, in February 1981 a new medium became available. This was the Reuters Money Dealing service, which allowed dealers around the world to contact one another through a Reuters’ terminal. This service enabled dealers to initiate online conversations and, on a bilateral basis, to negotiate and sanction actual foreign exchange deals.37 A linked teleprinter provided hard copy of deals that were undertaken. The telephone had long held sway as the favoured medium for booking foreign exchange deals. It now faced a new challenger for this position. Derivatives make an entrance Technological innovation, apart from supporting the expansion of the traditional foreign exchange market, also facilitated the development of new financial products. The high and variable inflation of the 1970s increased the need for companies and investors for protection from the accompanying gyrations in interest rates and exchange rates. During the 1970s and early 1980s, new or additional hedging products were brought forth to deal with this problem. Some of these products were mathematically complex, and the ability of dealers both to trade and to refine these instruments owed much to the growing availability, the increasing power and the declining real cost of computers. Little of the product innovation that characterised this period took place in the City of London. Most of the new ideas originated in the United States. This may have had something to do with the size and vitality of the US financial markets. It may also have had something to do with the intensive research undertaken in US universities on the financial markets. Whatever the reasons, the genius of the City was not so much to innovate as it was to willingly import ideas that had been developed elsewhere. Financial futures were the first new instruments to come off the production line. In May 1972, the International Monetary Market (IMM) of the Chicago Mercantile Exchange started to trade seven currency futures con tracts.38 Interest rate futures followed shortly thereafter with the launch of the Chicago Board of Trade’s mortgage backed securities contract in October 1975, and the IMM’s 90 day US Treasury bill contract in January 1976. The first listed currency options were introduced on the Philadelphia Stock Exchange in December 1982. Around the same time, an over-thecounter (OTC) market was developed in currency options by banks in the United States and then in Europe.39 London had to wait until 30 September 1982 to catch up with developments on the other side of the Atlantic. It was on that day that the London International Financial Futures Exchange (LIFFE) opened its doors for business.40 The initial instruments traded on the LIFFE included four currency futures contracts (involving sterling, the German mark, the Swiss franc and the yen each against the US dollar). Three years later the LIFFE also made a foray into currency options. During the early 1980s, derivative instruments also made an entrance on the capital markets. One such instrument warrants a brief comment if only because of the need to distinguish it from a traditional instrument that had been a staple product of the foreign exchange markets since the 1920s. The derivative in question is the currency swap.

Innovation and deregulation 1972–86

139

A currency swap refers to, ‘…a transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay over time according to a predetermined rule which reflects both interest payments and amortisation of principal’.41 In contrast, a traditional swap: …involves the sale of one currency against another for one delivery date with a simultaneous agreement to reverse the transaction at a future date. In such transactions only the principal amounts are exchanged on the initial and again on the maturity dates, with no exchange of interest streams in the interim.42 The convention nowadays is to describe the traditional instrument as a foreign exchange swap in order to distinguish it from the upstart currency swap provided on the capital markets. Currency futures and options increased the array of hedging instruments available to companies and investors. However, whereas options provided a new technique for covering exposures, futures offered little that was not already available in the forward exchange market. In a currency futures contract, an operator enters into a binding agreement with a counterparty to buy or sell a fixed amount of currency at an agreed rate on a specified date in the future. Unlike forwards, which are dealt in on a discrete basis between two counterparties, futures contracts are traded on an organised exchange at publicly disclosed prices. The four currency futures contracts offered on the LIFFE in 1982 were quoted in US dollar units per one foreign currency unit and were for delivery on the second Wednesday of four delivery months (March, June, September and December). The contract sizes were small. For instance, the sterling contract was for only £25,000.43 Profits and losses on outstanding contracts were calculated daily with an appropriate adjustment being made to the margin required on each contract. Contracts were payable in cash on maturity, although the vast majority were closed out beforehand.44 In the United States, the currency futures market attracted early interest from individuals and small companies who found it difficult either to enter the forward exchange market, or to do so on attractive terms. Indeed, some individuals regarded speculating in currency futures as a worthwhile alternative to investing in the equity market. This retail demand did not exist in the United Kingdom. Years of exchange control had killed off any retail interest in currency trading, and those individuals wishing to play the currency markets invariably did so by buying and selling foreign shares and bonds (often indirectly via unit trusts). This perhaps was not a good omen for the market. Indeed, the problems currency futures would face in the United Kingdom had been foreseen long before the establishment of the LIFFE. Prior to the start of futures trading in the United States, Edmond de Rothschild had reminded the chairman of the Chicago Mercantile Exchange that the demand for futures trading in the major currencies was already well serviced and satisfied by the forward exchange market.45 Indeed, in catering to the needs of big companies and institutional investors (the natural customers for hedging products), the forward market possesses the following compelling advantages over the futures market: 1 There is no margin requirement on foreign exchange, and banks will normally trade

The foreign exchange market of London

140

forward exchange with their own corporate customers without seeking any collateral. 2 Forward exchange can be traded for longer maturities than currency futures. 3 Forward exchange can be bought and sold for negotiated maturity dates, whereas currency futures are subject to fixed maturity dates. 4 An exact amount of cover can be obtained in the forward market (say for £110,325), whereas only round amounts divisible by the unit size of the contract (say £100,000, or 4 contracts @ £25,000) can be covered on futures exchanges. 5 The low unit size of futures contracts (£25,000 on the LIFFE and £62,500 on the IMM for sterling against the US dollar) makes them inconvenient to use for large transactions. In view of these drawbacks, it is perhaps unsurprising that currency futures failed to take off in the United Kingdom. Whereas the short-term interest rate and long-term bond contracts launched on the LIFFE were a runaway success (no means previously had been available for covering interest exposures), the demand for its currency contracts weakened dramatically two years after their launch. The latter were to come to a sticky end in the following decade. Currency options, in contrast to currency futures, provided operators with an alternative way of hedging and this characteristic helped to underwrite their eventual success. A currency option contract conveys the right, but not the obligation, to buy or sell a given amount of currency at an agreed rate on or before a certain date. The buyer or holder of an option pays a premium of around 2 per cent of the value of the underlying contract to acquire this right. Options give companies greater flexibility in hedging their currency exposures. A key issue facing a company buying forward exchange cover is that many of its competitors may not have followed suit. This will put it at a competitive disadvantage when, for instance, it buys a currency forward that it expects to fall, and the currency in question fails to oblige and appreciates. In this situation, the hedged company will pay more for its foreign exchange than its unhedged rivals. A currency option overcomes this problem by allowing a company to hedge its downside risk, while at the same time giving it the right to benefit from a favourable exchange rate movement. The catch, of course, is that a not inconsequential premium has to be paid for this right. Speculators also have a liking for currency options, because they provide scope for a leveraged bet on exchange rate movements. Purchasers have to pay only a premium (not the full underlying value) and in-the-money options can be sold for a cash profit before maturity. From the mid-1980s onwards, trading in currency options (but not in currency futures) would become a worthwhile activity in London. Even so, turnover in options would never amount to more than a tiny fraction of turnover on the traditional foreign exchange market. Some of the banks that participated in the traditional foreign exchange market in London moved into derivatives by trading OTC options and by operating, via subsidiary companies, on the floor of the LIFFE. However, there were more than just institutional links between the traditional and the derivative markets, because significant arbitrage trading also took place between them. Despite these close links, the Bank for International Settlements (the main number cruncher on foreign exchange and derivatives turnover) decided, after initial hesitation, to

Innovation and deregulation 1972–86

141

count turnover in currency options and futures separately from turnover on the traditional foreign exchange market. Brokers under scrutiny The more enterprising foreign exchange and currency deposit brokers were quick to spot the opportunities presented by derivatives trading, and during the early 1980s they started to offer brokerage services for such products as OTC currency options, forward rate agreements and interest rate swaps.46 Big changes in the rules that applied to their core brokerage activities anyway had made it essential for members of the FECDBA to find new ways of earning a crust. The officially sanctioned rules (banks to eschew direct dealing in London and only to use the brokerage services of members of the FECDBA) that had long guided the relationship between brokers and principals in the London foreign exchange market had started to fray at the edges by the commencement of the floating exchange rate era. Central to the well-being of the brokers’ cartel was the willingness of banks to exclusively use FECDBA members in London and to pay the brokerage charges set by that Association. However, many banks resented paying what they considered to be the high brokerage rates (especially for currency deposits) fixed by the FECDBA and, in the early 1970s, some were threatening to pull out of the 1967 accord that had set up the prevailing arrangements.47 In some instances, banks had acted to reduce their brokerage bills, by putting business through one or other of the small independent brokers that had sprung up in London. These brokers, a number of whom were owned by principals—something that was frowned upon by the authorities—operated outside of the ambit of the FECDBA, and so were viewed with disdain by the Bank of England. Keeping London’s foreign exchange business under the tripartite control of the Bank of England, the Foreign Exchange Committee and the FECDBA (previously the FEBA) had long been seen by the authorities as the best way of maintaining good order and preventing bad practice on the London markets. Interlopers were unwelcome and, therefore, were to be frozen out. This was very much on the mind of Sir Leslie O’Brien, the outgoing Governor of the Bank of England who, in March 1973, reminded the banks that the Bank of England continued to believe that the independence of brokers from principals in the London markets made a major contribution to the breadth and efficiency of those markets and that in order to preserve existing arrangements they should decline ‘…to accept the services of a London broker associated with a principal’.48 Sir Leslie left the Bank in mid-1973, but as Lord O’Brien he would have more to say later on these matters in his new role as president of the British Bankers Association (BBA). The Bank’s strictures, however, failed to discourage newcomers from entering the lucrative London market in search of brokerage business. And one of these newcomers was to rock the foundations of the market structure that had been so carefully constructed by the Bank of England over the previous forty years. The firm in question was Sarabex Ltd, an Arab owned foreign exchange and currency deposit broker that had set up shop in London, in April 1974, mainly to deal with Middle Eastern banks. Firms such as Sarabex

The foreign exchange market of London

142

offered their services at brokerage rates well below those set by the FECDBA. This was a matter of some concern to the City establishment, because it threatened to undermine the long-running understanding between the Bank, the FEC and the FECDBA on how business should be done in London. In a nutshell, the Bank ‘persuaded’ authorised dealers to use only FECDBA members for brokerage services in London, in order to reward the latter and so keep them content in their membership of the Association. Inside the Association, brokers could be compelled to observe market rules, whereas outside the Association they might be tempted to engage in unseemly practices. However, it made little sense to allow the members of the brokers’ cartel to set a relatively high brokerage tariff, if—because of business lost to rate-cutting interlopers—they were unable to find sufficient customers willing to pay this tariff. In this situation, there would have been the risk not only of the FECDBA imploding in the same way that the Association of Foreign Exchange Brokers had done in 1929, but also of the Bank of England losing its cherished sway over the market. The BBA, which in 1972 had taken over the leadership role in the FEC from the Committee of London Clearing Banks (CLCB), was pressed into service in an attempt to shore up the existing arrangements. In July 1975, its president, Lord O’Brien, informed all BBA members in a letter that, ‘…authorised banks should not use the services of a foreign exchange and currency broker operating from an office in the United Kingdom who is not a member of the Foreign Exchange and Currency Deposit Brokers Association’.49 Authorised banks also were instructed to observe and pay the FECDBA’s tariff, and were requested to send written confirmation of their agreement with the contents of Lord O’Brien’s letter. Despite the best efforts of the BBA, Sarabex and other independents continued to tout for business in London. They did so partly by arranging deals in London via overseas telephone links, so as not to appear to be ‘operating from an office in the United Kingdom’. Clients were attracted to the interlopers by their bargain basement brokerage charges. Sarabex, for instance, charged £5.80 to £14.52 per $1 million, or its equivalent, depending on the currency involved, whereas the FECDBA scale ranged from £14.60 to a whopping £242.30 per $1 million according to the currency being transacted. Even the lowest rate charged by members of the FECDBA (for spot transactions in US dollars/sterling) was massively above the uniform brokerage rates levied in continental Europe. High brokerages were in effect the price paid by the market for sustaining the market structure favoured by the Bank. However, abnormally high brokerage rates only could be sustained by restricting supply, and the triumvirate organising the market sought to do this both by chasing after interlopers and by restricting membership of the brokers’ cartel. FECDBA’s entry requirements had been set deliberately to deter newcomers. Applicants had to be sponsored by at least six authorised banks to whom they were providing ‘a full service’. However, it was almost impossible to provide ‘a full service’ unless one was already a member of the FECDBA.

Innovation and deregulation 1972–86

143

Commission to the rescue There seemed little that could be done about this Catch-22, given that the Bank of England, the natural adjudicator on such matters, stood fully behind the FECDBA rulebook. However, one of those excluded from the cartel was not prepared to allow its restrictive practices to go unchallenged. Perhaps being less in awe of the City establishment than its domestically owned rivals, Sarabex did the unthinkable. It sent a letter of complaint to the EEC Commission. In the summer of 1978, the Commission informed the FECDBA and the BBA that it had been asked to institute proceedings against them, and also against all of their individual members, for allegedly operating a cartel in contravention of Articles 85 and 86 of the Treaty of Rome. Despite a strong rearguard action by the Bank of England, a series of reforms were eventually agreed between it and the Commission. These were put into effect at the beginning of 1979. The reforms embraced the following key elements: I Control over entry into the brokerage market was shifted from the FECDBA to the Bank of England. Newcomers had to be ‘recognised’ by the Bank. To obtain this status they had to submit an application to the Bank supported by a minimum of six banks (with at least three being from the list of the 100 biggest in the world, and at least two being either clearing banks or acceptance houses). The sponsors had to, ‘… testify to the technical expertise, integrity and conduct of the applicant and agree to use his services over a direct dealing line’.50 II Any applicant turned down by the Bank of England had the right of appeal to the Chairman of the Appeals Committee of the Panel on Takeovers and Mergers. III The Bank was granted supervisory powers over the technical expertise and ethical conduct of member firms. IV The brokerages levied by the FECDBA were drastically reduced, and—to create an element of competition—they were set in a range and not on a fixed scale. In the case of a spot transaction in US dollar/sterling the old fixed rate of £14.60 per $1 million was replaced by a new range set at £8 to £9 Per $1 million.51 These reforms made it slightly easier for newcomers to gain admission to the Association, if only because they no longer required an applicant to offer the full service that was impossible to provide outside of the FECDBA. Sarabex eventually gained admission, albeit under a new management.52 The ban on direct dealings in London was left untouched by the accord struck between the Bank of England and the Commission. However, this geriatric ruling (it had been introduced in 1937) was not to survive for much longer. The abolition of exchange controls in October 1979 removed at a stroke the direct control of the Bank of England over the admission of principals into the London foreign exchange market. In these circumstances, there was no way that the ban on direct dealings could be properly enforced, and after a brief round of discussions this ruling was lifted on 2 January 1980.53 Banks quickly exploited their newfound freedom to deal directly with one another in

The foreign exchange market of London

144

London, and this contributed to a sharp increase in activity on the inter-bank market.54 The brokers lost market share, but—with many banks still finding it convenient to use their services and with turnover rising—their overall business did not decline. Another restrictive practice was thrown out along with the ban on direct dealings. Previously, brokers had not been allowed to ‘pass names’, that is to arrange a deal between a bank and a non-bank. This rule ostensibly had been adopted as an exchange control measure (only authorised dealers were judged to be competent to judge whether a given transaction complied with the 1947 Exchange Control Act). The abolition of exchange controls removed the raison d’être of this rule, and the decision to scrap it had the added advantage of offering brokers a consolation prize for accepting direct dealing. In the event, it turned out to be a pretty dud prize, because most banks proved unwilling to book corporate foreign exchange deals passed by brokers.55 Brokers responded to the changing times of the late 1970s and the early 1980s, both by diversifying their activities by moving overseas, and by merging their businesses in London. The trend towards overseas diversification had started in the mid-1970s with London based brokers either opening or acquiring offices in continental Europe and North America. Those with offices in New York were particularly well placed to exploit the reforms that were introduced, in September 1978, to integrate the New York foreign exchange market more closely with the global market. From that time, foreign exchange brokers in New York started to quote the continental European currencies and the Japanese yen in European terms (or foreign currency units per US dollar) instead of in US terms (or dollars and cents per unit of foreign currency), and the links between New York banks and the outside world were strengthened by the decision of brokers in New York to accept bids and offers from banks abroad.56 This opened up a new channel for US banks to do business with foreign banks, and those British brokers with offices in New York were well positioned to exploit this business given their existing strong customer base in foreign markets. During the early 1980s, brokers were faced not only by renewed downward pressure on brokerage rates, but also by rising labour costs and increasing expenditures on technology. The FECDBA’s tariff had been lowered again in 1982, when the principle of volume discounts also had been introduced. Banks providing more than £5,000 a month of fee income to a broker were entitled to a volume discount, whereas those providing more than £10,000 were entitled to negotiate their brokerage rates.57 The introduction of negotiable brokerages for big customers soon led to demands for the total elimination of fixed brokerages, and this duly came about at the end of 1985.58 The combination of lower brokerage rates and rising costs led many brokers to seek their salvation through amalgamation. In 1983, Michael Knowles, the chairman of the FECDBA, exclaimed, ‘We had to achieve economies of scale’ and so ‘the larger brokers got larger by acquisition, although there is still room for the small broker offering a specialized service’.59 The process of amalgamation led by 1983 to the creation of four dominant brokerage groups: Exco (owner of Astley & Pearce and Godsell and Co), Mercantile House (owner of Marshall Woellwarth), R.P.Martin (which in 1981 had merged with the German based Bierbaum group); and Mills & Allen (owner of Harlow, Meyer, Savage and Guy Butler). Beneath this big four stood a quartet of medium sized independents: Tradition (which was Swiss owned), Tullet & Riley, Charles Fulton and

Innovation and deregulation 1972–86

145

Kirkland-Whittaker (both of the last two had at one time been part of the Mercantile House stable). Few things, however, stay constant in the brokerage world and the collapse of one of the earlier behemoths along with the creation of new broking groups were to reshape the competitive map later in the decade. Dealers prosper in booming market The period between 1972 and 1985 was generally a prosperous time for foreign exchange dealers. While there were setbacks (the trading debacles of 1974 spring swiftly to mind), the strong underlying growth in market turnover was enough to ensure that most dealers made a decent living plying their trade. Rising levels of activity both on the foreign exchange and the Eurocurrency markets attracted more foreign banks to London, and this helped to swell the ranks of authorised dealers from over 200 in 1972, to 309 in 1978.60 Authorised dealer status was scrapped in 1979, but the 347 dealers that contributed to the Bank of England’s 1986 foreign exchange survey confirmed a further rise in the population of the market by the mid-1980s.61 The market may have been densely populated, but not all of the participants were significant players. Many of the smaller foreign branch banks treated foreign exchange as a sideline, and around 20–30 banks (the clearers, the main acceptance houses and the bigger Commonwealth and foreign banks) accounted for a disproportionate share of activity. While the influx of foreign banks largely accounted for the growing number of participants on the foreign exchange market, around one-third of the 399 foreign banks directly represented in London, in 1985, maintained only a representative office and so had no direct dealings on the market.62 However, those foreign banks that wished to enter the market found few official obstacles put in their way. Prior to October 1979, entry was conditional on a newcomer obtaining the Bank of England’s blessing as an authorised dealer. US and European banks often were able to achieve this status in less than two years.63 The key gatekeeper at the Bank was Jim Keogh, Chief Cashier at the Discount Office. Applicants had to demonstrate their technical expertise and a thorough understanding of exchange controls before being anointed as authorised dealers. Keogh maintained a list of respected (and mostly recently retired) dealers and exchange control managers and the surest and quickest way for newcomers to obtain authorised status was to hire from this list. They were not the only ones to gain, because inclusion on the ‘Keogh list’ provided a very tidy post-retirement income for some of the City’s old-timers. Increasing demand for foreign exchange dealers led to an improvement in their relative earnings. From the mid-1970s, they started to move up the pay ladder in the City, and some also started to receive bonuses. Initially, these were set at only a small percentage of salary. However, ‘bonus inflation’ developed during the 1980s as dealing profits rose, and as US investment houses, which were imbued with a greater bonus culture than either UK or foreign commercial banks, began to compete with the latter as principals on the London foreign exchange market. Traditionally, a foreign exchange dealer had entered a bank as a school-leaver, and had moved onto a dealing desk via a support function (e.g. reconciliation clerk, telex operator

The foreign exchange market of London

146

or journal keeper). While this rich seam of talent continued to be tapped, some banks also started, from the mid-1970s, to hire graduate trainees for their dealing rooms. It is no coincidence that this took place around the same time that banks, led by Citibank in London, began to establish specialist customer traders within their dealing rooms. The main role of these specialists, each of whom was given a specific list of customers to look after, was to act as a buffer between the latter and a bank’s inter-bank traders. Customer dealers would ‘negotiate’ a rate with the inter-bank traders and then would seek to ‘sell’ this to their customer. Graduates eventually would serve many different roles in dealing rooms, but the pioneers almost invariably started out as customer traders. Women comprised part of each graduate intake, and those who entered dealing rooms as customer dealers played a pioneering role in ending the status of foreign exchange trading as a male-only occupation. Subsequently, women also started to enter dealing rooms as transferees from other banking departments. The late 1970s witnessed the publication of the first Euromoney survey of foreign exchange dealers. In this survey, corporate treasurers were asked a number of questions about their foreign exchange banks and also about the volume of business that they undertook with each one. The survey was launched in 1979, by which time London was almost certainly the biggest foreign exchange centre in the world. Yet, in 1979, only one British owned bank (Standard Chartered) featured in the top ten (although Midland Bank maintained a shareholding in the ninth-ranked European American Bank).64 US owned banks accounted for no less than seven places in the top ten, with Citibank, Chase Manhattan and Morgan Guaranty taking the first three spots. The failure of any of the British clearing banks to directly make the top ten had something to do with the global nature of the survey. Whereas the top-ranking American banks were big players both in New York and London (as well as in lesser centres), the British clearing banks were a major force in London, but had only a modest presence in New York. This made it hard for them to outrank the globally active US banks. However, things improved a little bit by the time of the 1985 Euromoney poll. In that year, Citibank retained the top position, but Barclays managed to pip Chase Manhattan to claim the second spot.65 Organisations change with the times Since the 1930s, the Foreign Exchange Committee had looked after the interests of banks engaged in the London foreign exchange market. While the members of this committee were selected to represent all of the market’s participants, it served as a sub-committee of the CLCB. In view both of the growing importance of foreign banks in London, and of Britain’s impending entry into the EEC, this structure no longer was deemed to be appropriate. In 1972, the BBA (which, up until then, had been open only to British deposit banks) was reconstituted, ‘…to represent comprehensively the interests of all banks operating in the United Kingdom’.66 Following this change, the FEC was put under the BBA’s wing. In 1973, the links between the three main parties involved in foreign exchange trading

Innovation and deregulation 1972–86

147

in London (dealers, brokers and the Bank of England) were strengthened with the establishment of the Foreign Exchange Joint Standing Committee (FXJSC). The initial membership of the committee comprised four representatives of banks active in foreign exchange, and four representatives of foreign exchange brokers. The Bank of England also was represented and it played a leading role by providing both the chairman and the secretary of the committee. The purpose of the FXJSC was to serve, ‘as a forum of discussion of developments in market practices with a view to identifying problems and, where possible, recommending solutions’.67 However, it also fulfilled two other important functions. One was to devise and oversee the ‘Guide to Market Practice’ (eventually to be known as the London Code of Conduct) that set out the procedural rules and standard of conduct for market participants.68 The other was to serve as arbitrator in the event of disputes between those engaged in the market. With the notable exception of the hiatus in inter-bank trading that followed the Herstatt crisis, the FXJSC spent its formative years presiding over a dramatic expansion in turnover on the London foreign exchange market. In part, this expansion was due to the high inflation that characterised the 1970s and early 1980s. However, other factors also were at work, including the recycling of petro-dollars, the liberalisation of capital movements in Britain and elsewhere, the exploitation of arbitrage opportunities between the cash and derivatives markets, the expansion in London’s foreign bank population, and—during the mid-1980s—the investment boom in the United States. The Bank of England only started to publish survey data on turnover in the London foreign exchange market in 1986.69 Earlier surveys are available but, as noted in the previous chapter, their reliability cannot be taken for granted. But for what it is worth, estimates gathered by the Group of Thirty from a range of central banks (in 1973), and from 40 banks and 15 securities houses (in 1979 and 1984), show the average daily turnover on the London foreign exchange market rising from $4−5 billion in 1973, to $25 billion in 1979 and to $49 billion in 1984.70 In 1979 and 1984, the Group of Thirty credited London with having the biggest foreign exchange market in the world. In both years, New York was put in second place followed by Zurich in third. These rankings have a ring of authenticity, given that the first official survey to be published by the Bank of England, in 1986, also put London in the top spot ahead of New York. It was a position that London was to hold on to in all subsequent official surveys.

8 On top of the world 1986–2003 The publication of the first of the Bank of England’s regular triennial surveys of the London foreign exchange market was witnessed in 1986. The Bank’s initial survey coincided with the issue of similar surveys by central banks in the United States, Canada and Japan. Starting in 1989, more and more central banks became involved in this process and the Bank for International Settlements also began collating these local findings and publishing its overviews of global exchange market activity.1 These official surveys painted, at least until recently, a rosy picture of foreign exchange trading in London. Between 1986 and 1998, they revealed an increase in turnover and showed London with a commanding lead as a foreign exchange centre over New York, its nearest rival.2 The market, however, lost some of its fizz in 2001. The survey undertaken in that year showed not only a significant 21 per cent contraction in foreign exchange activity in London, but also a slight decline in its still commanding share of the global market. Blame for this setback cannot be attributed to a shift in exchange rate behaviour, because currency volatility was as high at the start of the twenty-first century as it had been at the end of the twentieth century.3 Rather it can be put down to a number of structural changes of which the introduction of the euro, consolidation within the banking sector and the rapid development of automated order matching systems (otherwise known as electronic brokers) are the most important. The expansion of electronic brokerage between banks and the introduction, from the late 1990s, of internet portals for corporate users of foreign exchange served to reduce the mystique of currency trading. New trading systems, by increasing price transparency and facilitating price discovery, squeezed profitability in plain vanilla foreign exchange trading and forced dealers to seek their salvation either by becoming high volume traders (a route open only to the biggest banks), and/or by concentrating on higher value-added products, such as long-dated forwards and options. Favourable trading conditions The clear currency trends and big intra-day exchange rate movements that are so dear to foreign exchange dealers were much in evidence between 1986 and 2003. During this period, the US dollar exhibited lengthy bouts of cyclical strength or weakness, whereas more-localised currency gyrations were provoked by the trials and tribulations of the Japanese economy, by the fallout from the German re-unification boom and by the late 1990s balance of payments crises in SE Asia and Latin America. The downtrend in the US dollar that had started in 1985 gathered momentum during 1986–87, as operators turned their attention to the massive US current account deficit,

On top of the world 1986–2003

149

which rose from $149 billion (2.8 per cent of GDP) in 1985, to $163 billion (3.4 per cent of GDP) in 1987. The belief that a more competitive exchange rate was needed to correct this mounting imbalance oiled the dollar’s descent and it fell, almost without interruption, from DM2.4455 to DM1.9235 against the German mark, between the end of 1985 and the end of 1986. This depreciation was applauded in official circles and no attempt was made to arrest it. However, attitudes began to change during the opening months of 1987, as the dollar’s continued slide (it fell to DM1.8250 by mid-February) aroused fears that it would massively overshoot its fair, or purchasing power parity, level on the way down, in much the same way as it had overshot this level on its way up in 1982–85. Just seventeen months after the Plaza Agreement, a new accord was struck between the Group of Five finance ministers to stabilise the exchange markets. This time around, the intention was to halt the dollar’s decline and so give time for its earlier depreciation to treat the underlying cause of its weakness, namely the yawning US current account deficit. The so-called Louvre Accord was reached on 22 February 1987, and contained a pledge by the participating finance ministers, ‘to foster stability of exchange rates around current levels’.4 Towards this end, unpublished central rates were agreed for the dollar in terms of the German mark (DM1.8250) and the Japanese yen (Y153.50) and outer margins of +/−5 per cent were set around these rates.5 Further dollar weakness soon put this new commitment to the test, and the leading central banks were obliged to engage in heavy intervention between March and May 1987. Sentiment, however, can change quickly on the currency markets and signs of an incipient improvement in US visible trade balance provoked a sharp dollar rally over the summer, and by August both the Federal Reserve and the Bundesbank had to intervene on the other side to stop the dollar from rising above DM1.90. The US currency did not remain in favour for long. The October 1987 stock market crash, and subsequent easing in US short-term interest rates, sent it into a tailspin and, despite central bank intervention, it fell to DM1.5740 (or below the floor, of around DM1.73, that had been secretly agreed at the Louvre meeting) by the end of 1987. It fell even more steeply against the yen to close the year at a record low of Y121.35 (see Figure 8.1).

The foreign exchange market of London

150

Figure 8.1 Currency tensions 1986–99 (source of data: Citibank).

Fears that a renewed slide by the dollar would further undermine business confidence, which already had been badly dented by the stock market crash, led the finance ministers of the seven biggest industrial nations, at their meeting on 22 December, to reaffirm their commitment to the Louvre Accord.6 Heavy intervention followed and by the end of

On top of the world 1986–2003

151

January 1988, the dollar had climbed to DM1.68, and to Y128. This rally marked the first move in a new cyclical phase for the dollar. Stronger US economic growth and firmer US short-term interest rates replaced the still wide (if now improving) US current account deficit as the main focus of attention of currency operators. During 1988–89, the dollar returned to favour and climbed with only minor setbacks to reach DM1.9575 and Y144.55 by August 1989. This rise was not obstructed by official intervention, even though it resulted in the US dollar/German mark rate climbing above the informal ceiling that had been agreed under the Louvre Accord. The dollar was not the only currency to benefit from relatively high interest rates. During 1988, the fad for high yielding currencies—invariably from countries with wide current account deficits—also benefited the Canadian dollar, the Australian dollar and sterling. Growing international demand for the Australian dollar, a particular favourite, served both to boost market turnover in this currency (thereby providing dealers with wider trading opportunities), and to fuel a 25 per cent rise by it against the US dollar over the twenty months to February 1989. Sterling emerges from shadows Sterling also was buoyed by relatively high interest rates in 1988, although its return to favour had started some months beforehand. Prior to that recovery, the British currency had had a difficult time on the exchange markets. Between mid-1985 and the beginning of 1987, it had eased from DM3.96 to DM2.77, as falling oil prices focused international attention on the underlying deterioration in Britain’s current account balance. Sentiment, however, began to improve in early 1987, thanks to a rebound in oil prices and to an earlier tightening in monetary policy. If anything, the British authorities found the pound’s renaissance a little too impressive for their own liking. Over the two weeks to March 10, sterling jumped by 5 per cent to reach DM2.94. With the current account still deteriorating, there was little desire in Whitehall to surrender all of the earlier competitive gain in the exchange rate, and interest rates were cut twice to prevent the pound from breaching DM3.00. These cuts, along with ministerial comments expressing satisfaction with a rate of DM2.90, soon gave rise to the (correct) impression that the Treasury was seeking to stabilise sterling in a DM2.90–3.00 range.7 During 1987, British short-term interest rates averaged 9.7 per cent, or more than twice the level of their German counterparts. This yield advantage proved to be especially tempting, because there appeared to be little or no downside risk in holding sterling, given the Treasury’s policy of shadowing the mark (which was intended as a dry run for eventual ERM membership). Strong demand soon pushed sterling rate towards DM3.00, and it was only kept below this officially sensitive level by a judicious mix of interest rate cuts and intervention. Things were just about kept under control in 1987, but as the high yielding currencies came into vogue in 1988, demand for sterling intensified and overwhelmed the government’s defences. With interest rate cuts and intervention fuelling a dangerous and eventually damaging increase in money supply, the decision was taken to uncap the

The foreign exchange market of London

152

German mark/sterling rate, which promptly rose to DM3.05 on 7 March 1988. Further gains were to come, and by the end of 1988 this rate was standing above DM3.20. The failure of the ‘shadowing’ policy soon cast aside any thoughts of early ERM entry. The tide turned against the high yielding currencies during 1989. Sterling was the first to suffer as operators switched their gaze away from interest rate differentials and back to key economic fundamentals, such as the rate of inflation and the trend on current account. Earlier monetary expansion led to a sharp escalation in British economic growth in 1989, and it did not take long for the markets to take fright at the ensuing acceleration in inflation and widening in the current account deficit. Sterling came under the hammer and tumbled to a low of DM2.7275 by the end of 1989. Sentiment also turned against the US dollar during 1989 (it fell from DM1.9575 to DM1.6915 in last four months of the year). The dollar lost its appeal as a high yielding currency, as US short-term interest rates edged down in response to signs of weaker economic growth, and as an incipient inflationary boom in Germany mandated a tightening in monetary policy. During the winter of 1989–90, German short-term interest rates climbed above US short-term interest rates for the first time since the early 1970s.8 They were to remain above their US counterparts until late 1994, in response to the restrictive monetary stance adopted by the Bundesbank to counteract the budgetary problems and inflationary pressures emanating from German reunification (which took place on 3 October 1990). During the early 1990s, the combination of lax fiscal policy and tight monetary policy strengthened the mark in much the same way that it had buoyed the dollar ten years beforehand. The dollar slipped to DM1.4430 in early 1991, before entering into a sharp (but shortlived) rally on hopes of an early rebound in US economic activity. However, these hopes were not realised, and the dollar—after rising above DM1.8400 in mid-1991—retreated once again and tumbled to a record low of DM1.39 by September 1992. It was not just the dollar that suffered a pasting at the hands of the ebullient mark. The collapse in prices on the Tokyo stock market in March 1990, along with a sharp reduction in the Japanese current account surplus, dented confidence in the yen. However, with the dollar also on the slide, the plight of the Japanese currency was mainly reflected in the hefty fall in its cross-rate (20 per cent in 1990) against the mark. Divergent economic trends in Germany and Japan led to significant volatility in this cross-rate during the early 1990s. Dealers did not overlook this development, and there was a modest yet still discernible increase in the share of trading in yen/mark, in the total turnover on the London foreign exchange market, during this period.9 Troubles in the ERM The strength of the German mark eventually would deal a hefty, although not a fatal, blow to hopes of European monetary integration. Such hopes were riding high at the start of the 1990s, in response both to the newfound stability in the ERM, and to the renewed enthusiasm for European monetary union. The latter development had followed the publication, in April 1989, of the Delors Report, which had proposed a three-stage plan to achieve economic and monetary union. Approval to proceed with the first stage of the

On top of the world 1986–2003

153

Delors plan, to start on 1 July 1990, was given by the European Council in June 1989. This stage required the closer coordination of economic policies but within the existing institutional framework.10 There was already some evidence, by the late 1980s, of increased economic convergence between the member countries of the ERM.11 Between 1979 and 1985, there had been eight separate occasions involving the realignment of one or more of the ERM currencies. However, between 1986 and 1989, there were only three realignments with the last being in January 1987. Thanks to the enlargement of the European Community, the ERM also was attracting new members. The Spanish peseta joined in June 1989, and the Portuguese escudo followed suit in April 1992. Under the rules of the ERM, the member countries were obliged to keep their exchange rates within margins of +/−2.25 per cent relative both to the other participating currencies in a cross-exchange rate grid, and also to the ECU (the effective margin against the ECU, however, was adjusted to allow for the weight of a given currency in this basket). When the ERM was launched, it was acknowledged that this narrow band might not initially suit every country and a provision was made for the ‘temporary’ adoption of wider +/−6 per cent margins.12 Italy had joined the ERM with these wider margins, but as if to demonstrate the increased stability in this arrangement, the lira—which had been one of its more trouble prone participants—switched to the narrow margins, following a technical realignment of its central rate in January 1990. Whereas the ERM currencies had been remarkably stable against the mark after the January 1987 realignment, sterling had been prone to violent and disruptive swings. The quest for greater exchange rate stability, in conjunc-tion with the desire to strengthen Britain’s anti-inflation defences, informed the British government’s decision to enter sterling in the ERM in October 1990. Speculation about membership had allowed sterling to rally from its earlier lows against the mark, and when it joined the ERM it did so with a central rate against the mark of DM2.95 and with +/−6 per cent margins. Sterling’s entry into the ERM came in the same month as German reunification. It also occurred at a time when the British economy was mired in recession. While it was not obvious at the time, these two events were to conspire to truncate sterling’s sojourn in this arrangement. The first year was quiet enough, but by the start of 1992 the opposing interests of the British economy (which needed lower interest rates to tackle recession) and the German economy (which required high interest rates to combat inflation) were beginning to cast a shadow over sterling’s DM2.95 parity. Based on the economic fundamentals there was a convincing argument for a realignment of sterling (against the mark although not necessarily against all of the other ERM currencies). However, the government had come to regard DM2.95 as an emblem of its anti-inflation resolve, and as tensions mounted over the summer of 1992— following Denmark’s initial decision not to ratify the Maastricht Treaty on economic and monetary union—it was obliged to rush to sterling’s defence. The market, however, had come round to the view that the struggling British economy was in need of significantly lower interest rates—something that could not be achieved without jeopardising sterling’s position in the ERM. Confidence in sterling’s ERM parity waned and a massive speculative assault was launched against it towards the end of August 1992. Despite protestations of EC Finance

The foreign exchange market of London

154

Ministers on 28 August that, ‘…a change in the present structure of central rates would not be the appropriate response to the current tensions in the EMS’, and the announcement, in early September, of massive foreign currency borrowings by the British Treasury, there was no let-up in the pressure on sterling.13 The lira had also been ensnared by the turmoil, and a devaluation of its central rate, over the weekend of 12–13 September, served to aggravate rather than to relieve tensions, by highlighting that ERM parities were not exactly carved in stone. Selling of sterling intensified and despite massive intervention and the announcement, on 16 September, of a two-stage hike in MLR from 10 to 15 per cent (the last 3 percentage points of which never was put into effect), the Treasury had little choice but to throw in the towel later that day. Sterling’s ignominious departure from the ERM in 1992 marked the last fixed-rate crisis to beset the British currency during the twentieth century. It shared much in common with all but one of its predecessors. The odd one out was the 1949 devaluation, which created little excitement or profit for currency operators, partly because the London market was so tightly controlled, and partly because of the pre-emptive nature of that parity adjustment. However, all of the other crises (the 1931 departure from gold, the 1967 devaluation and the 1972 exit from the snake) involved not only feverish activity on the exchange markets, but also: • The futile defence of a fixed exchange rate. • Hefty foreign exchange translation losses for the authorities. • Sizeable foreign exchange profits for market participants. • The search for scapegoats (invariably foreign speculators). In 1967, Harold Wilson selected the ‘gnomes of Zurich’ as a scapegoat. In 1992, the press picked George Soros to fulfil this role. His Quantum Fund group bet $10 billion against sterling remaining at DM2.95, and they pocketed a cool $1 billion when sterling tumbled out of the ERM.14 However, it was not just Soros who profited from sterling’s demise; 1992 was a very good year for London foreign exchange dealers. Turnover soared and spreads widened during the ERM crisis, and this allowed banks to make a pretty penny, even without running open positions. However, going short of sterling in mid-September 1992 was hardly a high-risk strategy and banks’ proprietary trading desks also did rather well out of sterling’s misfortune. Turmoil in the ERM did not end with sterling’s departure on 16 September (the lira’s membership also was suspended at the same time). The Spanish government, fearful that its currency would be picked on next, announced a pre-emptive 5 per cent devaluation of the peseta. The markets, however, had a bigger target in sight. Massive speculative positions were taken out against the French franc ahead of the French referendum on the Maastricht Treaty on 20 September. This time around the defences held, largely because of the Bundesbank’s unprecedented decision to support the franc with intra-marginal intervention.15 Even though the franc remained weak after the weekend, following the announcement of only a slim yes vote in the referendum, dealers were to be denied a second week of windfall foreign exchange profits. The German interest rate cycle turned in September 1992. However, over the next twelve months short-term rates fell only slowly, and this discomforted the other ERM

On top of the world 1986–2003

155

countries that were anxious to slash their own interest rates, in order to boost domestic economic growth and so combat unemployment. The need to compete with German interest rates prevented them from pursuing this course of action, but a few of the member countries chose to exercise another option. This was to devalue their currencies in order to stimulate net exports. ERM realignments came back into fashion with four taking place between November 1992 and May 1993. However, that did not mark an end to the trials and tribulations of the ERM. Many of the continental European countries sank into recession in 1993, and this caused the markets to question the sense of these countries raising interest rates whenever their currencies came under pressure. This viewpoint came to the fore in July 1993, when the French franc came under renewed attack. An emergency increase in French interest rates along with heavy intervention did little to ease the pressure, and over the last weekend of the month it was decided to widen temporarily both ERM bands to +/−15 per cent from 1 August.16 EMU comes into focus Euro-sceptics were delighted by this move and rushed to sound the death knell of European currency integration. However, even as they were rejoicing events were conspiring to prove them wrong. The Maastricht Treaty, which set out the road map for economic and monetary union (EMU), was ratified in 1993, following a positive outcome in a second Danish referendum. This Treaty imposed an obligation on all bar two of the countries of the European Union (EU), as the European Community now was called, to enter into monetary union, by no later than 1 January 1999, so long as they satisfied the conditions for membership set down in the Treaty.17 Britain and Denmark were the two countries given the right to remain outside of EMU, if they so chose. There was a strong political desire for EMU in most continental European countries and this provided an irrepressible momentum to secure its achievement. Following the ratification of the Maastricht Treaty, the second stage of this process was implemented on 1 January 1994. This involved the establishment of the European Monetary Institute (EMI)—the precursor of a future European central bank—that was tasked with strengthening cooperation between national central banks, increasing coordination of national monetary policies and making the necessary technical preparations for EMU. The quest by most of the EU countries for EMU membership served to transform conditions in the ERM. Increased policy coordination and greater economic convergence diminished tensions between the ERM currencies, and—in a development that few would have thought possible in August 1993—most of those that previously had observed the narrow margin were doing so again by the spring of 1994. By that time, the dollar was trading at DM1.67, or well above the lows it had struck in September 1992. Its rally had been fuelled by the expectation and subsequent realisation of a cyclical upturn in US short-term interest rates. The dollar’s advance against the mark, however, had coincided with its renewed weakness against the yen, which—after its tumble in 1990—had come back into favour due to Japan’s high and rising current account surplus. The yawning US current account deficit was an important counterpart of

The foreign exchange market of London

156

this surplus, and—as the market refocused its attention, during 1994, on the United States’ weak external position—the dollar also began to weaken against other currencies apart from the yen. Its decline continued well into 1995, when it was extended by doubts about the durability of the US economic recovery that had started in 1992. The dollar fell below Y100 (for the first time) in June 1994, before sinking further to reach a low. of just under Y85, by mid-1995. Around the same time, it was trading down at DM1.3807. The dollar was not the only currency to sink lower in 1994–95. Sterling also was in the wars during this period, and its post-ERM slide against the mark—which had been interrupted by a spirited rally in 1993—gained fresh impetus from British economic and political worries. It fell to a new low of DM2.18 in April 1995. The dollar’s slide came to a halt at the end of 1995. It then entered into a lengthy cyclical upswing in response to the attractive investment opportunities presented by the relatively fast growing US economy. Rapid economic expansion was accompanied by high productivity, subdued inflation and heavy investment in high technology industries (the celebrated dot-com boom). These factors boosted the dollar by underwriting sharp gains in US equity prices, and a related expansion in international demand for US shares. Heavy inflows of direct investment, induced by the stellar performance of the US economy, worked in the same direction. From its low in mid-1995, the dollar rose (albeit with the occasional setback) to DM1.6656 by the end of 1998. Sterling, which invariably traded more in sympathy with the dollar than the mark, benefited from this recovery and climbed, albeit erratically, to reach DM2.7711 by December 1998. The dollar’s rise from the end of 1995 coincided with the start of a slow but steady improvement in the market’s view of the prospects for EMU. Greater convergence in monetary policies within the EU, along with repeated expressions of support for EMU from political leaders in Germany and France, underpinned this shift in thinking. The markets responded to this development in two ways. First, they looked for financial opportunities to exploit in Europe, in the run-up to a possible future monetary union. Second, they sought to diversify their currency trading activities to allow for the possible disappearance in the future of a number of European currencies. If and when EMU started, it was expected that there would be only a very small spread between the yields on the government bonds of the member countries (intra-EMU exchange risk would be eliminated and only credit risk would remain). Accordingly, foreign investors began buying the relatively high yielding government bonds of those EU countries that they judged had a good chance of becoming founder members of EMU. These so-called convergence trades boosted exchange market turnover in many of the EU currencies during 1995–96, but thereafter growing confidence in the prospects for EMU, along with the achievement of greater convergence in EU government bond yields, triggered a slowdown in trading between the ERM currencies. This led banks either to downsize, or to close, their ERM trading desks during 1997–98. The formal decision to proceed with EMU (with eleven member countries starting on 1 January 1999) was taken on 3 May 1998. However, long before this go-ahead, foreign exchange dealers had begun to diversify their trading activities to allow for the potential disappearance of a number of EU currencies to be replaced by the euro. The quest for new trading opportun-ities caused the spotlight to fall on the currencies of the emerging

On top of the world 1986–2003

157

economies of Eastern Europe and the fast growing ‘tiger’ economies of SE Asia. Rapid real GDP growth in the tiger economies of SE Asia was accompanied by relatively high interest rates and booming stock markets, both of which attracted strong demand for the currencies of this region, most of which maintained formal or informal links with the US dollar. Strong growth, however, also caused the SE Asian countries to suffer from widening current account deficits, and these imbalances came into sharper focus, during 1997, as their currencies rose with the dollar, and so became increasingly uncompetitive. Eventually, the markets decided that strengthening currencies and widening external deficits were incompatible and, during the second half of 1997, the region was plunged into a dire financial crisis.18 The storm started in Thailand in July 1997, when—after a lengthy period of pressure— the authorities were forced to float the baht, which then tumbled by 45 per cent against the dollar over the remainder of the year. This started a domino-like collapse of currencies across the region with the steepest falls being recorded by the Indonesian rupiah and the Korean won. The restrictive policy measures introduced to stem these currency losses triggered a sharp cutback in economic activity in SE Asia—a development that served to further dull dealers’ enthusiasm for the currencies of this region.19 Emerging economies outside of SE Asia also were beset by currency difficulties in the late 1990s. The Czech koruna had taken a tumble in 1997, the Russian rouble came under the hammer in August 1998 and troubles spread to Latin America in 1998–99. The weakness in the currencies of the emerging economies triggered the odd setback in the dollar’s post-1995 rally, as operators worried about the damaging effect that this would have on the United States’ chronically weak current account position. However, these setbacks proved to be only short-lived. For instance, the dollar bounced back quite quickly from the 1998 rouble crisis, and it had already returned to favour by the time the euro was introduced as the single currency of the EMU area on 1 January 1999. Following this move, the legacy currencies of the member countries ceased to be traded on the currency markets.20 When the exchange markets re-opened on 4 January 1999 (after the long New Year weekend) the opening quote for the new single currency was given as 1 euro=$1.1668. The euro edged up to $1.18 by the end of that day, but then depreciated almost without interruption to hit a low of $0.82 by October 2000 (see Figure 8.2). Slow economic growth in the euro-zone and the perception that the more dynamic US economy offered better investment opportunities caused operators to shun Europe’s new single currency, which also lost ground both to the yen and sterling. Signs of slower US economic growth, over the winter of 2000–01, led to a temporary setback by the dollar, but by May 2001, it had regained its earlier highs against the euro, on renewed hopes about the prospects for the US economy. It was only after these hopes were falsified by events, and after a related slide in US equity prices, that the tide eventually turned in the euro’s

The foreign exchange market of London

158

Figure 8.2 The euro: the first five years (source of data: St. Louis Federal Reserve Bank).

favour. Its recovery started in the third quarter of 2001, faltered over the next six months, but then gained strong momentum thereafter. The euro exhibited underlying strength, during 2002–03, reaching its $1.1668 launch level in May 2003, and eventually rising above $1.20 towards the end of the year. The elimination of the legacy currencies of the euro-zone discomforted foreign exchange dealers, by reducing the global inventory of liquid and internationally traded currencies. Efforts to compensate for this development through more active trading of other currencies such as the Swedish krona, Canadian dollar, Australian dollar and the SE Asian currencies (which started to come back into favour following their recovery from the 1997–98 crisis) failed to fully bridge the gap. This caused banks to review the size and cost of their foreign exchange dealing rooms. Technological developments during the 1990s provided them with a further reason to engage in this process. Technology increases transparency One way foreign exchange dealers earn their crust is by maintaining a spread between their buying and selling rates. In the inter-bank market (nowadays commonly referred to as the inter-dealer market in recognition of the increasing role played in it both by investment houses and by other non-bank financial institutions) increased competition already had led to a halving of spreads between key players, to just five points in US dollar/sterling, by the end of the 1980s.21 However, spreads were to be squeezed still

On top of the world 1986–2003

159

further during the next decade, as electronic order matching systems and foreign exchange trading portals increased price transparency and aided price discovery. Electronic screen based dealing for market professionals had come into being in 1981, with the introduction of the Reuters Money Dealing Service (subsequently renamed Dealing 2000–01). This service allowed dealers to contact one another and to negotiate trades on a bilateral basis. The novelty of the new systems introduced in the early 1990s is that they arrange the automatic matching of transactions anonymously entered by dealers from around the world (which explains why they are commonly referred to as electronic brokerage systems). The first automatic order matching system was Reuters Dealing 2000–02, which was launched in April 1992. The Minex Corporation, an organisation largely owned by Japanese financial institutions, introduced a competitor system in April 1993, whereas Electronic Brokerage Service (EBS), a partnership formed by a group of big international banks, entered the market in September 1993.22 In 1996, Minex transferred its business rights to EBS, so leaving only two providers in the market. There is an element of specialisation in their offerings, with EBS concentrating on trades involving the US dollar, euro, yen and Swiss franc, and Reuters focusing heavily on transactions involving sterling, the Swedish krona, the Australian, Canadian and New Zealand dollars and some emerging market currencies.23 The central feature both of EBS and of Reuters Dealing 2000–02 (the latter was upgraded in January 2000 and renamed Reuters Dealing 3000) is that they automatically select and display on screen—after taking due account of pre-set credit limits—the best pairing of buy and sell orders for a stated amount of a given currency. Execution takes place at the touch of a terminal key. The beauty of electronic brokerage is that it simplifies price discovery and so reduces the need of dealers to constantly job in and out of the market in order to ‘feel’ prices. Dealers need to be comfortable with the credit standing of a counterparty before entering into a foreign exchange transaction. Unsurprisingly, they tend to be pickier in choosing counterparties for high value and/or long-dated transactions, than for low value near-dated transactions, and this makes it harder to pre-screen the former for order matching systems. This explains why electronic brokerage is dominated by spot transactions involving tickets of $5 million or less (so-called metro business). Higher value spot deals tend to be conducted on a bilateral basis on the inter-dealer market. The bulk of forward dealing between banks also is conducted in the same fashion. Indeed, it took until June 1997 for automatic order matching to be introduced for forwards (on Reuters Dealing 2000–02). However, this service has made only slow progress, partly because of the complexities of forward trading, and partly because of the credit issues raised by it (even though stored credit information is used, on Dealing 2000–02, to prescreen forward counterparties, users are still entitled to make further checks before deciding to proceed with proposals generated by the system). In contrast, electronic brokerage has been an outstanding success in spot trading on the London market. By 2001, almost 70 per cent of inter-dealer spot activity was being conducted via electronic brokers, compared with only 30 per cent in 1998.24 Competition from this source has led to the virtual elimination of spreads for small ticket transactions on the inter-dealer market.25 In turn, the reduced profitability of trading on this market

The foreign exchange market of London

160

led banks to put increasing emphasis on garnering foreign exchange profits from their customers, such as big companies and asset managers. However, their efforts in this direction have been made that much harder by the introduction of multi-bank electronic trading systems for these end-users, which have made it easier for banks’ customers to search for and find the best prices. The first to enter this sector was FXConnect (a portal set up by State Street, a US bank, but one that allows other banks to supply prices) that went live in 1996. It was followed in 2000 by Currenex (an independently owned portal), and in 2001 by two further portals, FXall and Atriax, both of which were owned by consortia of banks.26 Even before the last two commenced trading, one expert astutely observed: Atriax and FXall have locked up in two camps the major providers of liquidity. But at the end of the day it will come down to the service they are offering. If there is no differentiation between them, then give me one good reason why there should be two platforms.27 This observation proved to be remarkably prescient, given that Atriax folded in April 2002, with its founding banks (Citibank, Deutsche Bank, and JP Morgan Chase) decamping to FXall. Even after this move, market participants were not ruling out further consolidation in this sector. Proprietary, or single bank, systems were introduced alongside of these multi-bank portals. According to the e-commerce subgroup of the Foreign Exchange Joint Standing Committee (FXJSC) these systems, in common with multi-bank portals, bring advantages both to banks and their customers, because: …time is saved in processing trades, especially the small ones; the system can be linked electronically to each party’s in-house systems for recording, settling, accounting and risk managing trades and therefore reduces the need for rekeying and aids straight through processing; and it simplifies complex crossproduct transactions… All these factors should reduce costs.28 The reference above to straight through processing, or STP, is significant because in the leaner and meaner markets of the new century, worthwhile dealing profits often are dependent on low back-office costs. One disadvantage of proprietary systems relative to multi-bank portals is that some end-users are bound by internal rules to obtain more than one quote whenever they trade.29 Be that as it may, many customers still have been willing to be connected to their own ‘house’ bank’s system not only to deal, but also to access online analysis and research. Big banks also have gained success in providing online foreign exchange facilities to smaller banks. Under so-called white labelling arrangements, customers deal directly with their own bank via an e-commerce platform. However, each time they transact an equivalent deal is automatically executed online between that bank and a third-party liquidity provider (usually one of the big foreign exchange banks). The liquidity provider takes the foreign exchange risk, but the smaller bank retains the credit risk to the enduser.30 The latter benefits from this arrangement by being able to outsource an activity in

On top of the world 1986–2003

161

which it may not have particular expertise; whereas the former gains by attracting greater trading volumes and so increasing its muscle on the global markets. Exploiting this approach helped UBS to top Euromoney’s global foreign exchange rankings in 2003.31 Online foreign exchange trading is still in its infancy and while volumes are growing fast, they account for only a tiny fraction of total market turnover. Between May 2001 and October 2002, the daily volumes passing through the multi-bank portals increased from an estimated $7 billion to $14 billion.32 These systems are accessed around the world, and so it is more appropriate to scale these figures against turnover on the global, rather than just on the London, foreign exchange market. In April 2001, the average daily turnover on the global foreign exchange market equalled $1,200 billion.33 New challenges for brokers Prior to 1992–93, a foreign exchange broker was understood to be an individual who brought two counterparties together to engage in a currency transaction. Since the introduction of electronic brokerage, in 1992–93, individuals plying this trade have been given a new moniker. Nowadays they are referred to as voice brokers to distinguish them from their two inanimate competitors, Reuters Dealing 3000 and EBS. This name is apposite, given that traditional brokers contact their customers either by telephone, or by open line voice boxes (aka squawk boxes) situated in foreign exchange dealing rooms. Just as brokers had to deal with the advent of direct dealing in the 1980s, so they have had to adjust to the challenge of electronic competitors since the early 1990s. Brokers had responded to the first of these challenges by merging into larger groupings. Big became beautiful and, by the mid-1980s, there appeared to be a relentless trend towards fewer and fewer brokers serving the London market. In 1986, only eight brokers were contacted by the Bank of England to complete a questionnaire for its first published survey on the London foreign exchange market.34 However, despite expectations of further concentration, no fewer than 13 brokers participated in the 1992 survey.35 This finding was surprising given that increased direct dealing between banks had led to an erosion in the share of principals’ foreign exchange business undertaken by brokers (it fell from 43 to 34 per cent between 1986 and 1992). Brokers might have received a smaller slice of the cake, but they were still able to grow their volumes due to the dramatic expansion in exchange market turnover. In turn, soaring volumes acted as a magnet for newcomers. Most of the new entrants sensibly decided to avoid the overcrowded spot market and instead chose to specialise either in forwards (a path pursued by the US firm Cantor Fitzgerald) or in derivatives.36 Since 1978, brokers had to be recognised by the Bank of England, in order to operate in the London market. The Bank’s control over foreign exchange brokers, as well as over the wider wholesale financial markets, subsequently was deepened and given statutory backing by the 1986 Financial Services Act. The Bank was granted widespread supervisory powers under this Act. An almost finalised version of these powers was contained in a paper published in July 1987.37 The paper (aptly) was given a grey cover, and this ensured that it soon became popularly known as the grey book. Under the Act, the Bank was charged with drawing up a list of institutions that were

The foreign exchange market of London

162

deemed by it to be, ‘…“fit and proper” to act in the relevant markets either as a market maker or broker’.38 In order to be listed, an institution had to demonstrate that it was suitably owned and controlled, was adequately capitalised and was willing to observe the London Code of Conduct. The latter previously had been maintained by the FXJSC, but responsibility for it now was transferred to the Bank of England. By the early 1990s, voice brokers not only had to cope with more formal rules and regulation, but they also had to respond to the intrusion of electronic brokers, and to the advent of less buoyant trading conditions. Partly due to competition from electronic brokers, the share of principals’ total turnover in London undertaken by voice brokers dwindled to only 27 per cent by 1998, by which time the number of such brokers contributing to the Bank of England’s survey had fallen to ten (comparable figures were not published in the 2001 survey).39 Tougher conditions forced brokers to review their business strategies, and most decided to respond to their altered circumstances by forging new ties and alliances and by refocusing their product offerings. There was a bewildering shift in the ownership of brokerage firms during the 1990s. In fact, the process had started at the end of the previous decade, when the M.W.Marshall group had exited from Mercantile House Holdings via a management buyout (this move followed in the wake of the failure of British and Commonwealth, a public company that had taken over Mercantile House in 1987). Marshalls, one of the dominant players in the spot market, remained independent until it entered into a merger with the Prebon Yarmane group in 1999. Prebon Yarmane (itself formed in the early 1990s through a series of mergers involving Charles Fulton, Kirkland-Whittaker and Babcock and Brown) was to emerge as one of the main forces on the slimmed down brokerage market. The other key participants, at the end of the 1990s, were Intercapital (which reversed into Exco in 1998 and merged with Garban the following year), Trio Holdings (which acquired MartinBierbaum in 1993, but sold the German part of the group in 1995), Tullets, Tradition and Cantor Fitzgerald. Brokers sought to put a positive slant on this painful consolidation process. According to Michael Beales, chairman of the Wholesale Market Brokers’ Association, ‘The industry is shrinking, but we’re getting quality rather than quantity’.40 Competition from electronic brokers was mostly felt in spot trading, and a number of voice brokers reached the not very difficult decision to exit this business. In 1996, David Hagan, the head of Trio Holdings, observed: We had seven desks in spot dollar/deutschmark…we now have none. We don’t do spot forex at all, which for many years was a core product for Martins. Our core products now are forward foreign exchange, arbitrage, deposit broking, domestic sterling and globally some highly specialized niche areas such as OTC equity options.41 Other voice brokers also sought their salvation by concentrating on products in which they had either a particular expertise or a substantial market share. The brokerage firms were not alone in running into turbulence during the 1990s. The FECDBA, the trade association of voice brokers in the currency deposit and foreign exchange markets, also sailed into stormy waters. The influence and power of this

On top of the world 1986–2003

163

organisation had been on the wane for some time due to the emergence of the FXJSC as the principal point of contact for policy discussions between market participants (brokers and dealers) and the Bank of England, to the elimination of fixed brokerages in the 1980s, and to increased statutory supervision of the London foreign exchange market (which removed the FECDBA’s policing role over brokers). Without a significant role to play, the FECDBA meekly pulled down the shutters in 1991 (the dealers’ Foreign Exchange Committee was to share the same fate for similar reasons in the mid-1990s).42 However, some brokers still felt that there was a need for a trade body to represent their interests, and with this aim in mind the Wholesale Market Brokers’ Association was established in 1994. It boasts a broad based membership comprising voice brokers from the foreign exchange, currency deposit and domestic sterling markets as well as the two electronic brokers. Change of climate in foreign exchange market The problems faced by brokers, as well as by dealers, from the mid-1990s, owed much to the changing tempo of activity on the London foreign exchange market. This is vividly illustrated by turnover data published in the Bank of England’s triennial surveys. These data reveal three distinct phases in the progress of the London market. Between 1986 and 1989, average daily turnover more than doubled from $90 billion to $184 billion. This was followed by a period of vibrant, if less frenetic growth, with turnover climbing by 58 per cent to $291 billion in 1992, and by a further 59 per cent to $464 billion in 1995. Thereafter, the heat went out of the market. Average daily turnover climbed by 37 per cent to $637 billion in 1998, before registering a 21 per cent drop to $504 billion in 2001 (see Table 8.1).43 Three main factors appear to have been behind the reversal in the fortunes of the global foreign exchange markets since the mid-1990s (turnover in other centres weakened broadly to the same extent as in London). These have been identified in a BIS study as (a) the introduction of the euro, (b) consolidation in the banking industry and (c) expansion in electronic broking.44 Introduction of the euro Trading between the EMU candidate currencies already had begun to moderate before the introduction of the euro.45 Obviously, such trading ceased altogether once EMU was underway, and this badly dented activity on the global foreign exchange markets, especially those of continental Europe. However, it had less of an impact in London, where intra-ERM currency trading had never been much of a forte. For instance, in 1998, such trades had accounted for a mere 5 per cent of turnover on the London market. The main impact of the euro on trading in London was felt in another way. In 1998, trades between the EMU legacy currencies and the US dollar

The foreign exchange market of London

164

Table 8.1 UK foreign exchange market 1986–2001

1986 1989 1992 1995 1998 2001 Average daily turnover (US$ 90 billion) Composition of turnover (per cent total) Spot 73 Forwards 27 of which: Outright n.a. Swaps n.a. Counterparties (per cent turnover) Non-financial institutions n.a. Other financial institutions n.a. Interbank n.a. Number of principals 347

184

291

464

637

504

64 36

52 48

41 59

35 65

30 70

n.a. n.a.

6 42

7 52

7 58

10 60

5 9 86 356

8 14 78 352

7 18 75 301

7 10 83 293

5 27 68 257

Source: Bank of England Triennial Surveys of Foreign Exchange Market Activity in the United Kingdom.

had accounted for 43 per cent of net turnover on the London market. While US dollar/euro emerged as the most actively traded currency pair in 2001, capturing 34 per cent of the market, this fell short of the previous share of trading between the legacy currencies and the US dollar. As the single currency of 12 countries, the euro is endowed with greater liquidity on the foreign exchange markets than any one of the individual legacy currencies that it replaced. Paradoxically, the illiquidity of many of the legacy currencies had served previously to boost the volume of trading on the exchange markets. It had done so by increasing the number of trades needed to effect transactions between these currencies. Commonly, it had proved hard to find acceptable prices, especially in the swap and forward exchange markets, for cross-trades involving the legacy currencies. These trades, invariably, had to be conducted via the more liquid market for these currencies against the US dollar. This meant, for instance, that the outright forward purchase of Italian lire with Spanish pesetas would have involved two transactions: the forward purchase of dollars with pesetas and the simultaneous forward sale of dollars for lire. These transactions disappeared with EMU. Consolidation in the banking industry Between 1992 and 2001, the number of dealers (mostly banks) covered by the triennial Bank of England survey shrank from 352 to 257. This decline, which started in the early 1990s but gathered momentum towards the end of the decade, owed a little to the departure of a number of smaller foreign banks from London, but was due mainly to increasing consolidation in the global banking industry.

On top of the world 1986–2003

165

Among the factors contributing to this process were the reconstruction of the distressed Japanese banking system, the integration of the European banking sector in response to EMU and the drive by banks in Britain and the United States for greater market share. Consolidation led to the disappearance from the London foreign exchange market of previously big players such as Swiss Bank Corporation (merged with UBS), Bankers Trust (taken over by Deutsche Bank) and Chemical Bank (merged with Chase Manhattan which, in turn, merged with JP Morgan). The volume of foreign exchange business undertaken by a merged entity almost always will be lower than the combined volume that had been undertaken previously by the two merger partners. One reason for this will be the elimination of inter-dealer transactions between the two merged banks. Another arises from the reaction of endusers to banking mergers. Most customers seek to diversify their foreign exchange business across a number of banks. It follows that those that had had a dealing relationship with both partners in a merger probably would not transfer, to the new entity, all of the joint business that they had given beforehand to the two merger partners. This customer business, of course, would not be lost to the foreign exchange markets. It simply would be redistributed among other dealers. Mergers, however, still had an unfavourable impact on foreign exchange market turnover, by providing banks with greater scope to cover deals in-house. The level of trading with end-users (even allowing for the defections noted above) would be greater in a merged bank than it had been in either one of the merger partners. This would provide the new entity with greater opportunities to marry-up customer transactions—something that would reduce its need to undertake additional covering transactions on the inter-dealer market. A reduction in proprietary trading invariably also would follow from the combination of two foreign exchange dealing rooms. The desire to control the absolute, as well as the relative, level of risk usually would persuade the senior management of a merged bank to set an overall limit on open positions below the combined level of the positions previously maintained by the two merger partners. This would serve to reduce the volume of business conducted on the inter-dealer market by the combined entity. Expansion in electronic broking The need for banks to operate in the inter-dealer market was further reduced by the development of electronic broking. Previously, banks, especially smaller ones, had to enter the inter-dealer market on a regular basis in order to find out the prices at which other banks were prepared to trade with them. According to the Bank of England, electronic brokerage systems: …increase the transparency of market prices meaning that deals traditionally executed by phone to facilitate price discovery are no longer necessary, leading to a more efficient market, with less opportunities for arbitrage, and an overall fall in foreign exchange turnover.46 The lower turnover figures recorded by London, in 2001, are more than accounted for by a slump in inter-dealer activity. Between 1998 and 2001, total daily turnover fell by $133 billion to 504 billion. However, over the same period, daily turnover on the inter-dealer

The foreign exchange market of London

166

market tumbled by $189 billion to $341 billion. Despite this contraction, the inter-dealer market still accounted for the lions’ share (68 per cent) of the business conducted on the London foreign exchange market in 2001. Importance of financial customers Global current account transactions are equal to only a tiny fraction of turnover on the global foreign exchange markets. This has led some to view the markets as little more than a casino in which banks and other financial institutions speculate in currencies and cause exchange rates to move in directions that are devoid of any economic justification. At first glance, the counterparty information contained in the triennial surveys seems to flatter this viewpoint. Between 1989 and 2001, the share of foreign exchange turnover in London directly attributable to non-financial institutions (mostly industrial and commercial companies) fluctuated narrowly between 5 and 8 per cent. These corporate customers use foreign exchange for settling external trade in goods and services, and for financing foreign direct investment. Those with a cynical view of the operation of the foreign exchange markets often regard these customers as the only ‘legitimate’ users of foreign exchange, given the perceived economic justification for their transactions. The next biggest users of foreign exchange after industrial and commercial companies are other financial institutions (mostly pension and life insurance funds, mutual funds and hedge funds). During the 1960s and 1970s, corporate customers were the principal end-users courted by foreign exchange dealers. However, this changed by the start of the 1980s, due to the increasingly important role of asset managers as users of foreign exchange. In 1989, other financial institutions accounted for 9 per cent of turnover on the London market. Their share climbed progressively to 18 per cent in 1995, before taking a dive to 10 per cent in 1998, in the wake of the Asian financial crisis. However, this setback proved to be only temporary and, by the time of the 2001 survey, no less than 27 per cent of turnover in London was attributable to these financial customers. The growing importance of asset managers, as consumers of foreign exchange, was due to three main factors. The first was the rapid growth of funded pension schemes in the United States, Japan, the United Kingdom and the Netherlands. The second was the increased willingness of pension fund managers to diversify their risks by granting a higher asset allocation to overseas securities (a shift that was facilitated in the United Kingdom by the abolition of foreign exchange controls). The third was the development of hedge funds, or funds with a bias towards exploiting arbitrage opportunities and yield spread differentials on global markets.47 Most asset managers do not regard foreign exchange as an asset class in itself. The need of pension funds and most mutual funds for foreign exchange arises simply out of their desire to hold bonds and equities denominated in a currency, or currencies, other than that of their own country. It is totally wrong, therefore, to regard these operators as currency speculators, because their demand for foreign exchange is directly generated by day-to-day business needs. Some hedge funds, along with a few mutual funds, will count foreign exchange as a

On top of the world 1986–2003

167

distinct asset class. Those that act in this way can be viewed as currency speculators. The Quantum Fund, for instance, was given this label (as well as other and more colourful names) by the press after the 1992 sterling crisis. Hedge funds, however, spend most of their time and money in wheeling and dealing on the global bond and equity markets, and their demand for foreign exchange arises largely from their involvement in these activities. A common play for such funds in the late 1990s was to borrow Japanese yen at microscopic interest rates in order to invest in higher yielding US Treasury securities.48 Derivatives were widely used to control the risks in these and other such transactions. Hedge funds are inclined to engage in big (and sometimes leveraged) deals, and the high value and complex nature of their foreign exchange needs make them profitable, and so much sought after, customers for banks’ foreign exchange dealing rooms. Inter-dealer transactions dominate turnover Despite the significant activity generated by hedge funds and other financial institutions, the bulk of the turnover on the London foreign exchange market is attributable to business undertaken on the inter-dealer market (between dealers within London and between London dealers and those located abroad). Over the period 1989–98, the share of daily turnover attributable to inter-dealer activity fluctuated between 75 and 86 per cent, before falling to 68 per cent in 2001. Proprietary trading undertaken by banks and other dealers contributes to the flow of business passing through the inter-dealer market. However, the volume of such trading, especially where it involves running open overnight positions, is controlled by limits set both by the banks themselves as well as by official regulators. In consequence, it makes only a modest contribution to total inter-dealer turnover. The bulk of the transactions undertaken on the inter-dealer market are spawned, in fact, by deals with end-users. The simplest way in which this will occur is when a bank buys US dollars for sterling from a customer and then covers the transaction by buying sterling for US dollars on the inter-dealer market. More complex deals, however, can lead to a much bigger multiplier effect. The operation of this process is fully explained in the Bank of England’s 1992 triennial survey. According to the Bank: …customer business normally generates considerable inter-bank activity. For example, notwithstanding the increase in direct cross-currency trading, banks wishing to lay off the exchange risk they have taken on through cross-currency transactions with customers may do so by undertaking two deals using the markets for each of the two currencies against the dollar. Moreover, outright forward orders from customers are likely to be covered by a swap and a matching spot transaction. This means, for example, that a bank that wished to cover a forward sale to a customer of a currency other than the US dollar or deutschmark against sterling might undertake at least four additional transactions (i.e. spot and swap deals in both sterling/dollar and dollar/foreign

The foreign exchange market of London

168

currency.49 High levels of inter-dealer activity lie behind a rather curious feature of the London market. This is the surprisingly low share formed, in recent years, by spot transactions in total turnover (the same has been true in other centres). From a high of 73 per cent in 1986, this fell progressively to only 30 per cent in 2001. Trading nowadays is dominated by forward transactions, especially foreign exchange swaps. Between 1992 and 2001, the proportion of activity attributable to outright forwards inched up from 6 to 10 per cent, whereas the proportion due to swaps soared from 42 to 60 per cent. End-users are the main counterparties in outright forward deals, but the bulk of activity in swaps takes place between dealers. The growth in forward transactions is noteworthy because, at the beginning of the 1990s, many commentators were inclined to take a gloomy view of the prospects for this business. Outright forwards, in particular, were deemed to be under threat from increased competition from currency options, as well as from the imposition of new capital adequacy rules on banks. These rules came into force in 1990 and required banks to set aside varying amounts of capital against different classes of assets. The inter-bank placements sometimes used to support forward activity were embraced by these rules and it was felt that banks, many of whom were short of capital at that time, would seek to curtail the growth of such assets in order to strengthen their balance sheets. As it turned out, banks’ capital ratios (other than in Japan) increased sharply after the recession of the early 1990s, and this reduced the need of banks to impose a tight squeeze on their balance sheets. Their ability and willingness to remain as active providers of forward exchange led most of their corporate customers to continue to cover the bulk of their exchange exposures on the traditional forward market rather than on the derivatives market. Anyway, after 1990, corporates would have been unable to pursue the latter approach on an organised derivatives exchange in London. Currency futures had never made much headway in the United Kingdom, and so it was almost an act of kindness when the LIFFE decided to discard these contracts in 1990. Greater interest had been shown in currency options, but most users had preferred the flexibly tailored options provided by banks on the over-the-counter (OTC) market than the one-size-fits-all currency options traded on the LIFFE. So these too were put to the sword in 1990.50 Activity in OTC currency options in the United Kingdom expanded strongly during the 1990s. Daily turnover climbed to $43 billion in 1998, before dropping to $37 billion in 2001, in step with the contraction in the traditional foreign exchange market.51 In 2001, turnover in currency options (which are not included in the figures for the traditional market) equalled 7 per cent of turnover on the London foreign exchange market. This was less than the share (10 per cent) claimed by outright forwards. The main end-users of currency options are other financial institutions, especially hedge funds. The relatively low market share attributable to these instruments belies their importance to foreign exchange dealing rooms. Currency options are complex products and the premiums obtained by banks for writing them make a disproportionate contribution to dealing profits. The emergence of wafer thin spreads in the traditional market has served to further underline the importance of this income stream.

On top of the world 1986–2003

169

Since 1995, foreign exchange swaps have become the most widely traded foreign exchange instruments in London. Swaps are mainly traded on the inter-dealer market, and are used by banks and others to cover end-user foreign exchange transactions and to manage dealers’ own interest rate risks and currency positions. The bulk of activity in swaps is for very short dates of seven days, or less. In 1998, these very short-dated swaps accounted for no less than 43 per cent of the total turnover on the London market (comparable data were not published in 2001). Widespread use is made both of overnight swaps (which involve purchasing a currency for value today and simultaneously selling it back for value tomorrow) and ‘tom/next’ swaps (which involve purchasing a currency for value tomorrow and simultaneously selling it back for spot value on the following day).52 Good value for spot exchange is obtained two working days after the initiation of a transaction. However, in the case of certain currencies (most notably the US dollar) banks are able to provide those end-users with more urgent needs the facility of receiving good value on the same day as the initiation of a deal, or the day after. Overnight swaps and/or tom/next swaps will be used to cover these irregular transactions. Dealers also will use a tom/next swap when they wish to rollover their own spot positions in foreign exchange. Harder pounding for smaller dealers Taking a spread on deals transacted with end-users and with other dealers traditionally has provided a stable stream of income for banks engaged in foreign exchange. However, this annuity style income has been eroded, since the mid-1990s, as spreads have been sliced wafer thin by the improvements in price transparency and price discovery promoted by the technological changes noted earlier. The pressures have been the greatest in the inter-dealer market, in which many of the smaller players have found it no longer worthwhile to quote two-way prices. The result has been a deterioration in liquidity.53 Increasingly, business in the inter-dealer as well as in the wider market has been concentrated in the hands of the biggest banks and investment houses. These institutions possess a number of advantages over their smaller brethren. They have the credit standing to be deemed as suitable counterparties for the jumbo size deals, each worth as much as $2 billion, that sometimes pass through the inter-dealer market (such deals invariably are connected with derivatives activity). They have the means to invest in the technology that nowadays is needed to maintain a competitive edge. They have a wide and varied customer business, which leaves them well placed to judge the direction of the market from their own order flow, and to arrange their own positions accordingly. And the level of business that they undertake allows them to achieve significant economies of scale. The charmed circle of really successful foreign exchange traders is extremely small. According to Euromoney: As spreads have tightened, it has become more and more difficult to make money through straightforward transactions or everyday flow business, other than by dealing huge volumes. That is bad news for those institutions that don’t

The foreign exchange market of London

170

make it into the top 10.54 The big ten certainly have been more and more successful in garnering business in London. In 1986, the top ten dealers accounted for 36 per cent of the turnover on the London foreign exchange market. This rose to 44 per cent in 1995, before climbing further to 58 per cent in 2001. In all, 257 dealers contributed to the 2001 survey, when the average daily turnover in London was $504 billion. The top ten dealers grabbed $292 billion of this total, thereby leaving only $212 billion to be shared between the remaining 247 players. Low spreads and low volumes make for a poor business model and it is likely that the number of active players in London, which has been falling since 1989, will shrink further in future years. Another interesting feature highlighted by the Bank of England’s surveys is the dominance of foreign owned institutions on the London foreign exchange market. Between 1986 and 2001, the share of turnover attributable to such dealers remained fairly close to 80 per cent. Throughout the centuries, London’s success as a financial centre has owed much to the warm reception it has given to banks and investment houses from abroad. The resources and ideas brought in by these foreign institutions have played a key role in enabling the City to compete successfully with other international financial centres. In the case of the London foreign exchange market, its turnover would have been decimated if foreign banks had been barred from participation. The main reason for this is that British owned banks do not have anything like the capital resources needed to support the volume of business that is undertaken in London. This situation has been exacerbated, in recent years, by a reduction in the number of British owned banks possessing both the means and the desire to compete on the exchange markets. The British merchant banks—in earlier times a force to be reckoned with on the London foreign exchange market—have become an endangered species, with most being taken over, often by foreign institutions.55 Mergers have further reduced the number of British clearing banks, whereas most of the building societies that have converted into banks have chosen to steer clear of the exchange market. Considerations such as these help to explain the modest showing of British owned institutions in the annual Euromoney surveys of foreign exchange dealers (see Table 8.2).56 These surveys provide a global poll of foreign exchange dealers plus, since the mid1980s, a separate smaller poll of dealers just in the London market. Rankings in the former are based on the share of business given to dealers by respondents (which nowadays comprise corporate treasurers, institutional investors and banks) from around the world. In contrast, the London poll is based just on votes cast by respondents using the services of London dealers. The global poll has been dominated, since its inception in 1979, by US institutions. They have regularly accounted for half or more of the top ten positions each year. Indeed, Citibank (sometimes appearing in the guises of Citicorp or Citigroup) has topped the poll in all bar two of the past 25 years. The two exceptions were in 2000 when this accolade went to Deutsche Bank, and in 2003 when it went to UBS. The success of these US, German and Swiss behemoths has owed much to their extensive global networks, to their heavy investment in dealing technology and to their innovative approach towards

On top of the world 1986–2003

171

servicing their customers’ needs. Another interesting aspect of the global survey is the growing importance of investment banks as providers of foreign exchange. In 1986, only one investment bank (Morgan Guaranty) was listed in the top ten, with all the other slots being taken by commercial banks. However, by 2003, there were not only three pure investment houses (Goldman Sachs, Credit Suisse First Boston and Morgan Stanley) in the top ten, but also most of the other entrants were universal banks (such as JP Morgan Chase, Citigroup and Deutsche Bank) with extensive capital market operations. For the first few decades after the Second World War, the big commercial banks were the dominant players on the exchange markets. However, their competitive position has been eroded and that of investment banks strengthened as capital market transactors have become ever more important as end-users of foreign exchange. Some of the big US and continental European commercial banks have kept abreast of this development either by merging with an investment bank (viz. the Citicorp/Travelers merger that brought Citibank and Salomon Smith Barney together as Citigroup, and the JP Morgan merger with Chase Manhattan), or by building and buying their own expertise (viz. UBS or Deutsche Bank). British commercial banks have failed to make much of a mark in the capital markets, and this has not helped their endeavours as foreign exchange providers. However, those with a worthwhile presence in all the key foreign exchange centres (London, New York, Tokyo, Singapore, Frankfurt and Zurich) still have managed to make an impression on the Euromoney global poll. In recent years, both Barclays Bank and HSBC Bank (which acquired Midland Bank in 1992) have appeared, at one time or another, within the top ten of this poll. The smaller, and also more subjective (because it is based on votes cast rather than business given) London poll fails to cast British owned banks in a

Table 8.2 Euromoney top ten polls of global foreign exchange dealers

1986

1990

1995

2000

Citibank Barclays

Citibank Barclays

Chemical

Chemical

Chase Manhattan Bank of America Bank of Montreal Morgan Guaranty Bankers

Natwest Royal Bank of Canada Chase Manhattan Lloyds

Citibank Deutsche Bank UBS Chase Manhattan Chase Citigroup Manhattan HSBC/Midland Citigroup Deutsche Bank Chemical Warburg Dillon JP Morgan Read Chase Union Bank of HSBC Goldman Switzerland Sachs Bank of America Goldman Sachs Credit Suisse First Boston Natwest JP Morgan HSBC

JP Morgan

JP Morgan

Merrill Lynch

2003

Morgan

The foreign exchange market of London Trust First Chicago Standard Chartered

Midland Bank of America

172

Stanley Swiss Bank Corp Credit Suisse Barclays First Boston Capital Standard Morgan Stanley ABN Amro Chartered Dean Witter

Source: Euromoney, May edition of each year cited.

more favourable light. Only five rankings are given (compared with 20 in the full global poll) (see Table 8.3). In the late 1980s, it was commonplace for British banks to capture three or more of these positions. Indeed, in 1988 all five went to British banks (Barclays, Midland, Natwest, Lloyds and Standard Chartered). However, by 2002 the list was filled entirely by foreign owned institutions (Citigroup, UBS, Deutsche Bank, Goldman Sachs and JP Morgan Chase). While the Royal Bank of Scotland (which bought Natwest in 2000) featured in 2003, there is still a sense of déjà vu reading these recent lists. Most of the foreign banks that had dominated foreign exchange trading in London during the first decade of the twentieth century are also featured (allowing for a few name changes) in the 2002 Euromoney poll. Key players around a hundred years ago were Deutsche Bank, Swiss Bankverein (now UBS), Guaranty Trust Company of New York (now JP Morgan Chase) and International Banking Corporation (now Citigroup). Old Lady takes a lower profile British commercial banks were the dominant foreign exchange players in London during the middle decades of the twentieth century. This period also marked the zenith of the Bank of England’s influence and power over the London foreign exchange market. The Bank’s earlier and commanding role had arisen from its key responsibilities for: • Managing the Exchange Equalisation Account (EEA). • Enforcing exchange controls. • Supervising the British banking system. Intervening with the resources of the EEA had made the Bank a big player in its own right on the foreign exchange market. Exchange controls had given it direct sway over foreign exchange dealers and brokers and, between September 1939 and December 1951, had put it in a position of almost total command over foreign exchange activity in the United Kingdom. Supervising banks had allowed it to influence the risk-taking behaviour of banks operating in the London market.

On top of the world 1986–2003

173

Table 8.3 Euromoney polls of London foreign exchange dealers

1986

1990

Chemical Natwest Barclays Midland Midland Barclays Natwest Lloyds

1995

2000

2003

HSBC/Midland Citibank Chemical Natwest

Citigroup Deutsche Bank HSBC Chase Manhattan Barclays Capital

Citigroup Deutsche Bank UBS Royal Bank of Scotland Goldman Sachs

Citibank Chemical Chase Manhattan

Source: Euromoney, May editon of each year cited.

Over the past 25 years, these responsibilities either have been removed or have become less important. Abolition of exchange controls, in October 1979, removed at a stroke one of the Bank’s main roles in overseeing the London exchange market. While the Bank still has responsibility for the EEA, its need to intervene in support of sterling has been drastically reduced by the reformulation of British economic policies in the wake of the 1992 ERM crisis. The adoption of a symmetrical inflation target as the lodestar of economic policy, and the granting of operational independence to the Bank, have greatly enhanced its domestic importance, but the Bank’s success in meeting the inflation target set by the government—by promoting domestic economic stability—has all but obviated its need to intervene on the exchange markets. This has diminished its influence over the London market, and so too has the loss of responsibility for supervising the domestic banking system. This was transferred, in 1997, from the Bank to the Financial Services Authority (FSA). Previously, it was the Bank that determined the capital and risk ratios to be observed by banks operating in the foreign exchange market. Nowadays, this responsibility rests with the FSA. The Bank of England may have adopted a lower profile in the exchange market, but it is far from being invisible. Despite the establishment of the FSA, the Bank still has responsibility for securing the overall stability of the financial markets. This means that it would have a big role to play in, say, providing liquidity to foreign exchange dealers in the event of a major external shock. The Bank also has retained sway over the standards maintained in the London market. This is achieved through its membership of the Foreign Exchange Joint Standing Committee (FXJSC), on which its representatives serve as Chairman and Secretary. Nowadays a key task of the FXJSC is to oversee, in conjunction with the Bank’s Market Liaison Group and certain trade associations, the Non-Investment Products (NIPs) Code of good practice for the London financial markets. This Code is applied to wholesale transactions conducted on the sterling, bullion and foreign exchange markets, or to transactions that lie outside of the regulatory coverage of the FSA. It is the successor of the London Code of Conduct that, between 1987 and 1997, had been enforced by the Bank of England. Bank officials were deeply involved with market practitioners in preparing the new

The foreign exchange market of London

174

Code prior to its introduction in 2001.57 Membership of the FXJSC was widened in 2000 to take account of its responsibilities in respect of this Code. At the end of 2002, the FXJSC comprised 25 members representing dealers, voice brokers, electronic brokers, the British Bankers’ Association, the Association of Corporate Treasurers, the Wholesale Market Brokers’ Association, the FSA and the Bank of England.58 An event took place in September 2002 that would have attracted widespread applause in both the Bank of England and the FSA. This was the establishment of the Continuous Linked Settlement (CLS) Bank. The aim of continuous linked settlement is finally to do away with something that has bothered foreign exchange dealers ever since the collapse of Herstatt Bank in 1974.59 This is settlement risk. Earlier initiatives, including bilateral and multilateral netting, had not fully addressed this issue. In 1996, a report prepared by the central banks of the ten biggest industrial nations called for a bolder initiative, ‘…a key component of which was that private-sector groups should provide risk-reducing multi-currency settlement services’.60 CLS Bank (which is regulated by the US Federal Reserve, but has its headquarters in London) was set up with this in mind. It is designed to eliminate settlement risk by settling foreign exchange transactions on a payment-versus-payment basis. Seven settlement currencies—the US dollar, euro, Japanese yen, sterling, Swiss franc, Canadian dollar and Australian dollar—were embraced at the outset, but the CLS Bank plans to bring the Swedish krona, Norwegian krone, Danish krone and Singapore dollar into the net by the end of 2003, followed by further currencies in 2004.61 In order to be a settlement member of CLS Bank, a bank or investment house must also be a direct shareholder. All of the biggest dealers on the foreign exchange market enjoy this status. Settlement members submit to the CLS Bank details of transactions undertaken either on their own behalf, or on behalf of their customers, that are to be settled from the multi-currency accounts that they maintain with the latter. Based on this information the CLS Bank calculates daily each settlement member’s pay-in/payout position. Trades are then settled by CLS Bank over member’s multi-currency accounts by simultaneously crediting the buyer’s account and debiting the seller’s account in the relevant currencies. This feature, along with other safety nets in the system, all but eliminates settlement risk in those currencies covered by the CLS system.62 London’s past and future role Foreign exchange trading is one of the City of London’s great success stories. Based on data collated by the BIS, London holds a commanding lead over all other foreign exchange centres (strictly speaking these data refer to countries, but for the sake of convenience they are attributed in the text below to the dominant centre in each country). The first comprehensive global survey was undertaken in 1989. This put London’s share of global foreign exchange turnover at 26 per cent, or well ahead of the shares claimed by its nearest rivals, namely New York (16 per cent) and Tokyo (15 per cent) (see Table 8.4). London’s market share, as well as its lead over New York and Tokyo, increased still further over the next nine years. By 1998, 33 per cent of global activity was being

On top of the world 1986–2003

175

undertaken in London, compared with 18 per cent in New York and 7 per cent in Tokyo. However, London’s share dipped slightly to 31 per cent in 2001, largely in response to a revival in the fortunes of the Tokyo market (whose market share rose from 7 to 9 per cent between 1998 and 2001).

Table 8. 4 BIS estimates of global foreign activity by centre 1986–2001 (average daily turnover US$ billion)

Main centres

1986

1989

1992

1995

1998

2001

Amo- Amo- % Amo- % Amo- % Amo- % Amo- % unt unt share unt share unt share unt share unt share UK 90 184 26 291 27 464 30 637 33 504 US 50 115 16 167 16 244 16 351 18 254 Japan 48 111 15 120 11 161 10 136 7 147 55 8 74 7 105 7 139 7 101 Singapore na Germany na na na 55 5 76 5 94 5 88 56 8 66 6 87 6 82 4 71 Switzerland na Hong Kong na 49 7 60 6 90 6 79 4 67 29 4 29 3 40 3 47 2 52 Australia na France na 23 3 33 3 58 4 72 4 48 15 2 22 2 30 2 37 2 42 Canada na a 718 1076 1572 1969 1618 Global total 590 820 1190 1490 1200 Global totalb Source: BIS Triennial Central Bank Surveys of Foreign Exchange Activity Notes a adjusted for local double counting b adjusted for both local and cross-order double counting and for gaps in reporting.

31 16 9 6 5 4 4 3 3 3

This modest setback did little to dent London’s hegemonic position in foreign exchange. In 2001, its lead over New York, or the world’s second biggest centre, remained as wide as ever, and far more business continued to be performed in London than in all of the other EU foreign exchange markets taken together.63 London’s role as the capital of the global foreign exchange markets can be attributed to a number of factors. Important among these is the advantage it has long obtained by serving as a financial bridge between Europe and the United States. Close political and trading ties, the use of a common language and the employment of similar legal framework have helped over the years to concentrate transatlantic financial activity in London. In turn, this has served to concentrate European trading in US dollars in the same location. Adopting the US dollar as its vehicle currency has allowed the London foreign exchange market to punch well above its weight. In other countries, transactions involving the domestic currency dominate dealings on the local foreign exchange market. In 2001, for instance, the US dollar featured on one side in 93 per cent of foreign exchange deals transacted in the United States, the yen featured on one side in 75 per cent

The foreign exchange market of London

176

of deals in Japan and the euro in 64 per cent of deals in Germany.64 Yet in London, only 24 per cent of turnover was attributable to deals involving sterling. The US dollar is its key currency. In 2001, it featured in 92 per cent of all transactions performed in London (since two currencies are involved in every foreign exchange transaction, the total of the shares attributed to currencies in a given centre will sum to 200 per cent). Because it serves as an entrepôt centre, the fortunes of the London market have been little affected by the demise of sterling as a major international currency. It makes the bulk of its money by trading the US dollar against the euro, the yen, the Swiss franc and other leading currencies. The nature of the business it undertakes has made its progress largely dependent on global, rather than domestic, trends. Apart from trades between sterling and the US dollar (20 per cent of turnover in 2001), sterling barely features in the London turnover data. In 2001, only 4 per cent of transactions were attributable to trades between sterling and currencies other than the US dollar. The co-location in London of other key global markets in insurance, gold, derivatives and international bonds and loans also has been important in stimulating foreign exchange turnover. Apart from directly providing foreign exchange business, these other activities have helped the London foreign exchange market in a more indirect way. Financial markets cannot function efficiently without having immediate access to a wide range of support services. They are particularly dependent on the services of IT specialists, information providers, lawyers and accountants. The concentration of so many financial activities in the City has acted as a powerful magnet to the suppliers of these services, and the ease with which foreign exchange dealers have been able to access them has made an important contribution to the efficiency and smooth running of the London market. The cosmopolitan nature of the banks and investment houses that populate the London foreign exchange market also has served to sharpen its competitive edge. As already noted, foreign owned financial institutions—many of which had originally entered London to engage in other activities, and had only moved into foreign exchange to diversify their activities—have provided both the capital and other resources needed to support the high level of business undertaken in London. If the turnover attributable to foreign owned banks were to be excluded, London would rank as only the fourth most important foreign exchange centre in the world (behind New York, Tokyo and Singapore). Success breeds success in foreign exchange trading, and the size of the London market itself counts as one of its main competitive advantages. As the world’s biggest market, it breeds and attracts the talented dealers that are needed to keep it ahead of its competitors. It also attracts, by virtue of its depth and liquidity, a disproportionate share of the bigticket deals that pass through the global markets. Such deals serve to enhance the liquidity of the London market, so making it an even more attractive location in which to do business. London’s lead over other centres is so extensive that it is hard to see it being surrendered anytime soon. However, this does not mean that it faces a trouble-free future. Ongoing changes in technology are likely to affect both the level and the profitability of foreign exchange trading in London, and elsewhere. Electronic brokerage and single and multi-bank internet portals already have had a big impact on inter-dealer trading and on

On top of the world 1986–2003

177

spreads. Established dealers are now faced with a new threat. This is the advent of end-user to end-user matching systems, such as Hotspot FXi.65 These systems allow corporate treasurers and asset managers to by-pass foreign exchange dealers and to trade directly with one another. It will be hard for such systems to replicate the liquidity that is available on the traditional market, but even the transfer of a modest amount of business to them will have a disproportionate effect on turnover, because it will obviate the need for the inter-dealer transactions that normally are conducted after the initiation of a deal between an end-user and a bank. Activity in London also would be affected, if Britain ever decided to sign up for EMU. In EMU, there would no longer be a need to use foreign exchange to facilitate current and capital account transactions between Britain and the other members of the euro-zone. This would hit turnover in London. However, it would not make a big dent. In 2001, transactions involving sterling/euro accounted for only 3 per cent of London’s turnover. Membership of EMU, in fact, might actually strengthen London’s grip on foreign exchange trading. Even as a non-member, it serves as the foreign exchange capital for the euro. In 2001, trades involving the euro against all other currencies averaged 236 billion a day in London. This was well above the corresponding figure, of 165 billion, for the 12 EMU foreign exchange centres taken together.66 Faced with rising costs and thinning spreads many continental European banks already have decided to concentrate their foreign exchange operations in just one centre. Many have chosen London for this purpose. British membership of EMU, in all likelihood, would extend this process. Nowadays trading in the US dollar and the European currencies (mainly the euro, sterling and Swiss franc) dominate activity on the global exchange markets. However, this could change in the long-term future as the centre of world economic power shifts to the fast growing economies of the Asia-Pacific region. The increasing importance of China and the SE Asian ‘tiger’ economies in world trade will stimulate trading in their currencies, although it will take time (probably decades) before the capital markets in these countries are able to attract the sort of international financial flows that would bestow on their currencies the global status currently enjoyed by the US dollar, the euro and the yen. However, if this does eventually take place, London might find itself regarded as a less natural port of call for trading these currencies than say Singapore, Tokyo and San Francisco. This threat lies on the far distant horizon. In the nearer-term, London will have to confront the ongoing challenges presented by changes in technology. These changes already have altered the way in which business is conducted on the global currency markets. Trading has become not only more transparent, but also less mysterious. Computers now are performing many tasks that previously were performed manually. Dealers no longer are able to charge wide spreads for executing mundane transactions. Foreign exchange trading, in effect, has become commoditised. London is not alone in having to face up to this situation. So far at least, it has been as successful as other centres in responding to these challenges. There is no reason why this should change in the future. At a time when size is a key criterion for success in currency trading, the unrivalled breadth and depth of London gives it a compelling competitive advantage over other centres. In turn, this should allow London to maintain its rule over global foreign exchange trading for many years to come.

Notes 1 The somnolent years 1900–14 1 S.E.Thomas, The Principles and Arithmetic of Foreign Exchange, London: Macdonald and Evans, 1929, p. 168. 2 H.Withers, Money Changing, London: Smith, Elder, 1913, p. 95. 3 F.Escher, Elements of Foreign Exchange, New York: Bankers Publishing Co, 1915, p. 65. 4 W.A.Brown Jnr, The International Gold Standard Reinterpreted, vol. 1, New York: NBER, 1940, p. 16. 5 P.Einzig, The History of Foreign Exchange, London: Macmillan, 1962, p. 2. 6 H.W.Phillips, Modern Foreign Exchange and Foreign Banking, London: Macdonald and Evans, 1926, pp. 50–1. 7 R.H.I.Palgrave, Dictionary of Political Economy, vol. 1, London: Macmillan, 1894, p. 772. 8 R.C.Michie, London and New York Stock Exchanges 1850–1914, London: Allen & Unwin, 1987, p. 45. 9 Ibid. 10 E.H.Lever, Foreign Exchange From the Investor’s Point of View, London: Layton, 1925, p. 84. 11 W.F.Spalding, Foreign Exchange and Foreign Bill, London: Pitman, 1925, p. 30. 12 P.Einzig, The Theory of Forward Exchange, London: Macmillan, 1937, pp. 37–47. 13 Escher op. cit., p. 29. 14 HSBC Group Archives, OB Letter Book, AA 105. 15 Morgan, Grenfell & Co Records (Guildhall Library, GL), Ms 21809 (9). 16 Brown, Shipley & Co Records (Guildhall Library, GL), Ms 20111. 17 HSBC, OB Letter Book, AA105: Letter dated 2 May 1907. 18 The £3.8 billion estimate is offered in H. Feis, Europe, the World’s Banker, New Haven: Yale University Press, 1930, p. 27. However, it is claimed that this estimate fails to make sufficient allowance for foreign purchases of overseas issues in London and for defaults on outstanding issues, and that it also overstates British participation in global issues. D.C.M Platt’s estimate of £2.6 billion makes an allowance for these factors. His estimate is given in Britain’s Investment Overseas on the Eve of the First World War, Basingstoke: Macmillan, 1986, p. 5. 19 Morgan Grenfell, GL Ms 21802 (9). 20 The importance of trading in foreign securities, and especially arbitrage transactions, to the pre-1914 foreign exchange market is underlined by R.C.Michie

Notes

179

in ‘The invisible stabiliser: asset arbitrage and the international monetary system since 1700’, Financial History Review, vol. 5 (1), April 1998, p. 16. 21 Platt, op. cit., p. 33. 22 Brown op. cit., p. 154. 23 R.H.I.Palgrave, Dictionary of Political Economy, vol. 3, London: Macmillan, 1899, p. 527. 24 Kleinwort, Sons & Co Records (Guildhall Library, GL), Ms 22097 (1). 25 Brown Shipley, GL Ms 20111. 26 The Bankers’ Magazine, LXIII, 1901, p. 384. 27 Journal of the Institute of Bankers, XXI, 1900, p. 72. 28 Ibid. p. 52. 29 HSBC, ACC 150/1: Letter of 27 January 1905. 30 Journal of the Institute of Bankers, XXVII, 1916, p. 15. 31 Morgan Grenfell, GL Ms 21802 (11). 32 Journal of the Institute of Bankers, XXI, 1900, p. 57. 33 The Bank of Liverpool, a commercial bank that was not a member of the Bankers’ Clearing House had obtained a market presence in 1889 through its acquisition of Brown Shipley’s foreign exchange business in Liverpool. The Bank of Liverpool amalgamated with Martins in 1918. 34 HSBC, Extracts of Historical Records, Intelligence Department, 27 August 1954.

2 Innocence lost 1914–18 1 A good analysis of the financial upheaval caused by the outbreak of the First World War is provided by T.Seaborne ‘The summer of 1914’ in F.Capie and G.E.Wood (eds), Financial Crises and the World Banking System, London: Macmillan, 1986, pp. 78–110. 2 E.V.Morgan, Studies in British Financial Policy 1914–25, London: Macmillan, 1952, p. 21. 3 W.A.Brown Jnr, The International Gold Standard Reinterpreted, vol. 1, New York: NBER, 1940, p. 16. 4 Morgan, op. cit., p. 22. 5 Morgan, op. cit., p. 19. 6 Brown, op. cit., p. 23. 7 R.S.Sayers, The Bank of England 1891–1944, Cambridge: Cambridge University Press, 1976, p. 88. 8 Committee on Currency and Foreign Exchanges after the War, First Interim Report: Cmd 9182, 1918, para 8. 9 Bank of England Archives (BoE), London Exchange Committee (LEC) C91/6: Letter dated 13 October 1916. 10 Brown, op. cit., p. 35.

Notes

180

11 BoE, LEC C91/1: Treasury Minute dated 17 November 1915. 12 BoE, EC4/8: Report titled ‘Exchange control during the war 1914–18’. 13 Ibid. 14 D.Kynaston, The City of London: vol 3, illusions of gold 1914–1945, London: Pimlico, 2000, p. 20. 15 BoE, LEC C 91/1: Letter dated 24 December 1915. 16 BoE, LEC C91/1. 17 Sayers, op. cit., p. 90. 18 Brown, op. cit., p. 356. 19 BoE, LEC C91/1. 20 BoE, LEC C91/7: Undated file copy. 21 Morgan op. cit., p. 356. 22 See Chapter 1, p. 15. 23 Defence of the Realm Manual, 6th Edition: London, 1918. 24 The Economist 3 March 1917, p. 423. 25 Journal of the Institute of Bankers, XXVII, 1916, p. 8. 26 H.W.Phillips, Modern Foreign Exchange and Foreign Banking, London: Macdonald and Evans, 1926, p. 53. 27 Kleinwort, Sons & Co, GL Ms 22097 (4). 28 See Chapter 1, p. 12. 29 The Economist, 17 October 1914, p. 642. 30 The Economist, 12 September 1914, p. 460. 31 The Midland Venture, 15 August 1934, p. 329.

3 Tom Tiddler’s ground 1918–31 1 H.W.Phillips, Modern Foreign Exchange and Foreign Banking, London: Macdonald and Evans, 1926, p. 60. 2 See D.T.Jack, The Restoration of European Currencies, London: P.S.King, 1927, pp. 162–75. 3 H.F.R.Miller, The Foreign Exchange Market, London: E.Arnold & Co, 1929, p. 110. 4 R.Roberts, Schroders: merchants & bankers, Basingstoke: Macmillan, 1992, p. 187. 5 G.Bolton, Unpublished Memoirs. This text is deposited in the Bank of England Archive under the reference C160/178. 6 R.Skidelsky, John Maynard Keynes: vol. 2, the economist as saviour 1920–1937, London: Macmillan, 1992, p. 41. 7 Ibid. p. 43. 8 Committee on Finance and Industry, Cmd 3897, 1931, Minutes of Evidence, vol. 1, para 1550. 9 R.C.Michie, The London Stock Exchange, Oxford: Allen & Unwin, 1999, pp. 194–6. 10 See J.M.Atkin, ‘Official regulation of British overseas investment 1914–1931’, The

Notes

181

Economic History Review, XXIII, pp. 324–35. 11 J.Wake, Kleinwort Benson: the history of two families in banking, Oxford: Oxford University Press, 1997, p. 213. 12 Phillips, op. cit., p. 233. 13 See Chapter 1, pp. 12–13. 14 H.E.Evitt, Practical Banking Currency and Exchange, London: Pitman, 1933, p. 359. 15 P.Einzig, The Theory of Forward Exchange, London: Macmillan, 1937, p. 61. 16 Ibid. p. 252. 17 R.S.Sayers, The Bank of England 1891–1944, Cambridge: Cambridge University Press, 1976, p. 420. 18 Skidelsky, op. cit., p. 43. 19 A.W.Kiddy, ‘The cost of the war to Great Britain as measured by its effect upon our trade and foreign exchanges’, The Bankers’ Magazine, CVIII, 1919, p. 669. 20 Journal of the Institute of Bankers, XXXIX, 1918, p. 211. 21 Brown, Shipley, GL Ms 20111. 22 Phillips, op. cit., pp. 231–3 gives the names of 123 banks and finance houses that he reckoned comprised the London foreign exchange market in January 1925. This figure (often rounded down to 120) frequently was cited by contemporaries as equalling the number of institutions involved in the market. However, Phillip’s list also includes three groups (the Australian, South African and Indian banks) without itemising the banks involved. If the individual banks within these three groups are taken into the reckoning, the total number of participants rises to around 140. 23 P.Einzig, The History of Foreign Exchange, London: Macmillan, 1962, p. 240. 24 J.D.Wilson, The Chase: the Chase Manhattan Bank N.A., Boston, Mass: Harvard Business School Press, 1986, p. 14. 25 J.H.Robertson, The Story of the Telephone, London: Pitman, 1947, p. 88. 26 Ibid. p. 215. 27 BoE, OV 49/1: Memo dated 17 May 1928. 28 See Wake, op. cit., p. 214, and Citibank, The First Eighty Years, London: Citibank, 1983, p. 6. 29 BoE, OV 49/1: Memo titled ‘The London foreign exchange market’, 1 May 1928. 30 F.R.Miller, The Foreign Exchange Market, London: E.Arnold & Co, 1929, p. 61. 31 Bolton, op. cit. 32 BoE. C43 (114): Memo titled ‘Development of foreign exchange market’, 6 July 1936. 33 BoE, OV 49/1: Memo titled ‘Foreign exchanges’, 17 May 1928. 34 Ibid. 35 Miller, op. cit., p. 60. 36 BoE, C43/75: Memo dated 11 June 1928. 37 BoE, C43/75: Memo dated 28 July 1929. 38 League of Nations, International Currency Experience: lessons of the inter-war period, Geneva: League of Nations, 1944, p. 124. 39 The Economist, CXIII, 1931, p. 256. 40 D.Kynaston, The City of London: vol. 3, illusions of gold 1914–45, London:

Notes

182

Pimlico, 2000, p. 385. 41 Bolton, op. cit. 42 D.B.Kunz, The Battle for Britain’s Gold Standard in 1931: London: Croom Helm, 1987, p. 122. 43 BoE, C43/101: Memo titled ‘Some aspects of forward exchange in relation to control’, 7 March 1938.

4 Off gold and into the Bank 1931–39 1 BoE, C43/75. 2 P.Einzig, Exchange Control, London: Macmillan, 1934, p. 50. 3 BoE, C43/99: Memo dated 7.1.32 4 Quoted in S.Howson, Sterling’s Managed Float: the operation of the exchange equalisation account 1932–39, Princeton: Princeton University, 1980, p. 9. 5 Ibid. p. 15. 6 W.A.Morton, British Finance 1930–40, Wisconsin: University of Wisconsin Press, 1943, p. 143. 7 Howson, op. cit., p. 18. 8 Morton, op. cit., p. 172. 9 I.M.Drummond, London, Washington and the Management of the French franc, Princeton: Princeton University, 1979, p. 6. 10 Morton, op. cit., p. 174. 11 The Banker, XLI, 1937, p. 250. 12 League of Nations, International Currency Experience; lessons of the inter-war period, Geneva: League of Nations, 1944, p. 51. 13 Ibid. p. 52. 14 Einzig, (1934), op. cit., p. 52. 15 It is reckoned that by the end of the 1930s as much as 30 per cent of world trade was subject to exchange control. See: D.H.Aldcroft and M.J.Oliver Exchange Rate Regimes of the Twentieth Century, Cheltenham: Edward Elgar Publishing, 1998, p. 76. 16 P.N.Andersen, Bilateral Exchange Clearing Policy, Copenhagen: Munksgaard, 1946, p. 21. 17 Ibid. p. 28. 18 See Chapter 1, p. 10. 19 BoE, C43/101: Memo dated 7 March 1938. 20 F.J.Docker, Foreign Exchange, London: King, 1939, p. 240. 21 BoE, C43/101. 22 P.Einzig, The Theory of Forward Exchange, London: Macmillan, 1937, p. 75. 23 BoE, C43/49: Interview note 25 January 1932. 24 Einzig, (1937), op. cit., p. 75.

Notes

183

25 Docker, op. cit., p. 240. 26 BoE, C43/75. 27 BoE, C43 (114). 28 Howson, op. cit., p. 15. 29 BoE, C43 (114): Letter dated 23 September 1931. 30 BoE, C43 (114): Memo dated 9 June 1936. 31 Ibid. 32 BoE, C43 (114): Memo dated 16.12.35. 33 BoE, C43 (114): Memo dated 29.6.37. 34 BoE, C43 (114): Memo dated 7.7.36. 35 BoE, C43 (114): Memo dated 29.6.37. 36 Financial News, 4 September 1936. 37 BoE, C43 (114). 38 The Banker, XLI, 1937, p. 253. 39 BoE, C43 (114): Memo dated 29.6.37. 40 Ibid. 41 Financial News, 2 September 1936. 42 R.Fry (ed.), A Bankers’ World: speeches and writings of Sir George Bolton, London: Hutchinson, 1970, p. 21. 43 E.Hennessy, A Domestic History of the Bank of England 1930–60, Cambridge: Cambridge University Press, 1992, p. 85.

5 War and peace 1939–51 1 S.Howson, Sterling’s Managed Float: the operation of the exchange equalisation account 1932–39, Princeton: Princeton University, 1980, p. 32. 2 Ibid p. 32. 3 The Economist, CXXXVI, 9 September 1939, p. 495. 4 BoE, C43/35: Foreign Office telegram dated 2.6.45. 5 R.Fry (ed.) A Banker’s World: speeches and writings of Sir George Bolton, London: Hutchinson, 1970, p. 111. 6 James Foreman-Peck, A History of the World Economy: international economic relations since 1850, Hemel Hempstead: Harvester-Wheatsheaf, 1995, p. 236. 7 BoE, EC 3/1: History of Exchange Controls, p. 3. 8 G.Bolton, Unpublished Memoirs, BoE, C160/78. 9 Ibid. 10 BoE, EC3/1, op. cit., pp. 2–3. 11 Ibid. p. 3. 12 BoE, EC4/8: Memo dated 5.9.39. 13 Ibid. 14 E.Hennessy, A Domestic History of the Bank of England 1930–60, Cambridge:

Notes

184

Cambridge University Press, 1992, p. 87. 15 Bolton, op. cit. 16 BoE, EC6/25. 17 BoE, C43/27: Letter dated 21.6.40. 18 BoE, EC6/25: Memo dated 17.9.42. Initial plans had called for six such offices to be established. 19 BoE, EC4/8, op. cit. 20 BoE, C43/3: Memo dated 28.12.44. 21 BoE, M5/535: Unpublished History of the Bank of England, p. 627. 22 BoE, C43/2. 23 BoE, EC4/8, op. cit. 24 BoE, C43/114: Memo dated 9.3.42. 25 The following section on exchange control regulations has drawn heavily on two sources. The first is Midland Bank Review, August 1949, ‘The evolution of exchange control in the United Kingdom 1939–49’; the second is Bank of England Quarterly Bulletin (BoEQB), September 1967, ‘The UK exchange control: a short history’. 26 Midland Bank Review, August 1949, op. cit., p. 6. The first securities were mobilised and sold in late 1940. Subsequently mobilised securities were also used as collateral for hard currency loans. 27 The Economist, CXXXVIII, 1940, p. 608. 28 R.S. Sayers, Financial Policy 1939–45, London: HMSO, 1956, p. 245. 29 Midland Bank Review, August 1949, op. cit., p. 7. 30 The Banker, LIV, 1940, p. 43. Article written by Paul Einzig, who ranked as one of the sternest critics of the authorities initial exchange control measures. 31 Midland Bank Review, August 1949, op. cit., p. 8. 32 BoEQB, September 1967, op. cit., p. 249. 33 The Banker, LV, 1940, p. 90. 34 T.May, An Economic and Social History of Britain, Harlow: Longman, 1995, p. 404. 35 BoE, EC4/7 items 766–8. Subsequent amendments to these lists were announced in F.E. notices issued by the Bank and filed under EC4/7. 36 As the war progressed more currencies, including those of Panama, the Belgian Congo and Portugal were classified as specified currencies. 37 BoE, EC4/7: Letter of 3.9.39. 38 The Economist, CXXXVI, 1939, pp. 493–4. 39 BoE, C43/9: Memo dated 28.1.41. Italics introduced. 40 BoE, EC4/7: Draft press notice dated 17.7.39. 41 BoE, C43/9: Letter dated 9.10.39. 42 BoE, C43/9. 43 The Economist, CXXXVIII, 13 January 1940, p. 65. 44 BoE, C43/2: Letter dated 21.12.39. 45 BoEQB, September 1967, op. cit., p. 247. 46 BoE, C43/2: Letter dated 20.11.39. 47 BoE, C43/2: Letter dated 29.12.39.

Notes

185

48 BoE, C43/102: Letter dated 14.3.45. 49 BoE, M5/535, pp. 655–6. 50 J.Fforde, The Bank of England and Public Policy 1941–58, Cambridge: Cambridge University Press, 1992, p. 125. 51 Midland Bank Review, op. cit., p. 9. 52 C.P.Kindleberger, A Financial History of Western Europe, New York: Oxford University Press, 1993, p. 419. 53 A parallel loan of $650 million also was extended to Britain to cover the repayment of the country’s net liabilities under Lend-Lease. 54 BoEQB, September 1967, op. cit., p. 252. 55 Fforde, op. cit., p. 141. 56 BoE, C43/103: Memo dated 22.3.46. 57 BoE, C43/103: Memo dated 30.7.46. 58 The Economist, CLII, 1947, p. 116; BoE, C43/103: Memo dated 7.10.46. 59 BoE, C43/103: Letter dated 19.12.46. 60 The Economist, 18 January 1947, op. cit., p. 116. 61 Fforde, op. cit., p. 222. 62 Fforde, op. cit., p. 229. 63 BoE, C43/106: Memo dated 22.1.51. 64 Fforde, op. cit., p. 413. 65 The Bankers’ Magazine, CLXX, 1950, p. 361. 66 The Banker, XCV, 1950, p. 302. 67 Ibid.

6 Regaining lost ground 1951–72 1 D.Kynaston, The City of London: vol. 4, a club no more 1945–2000, London: Pimlico, 2002, p. 52. 2 BoE, C43/84: Memo titled ‘The foreign exchange and gold markets since 1939’, dated 20.1.61. 3 John Fforde, The Bank of England and Public Policy 1941–58, Cambridge: Cambridge University Press, 1992, pp. 413–14. 4 Ibid. 5 By 1950, public sector procurement accounted for around a half of British imports. See J.C.R.Dow, The Management of the British Economy 1945–60, Cambridge: Cambridge University Press, 1964, p. 155. 6 R.Weisweiller, Foreign Exchange, London: Allen & Unwin, 1972, p. 19. 7 BoEQB, December 1975, ‘Limits on banks foreign exchange positions’, p. 358. 8 BoE C43/84, op. cit. 9 The Bankers’ Magazine, CLXXIII, 1952, p. 124. 10 BoE, C43/108: Memo dated 10.1.52.

Notes

186

11 Ibid. 12 BoE, C43/103: Memo dated 22.5.46. 13 BoE, C43/108, op. cit. 14 BoE, C43/84, op. cit. 15 M.Phelan, ‘Money brokers’ in R.Weisweiller (ed.), Managing a Foreign Exchange Department, Cambridge: Woodhead-Faulkner, 1991, p. 129. 16 W.M.Scammell, The International Economy since 1945, London: Macmillan, 1980, p. 33. 17 BoEQB, September 1967, ‘The UK exchange control: a short history’, p. 256. 18 D.Kynaston, op. cit., pp. 48–50. 19 BoE, C43/109: Memo dated 11.5.53. 20 BoE, C43/109: Memo dated 19.5.53. 21 See Chapter 5, p. 106. 22 The Banker, CIX, 1959, p. 1. 23 S.Horie, The International Monetary Fund, London: Macmillan, 1964, p. 115. 24 BoEQB, September 1967, op. cit., p. 255. 25 BoEQB, September 1976, ‘The investment currency market’, p. 314. 26 The Banker, CXV, 1965, p. 386. 27 BoEQB, September 1976, op. cit., p. 315. 28 The Banker, June 1965, p. 387. 29 Horie, op. cit., p. 102. 30 F.Hirsch, The Pound Sterling, London: Victor Gollancz, 1965, pp. 48–9. 31 D.Marsh, The Bundesbank: the bank that rules Europe, London: Mandarin, 1993, pp. 180–1. 32 A.Cairncross and B.Eichengreen, Sterling in Decline, Oxford: Blackwell, 1983, p. 168. 33 Bank for International Settlements (BIS), 38th Annual Report, 1968, p. 7. 34 David Marsh, op. cit., p. 189. 35 BIS, 41st Annual Report, 1971, p. 194. 36 BIS, 42nd Annual Report, 1972, p. 26. 37 The Banker, January 1972, p. 10. 38 J.van Ypersele, The European Monetary System, Brussels: European Commission, 1985, pp. 40–2. 39 BoE, C43/109: Memo dated 23.6.53. 40 BoE, C43/112: Memo dated 5.7.56. 41 A.Gleeson, London Enriched, London: Foreign Banks and Securities Houses Association, 1997, p. 149. 42 C.R.Schenk, The origins of the eurodollar market in London 1955–1963’, Explorations in Economic History, 35, 1998, pp. 224–5. 43 Further details of the market’s early history are provided by E.Sarver, The Eurocurrency Handbook, New York: New York Institute of Finance, 1990. 44 These figures have been taken from various annual reports of the BIS. The data refers to external liabilities in foreign currency of the banks in Europe, Canada and Japan (the reporting area for which the longest consistent time series can be produced).

Notes

187

45 The later figure is taken from The Banker, November 1984, p. 93, and the earlier one from BoEQB, September 1961, p. 23. 46 BoE, C43/112: Memo dated 10.10.57. 47 Committee to Review the Functioning of Financial Institutions, Cmd 7937, Second Stage Evidence, vol. 4, 1979, p. 106. 48 P.Einzig, The Euro-dollar System, London: Macmillan, 1967, p. 43. 49 BoE, C43/774: Memo dated 18.12.68. 50 Cairncross and Eichengreen, op. cit., p. 184. 51 Phelan, op. cit., p. 131. 52 Gleeson, op. cit., p. 158. 53 H.McCrae and F.Cairncross, Capital City: London as a financial centre, London: Methuen, 1973, pp. 96–9. 54 The Banker, CXIV, 1964, p. 613. 55 H.E.Evitt, A Manual of Foreign Exchange, London: Pitman, 1955, p. 101. 56 BoE, C43/4: Memo dated 19.6.70. 57 C.Tygier, A Basic Textbook of Foreign Exchange: a guide to foreign exchange dealing, London: Euromoney, 1988, p. 22. 58 Often known in dealing rooms by its nickname—the Forex Association. 59 The Banker, February 1972, p. 201. 60 Group of Thirty, Foreign Exchange Markets under Floating Rates, New York: Group of Thirty, 1980, p. 14. 61 Ibid. p. 13.

7 Innovation and deregulation 1972–86 1 BIS, 43rd Annual Report, 1972/73, p. 24. 2 Italy, a founder member, had withdrawn on 13 February 1973. 3 J.van Ypersele, The European Monetary System, Brussels: European Commission, 1985, p. 43. 4 K.Burk and A.Cairncross, Goodbye Great Britain: the 1976 IMF crisis, New Haven: Yale University Press, 1992, p. 22. 5 This was the second time in less than ten years that Britain had landed up in the clutches of the IMF. In 1968, it had also borrowed in fourth tranche to shore up sterling after its November 1967 devaluation. 6 Burk and Cairncross, op. cit., pp. 34–7. 7 BIS, 49th Annual Report, 1978/79, p. 136. 8 D.Gros and N.Thygesen, European Monetary Integration: from the European monetary system to European monetary union, Harlow: Longman, 1992, p. 17. 9 van Ypersele, op. cit., pp. 53–7. 10 D.H.Aldcroft and M.J.Oliver, Exchange Rate Regimes of the Twentieth Century, Cheltenham: Edward Elgar Publishing, 1998, p. 135.

Notes

188

11 Quoted in N.Lawson, The View from No 11: memoirs of a Tory radical, London: Corgi Books, 1993, p. 474. 12 BIS, 56th Annual Report, 1985/86, p. 142. 13 Quoted in Lawson op. cit., p. 536. 14 BIS, 52nd Annual Report, 1981/82, p. 154; 56th Annual Report, 1985/86, p. 151. 15 International Currency Review, vol. 12 (2), 1980, p. 41. 16 The Banker, August 1974, p. 907; and September 1974, p. 1033. 17 Extract reprinted in annex of ‘Foreign currency exposure’, in BoEQB, June 1981, p. 237. 18 Ibid. 19 D.C.Gardner, Settlements for Foreign Exchange Transactions, London: FT Pitman, 1997, p. 23. 20 N.R.L.Hudson, Money and Exchange Dealing in International Banking, London: Macmillan, 1979, p. 78. 21 P.Bareau, ‘Death of the sterling area’, The Banker, August 1972, p. 1028. 22 BoEQB, September 1976, The investment currency market’, p. 318. 23 A good account of the circumstances surrounding the abolition of exchange controls is provided by D.Kynaston, ‘The long life and slow death of exchange controls’, Journal of International Financial Markets, 2000, 2 (2), pp. 37–42. 24 BoEQB, March 1978, p. 30. 25 BoEQB, September 1981, The effect of exchange control abolition on capital flows’, p. 372. 26 Figures taken from R.Roberts, ‘Setting the city free: the impact of the UK abolition of exchange controls’, Journal of International Financial Markets, 2000, 2 (4), pp. 131–7. 27 Lawson, op. cit., pp. 40–1. 28 S.Heffenan, Modern Banking in Theory and Practice, Chichester: Wiley, 1996, p. 222. 29 BoEQB, June 1981, ‘Foreign currency exposure’, footnote p. 235. 30 Ibid. 31 D.Read, The Power of News: the history of Reuters, Oxford: Oxford University Press, 1992, p. 301. 32 P.Gallant, Electronic Treasury Management, Cambridge: Woodhead-Faulkner, 1985, p. 50. 33 Ibid.pp. 27–31. 34 Ibid. p. 92. 35 J.Walmsley, The Foreign Exchange and Money Markets Guide, New York: Wiley, 1992, p. 476. 36 The Banker, October 1984, p. 74. 37 Read, op. cit., p. 310. 38 D.Kynaston, LIFFE: a market and its makers, Cambridge: Granta, 1997, p. 7. 39 Walmsley, op. cit., p. 325. 40 M.D.Fitzgerald, Financial Futures, London: Euromoney, 1983, p. ix. 41 BIS, Recent Innovations in International Banking, Basle: BIS, 1986, p. 37. 42 Ibid.

Notes

189

43 Fitzgerald, op. cit., p. 45. 44 B.Brown and C.R.Geisst, Financial Futures Markets, London: Macmillan, 1983, p.37. 45 Kynaston (1997), op. cit., p. 8. 46 M.Phelan, ‘Money brokers’, in R.Weisweiller (ed.), Managing a Foreign Exchange Department, Cambridge: Woodhead-Faulkner, 1991, p. 131. 47 A.Gleeson, London Enriched, London: Foreign Banks and Securities Houses Association, 1997, pp. 159–60. 48 Quoted in Gleeson, ibid, p. 160. 49 Quoted in M.S.Mendelsohn, ‘New rules for foreign exchange brokers’, The Banker, February 1979, p. 45. The next four paragraphs draw heavily on this article. 50 Committee to Review the Functioning of Financial Institutions, Cmd 7397, 1980, Appendices, para 3.337. 51 Mendelsohn, op. cit., p. 47. 52 D.Kynaston, The City of London: vol. 4, a club no more 1945–2000, London: Pimlico, 2002, p. 558. 53 The Banker, January 1980, p. 14. 54 H.McRae and F.Cairncross, Capital City: London as a financial center, London: Methuen, 1984, p. 92. 55 Ibid. p. 93. 56 R.M.Kubarych, Foreign Exchange Markets in the United States, New York: Federal Reserve Bank of New York, 1978. Insert entitled ‘Foreign exchange market practices: an update’. 57 Euromoney, May 1983, p. 221. 58 Gleeson, op. cit., p. 163. 59 Euromoney, May 1983, p. 221. 60 The latter figure reflects the number of banks that received a direct communication from the Commission during the Sarabex affair. 61 BoEQB, September 1986, ‘The market in foreign exchange in London’, p. 279. 62 The Banker, November 1985, p. 101. 63 Gleeson, op. cit., p. 88. 64 Euromoney, April 1979, p. 11. 65 Euromoney, May 1985, p. 193. 66 Committee to Review the Functioning of Financial Institutions, Cmd 7937, Second Stage Evidence, vol. 4, 1979, p. 104. 67 BoEQB, September 1986, footnote p. 379. 68 BoEQB, June 1986, ‘The changing foreign exchange markets’, p. 213. 69 The Bank had conducted, from as early as the 1930s, sporadic surveys of turnover on the London market, but these surveys were not published, and their value anyway was diminished by the absence both of any detail on principals, products and counterparties, and of suitable comparative data for other centres. 70 1973 data are published in Group of Thirty, Foreign Exchange Markets Under Floating Rates, New York: Group of Thirty, 1980, p. 14. The 1979 and 1984 data also published by the Group of Thirty in The Foreign Exchange Market in the 1980s, New York, Group of Thirty, 1985, p. 11. Both booklets provide turnover

Notes

190

estimates for 1979, but—as they are compiled from different sources—they show very different results. The former gives a central estimate of turnover in London in 1979 of $11 billion, whereas the latter gives a much higher figure of $25 billion. Such differences underline the need to take earlier and unofficial turnover data with a pinch of salt.

8 On top of the world 1986–2003 1 BIS, Survey of Foreign Exchange Market Activity, Basle: BIS, February 1990. 2 The BIS surveys allocate turnover by country rather than by city. In the case of the United Kingdom, this is of little consequence because virtually all activity is concentrated in London. However, in the case of the United States, some activity does take place in subsidiary centres (such as San Francisco and Chicago) outside of New York. There is a similar situation in a few other countries. However, as a matter of journalistic convenience, the data quoted in this chapter are attributed to the dominant centre in each country. 3 See G.Galati, ‘Why has global FX turnover declined? Explaining the 2001 triennial survey’, in BIS Quarterly Review, December 2001, p. 46. 4 Quoted in N.Lawson, The View from No. 11: memoirs of a Tory radical, London: Corgi Books, 1993, p. 554. 5 Ibid. 6 BIS, 58th Annual Report, 1987/88, p. 170. 7 Lawson, op. cit., pp. 682–3. 8 BIS, 60th Annual Report, 1989/90, p. 186. 9 The share of trading attributed to yen/mark increased from 2 to 2.4 per cent between 1989 and 1992. See BoEQB, November 1995, The foreign exchange market in London’, p. 363. 10 BIS, 60th Annual Report, 1989/90, p. 178. 11 D.Gros and N.Thygesen, European Monetary Integration: from the European monetary system to European monetary union, Harlow: Longman, 1992, pp. 83–90. 12 J.van Ypersele, The European Monetary System, Brussels: European Commission, 1985, p. 121. 13 BIS, 63rd Annual Report, 1992/93, p. 185. 14 J.Roberts, $1000 Billion a Day: inside the foreign exchange markets, London: HarperCollins, 1995, p. 18. 15 BIS, 63rd Annual Report, 1992/93, p. 188. Under the ERM rulebook all mandatory intervention in support of a weak currency at its parity floor had to be financed ultimately by the central bank of that country (even if the support had initially been provided by another ERM central bank). In contrast, intra-marginal intervention provided before a currency reached its parity limit had to be individually financed by the central bank(s) involved. Whereas Britain had to repay all of the support the

Notes

191

Bundesbank had given sterling, the (unknown) German share of the Ffrl60 billion intra-marginal support given to the franc over the week to 23 September 1992 was for its own account. 16 BIS, 64th Annual Report, 1993/94, p. 168. The bilateral margin between the Dutch guilder and the German mark was kept unchanged at +/−2.25 per cent. 17 Countries had to satisfy five convergence criteria to be eligible for EMU membership. Broadly speaking these involved: (1) An inflation rate no more than 1.5 percentage points over the rates observed in, at most, the three EU countries with the best inflation performance. (2) A long-term interest rate no more than 2 percentage points over the level of rates in the lowest inflation countries. (3) A general government fiscal deficit of no more than 3 per cent of GDP. (4) A government debt to GDP ratio of no more than 60 per cent. (5) Observance of the normal margins of the ERM without devaluing over a period of at least two years. Some discretion was allowed in the interpretation of the fiscal criteria. 18 BIS, 68th Annual Report, 1997/98, p. 105. 19 BIS, 70th Annual Report, 1999/2000, p. 98. 20 The 11 founder EMU member countries were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. While the legacy currencies of these countries remained in circulation (in the form of notes and coin) during a three-year transition period, they were replaced by the euro in currency trading on day one of EMU. Greece joined EMU at the start of 2000, at which time the drachma also ceased to be traded on the currency markets. 21 R.D.Comotto, Foreign Exchange and Money Markets, London: Euromoney, 1999, p. 9. 22 C.Luca, Trading in the Global Currency Markets, New Jersey: Prentice-Hill, 1995, p. 150. 23 Galati (2001), op. cit., p. 43. 24 BoEQB, Winter 2000, ‘The foreign exchange and over-the-counter derivatives markets in the United Kingdom’, p. 418. 25 Comotto, op. cit., p. 9. 26 Euromoney, May 2000, pp. 81–3. 27 Euromoney, December 2000, p. 16. 28 BoEQB, Summer 2003, Foreign Exchange Joint Standing Committee e-commerce subgroup report’, Summer 2003, pp. 235–9. 29 Euromoney, October 2001, p. 54. 30 BoEQB, Summer 2003, op. cit., p. 238. 31 Euromoney, May 2003, p. 43. 32 BoEQB, Summer 2003, op. cit., p. 236. 33 BIS, Triennial Central Bank Survey: foreign exchange and derivatives market activity in 2001, Basle: BIS, 2002, p. 1. 34 BoEQB, September 1986, ‘The market in foreign exchange in London’, p. 379. 35 BoEQB, November 1992, ‘The foreign exchange market in London’, p. 408. 36 Euromoney, May 1996, p. 91. 37 Bank of England, The Regulation of the Wholesale Markets in Sterling, Foreign Exchange and Bullion, July 1987.

Notes

192

38 Ibid. p. 1. 39 BoEQB, November 1998, ‘The foreign exchange and over-the-counter derivatives markets in the United Kingdom’, pp. 348–52. 40 Financial Times, 10 June 1999, p. 23. 41 Euromoney, May 1996, p. 91. 42 Information provided to the author by Michael Beales, chairman of the Wholesale Market Brokers’ Association. 43 The references for these Bank of England market survey figures (as well as subsequent ones quoted in this section) are cited above. 44 Galati (2001), op. cit., pp. 39–44. 45 Ibid. p. 40. 46 BoEQB, Winter 2001, op. cit., p. 418. 47 Comotto, op. cit., p. 13. 48 BIS, 70th Annual Report, 1999/2000, p. 87. 49 BoEQB, November 1992, op. cit., p. 412. 50 D.Kynaston, LIFFE: a market and its makers, Cambridge: Granta, 1997, p. 216. 51 BoEQB, Winter 2001, op. cit., p. 421. 52 B.Coyle, Foreign Exchange Markets, Canterbury: Financial World Publishing, 2000, p. 107. 53 Comotto, op. cit., p. 13. 54 Euromoney, May 2001, p. 62. 55 See P.Augar, The Death of Gentlemanly Capitalism, London: Penguin Books, 2000. 56 These surveys are published each year in the May edition of Euromoney. Subsequent references to these surveys are taken from the relevant edition of the magazine. 57 FXJSC, Annual Review, 2000. Online. Available http://www.bankofengland.co.uk/markets/forex/fxjsc/annualreview2000.pdf (Accessed 13 December 2003). 58 Bank of England, Financial Markets. Online. Available http://www.bankofengland.co.uk/markets/forex/fxjsc/main.htm (Accessed 13 December 2003). 59 See Chapter 7, pp. 158–9. 60 FXJSC, Annual Review, 2002. Online. Available http://www.bankofengland.co.uk/markets/forex/fxjsc/annualreview2002.pdf (Accessed 13 December 2003). 61 G.Galati, ‘Settlement risk in foreign exchange markets and CLS Bank’, BIS Quarterly Review, December 2002, p. 61. 62 Ibid, pp. 61–4. 63 All of these figures are taken from BIS, Triennial Central Bank Survey: foreign exchange and derivatives market activity in 2001, March 2002, p. 12. 64 Ibid. p. 58. 65 BoEQB, Summer 2003, op. cit., pp. 236–7. 66 BIS, March 2002, op. cit., p. 58.

Bibliography Books and articles Aldcroft, D.H. and Oliver, M.J. (1998) Exchange Rate Regimes in the Twentieth Century, Cheltenham: Edward Elgar Publishing. Andersen, P.N. (1946) Bilateral Exchange Clearing Policy, Copenhagen: Munksgaard. Atkin, J.M. (1970) ‘Official regulation of British overseas investment 1914–31.’ Economic History Review, XXIII: 324–35. Augar, P. (2000) The Death of Gentlemanly Capitalism, London: Penguin Books. Bareau, P. (1972) ‘Death of the sterling area.’ The Banker, August: 1028–31. Bell, P.W. (1956) The Sterling Area in the Post-War World, Oxford: Clarendon Press. Bell, S. and Kettell, B. (1983) Foreign Exchange Handbook, London: Graham & Trotman. Brown, B. and Geisst, C.R. (1983) Financial Futures Markets, London: Macmillan. Brown Jnr, W.A. (1940) The International Gold Standard Reinterpreted, vol. 1, New York: NBER. Burk, K. (1989) Morgan Grenfell 1838–1988: the biography of a merchant bank, Oxford: Oxford University Press. Burk, K. and Cairncross, A. (1992) Goodbye Great Britain: the 1976 IMF crisis, New Haven: Yale University Press. Cairncross, A. and Eichengreen, B. (1983) Sterling in Decline, Oxford: Blackwell. Capie, F. and Wood, G.E. (eds) (1986) Financial Crises and the World Banking System, London: Macmillan. Chalmers, E.B. (ed.) (1971) Forward Exchange Intervention: the British experience 1964–67, London: Hutchinson. Citibank. (1983) The First Eighty Years, London: Citibank. Clare, G. (1931) A Money Market Primer, London: E.Wilson. Cleveland, H.van B. and Huertas, T.F. (1985) Citibank 1812–1970, Cambridge, Mass: Harvard University Press. Cohen, B. (1971) The Future of Sterling as an International Currency, London: Macmillan. Comotto, R.D. (1999) Foreign Exchange and Money Markets, London: Euromoney. Coninx, R.G.F. (1978) Foreign Exchange Today, Cambridge: Woodhead-Faulkner. Coyle, B. (2000) Foreign Exchange Markets, Canterbury: Financial World Publishing. Docker, F.J. (1939) Foreign Exchange, London: King. Dow, J.C.R. (1964) The Management of the British Economy 1945–60, Cambridge: Cambridge University Press. Drummond, I.M. (1979) London, Washington and the Management of the Franc, Princeton: Princeton University. Dunn, R. (1973) Exchange Rate Rigidity: investment distortions and the failure of Bretton Woods, Princeton: Princeton University. Einzig, P. (1934) Exchange Control, London: Macmillan. ——(1937) The Theory of Forward Exchange, London: Macmillan. ——(1962) The History of Foreign Exchange, London: Macmillan.

Bibliography

194

——(1966) Textbook of Foreign Exchange, London: Macmillan. ——(1967) The Euro-Dollar System, London: Macmillan. Escher, F. (1915) Elements of Foreign Exchange, New York: Bankers Publishing Co. Evitt, H.E. (1933) Practical Banking Currency and Exchange, London: Pitman. ——(1952) Exchange Control in Theory and Practice, London: Pitman. ——(1955) A Manual of Foreign Exchange, London: Pitman. Feis, H. (1931) Europe, the World’s Banker, New Haven: Yale University Press. Fforde, J. (1992) The Bank of England and Public Policy 1941–58, Cambridge: Cambridge University Press. Fitzgerald, M.D. (1993) Financial Futures, London: Euromoney. Foreman-Peck, J. (1995) A History of the World Economy: international economic relations since 1850, Hemel-Hempstead: Harvester-Wheatsheaf. Fry, R. (ed.) (1970) A Banker’s World: speeches and writings of Sir George Bolton, London: Hutchinson. Galati, G. (2001) ‘Why has global fx turnover declined? Explaining the 2001 triennial survey.’ BIS, Quarterly Review, December: 39–47. ——(2002) ‘Settlement risk in foreign exchange markets and CLS Bank.’ BIS, Quarterly Review, December: 55–65. Gallant, P. (1985) Electronic Treasury Management, Cambridge: Woodhead-Faulkner. Gardner, D.C. (1997) Settlements for Foreign Exchange Transactions, London: FT Pitman. Gleeson, A. (1997) London Enriched, London: Foreign Banks and Securities Houses Association. Gregory, T.E. (1921) Foreign Exchange Before, During and After the War, Oxford: H. Milford. Gros, D. and Thygesen, N. (1992) European Monetary Integration: from the European monetary system to European monetary union, Harlow: Longman. Group of Thirty. (1980) The Foreign Exchange Markets Under Floating Rates, New York: Group of Thirty. —– (1985) The Foreign Exchange Market in the 1980s, New York: Group of Thirty. Hamilton, A. (1986) The Financial Revolution: the big bang worldwide, Harmondsworth: Viking. Headrich, D.R. (1991) The Invisible Weapon, New York: Oxford University Press. Heffernan, S. (1996) Modern Banking in Theory and Practice, Chichester: Wiley. Hennessy, E. (1992) A Domestic History of the Bank of England 1930–60, Cambridge: Cambridge University Press. Hirsch, F. (1965) The Pound Sterling, London: Victor Gollancz. Hodges, S. (ed.) (1990) Options: recent advances in theory and practice, Manchester: Manchester University Press. Holmes, A.R. and Green, E. (1986) Midland: 150 years of banking business, London: B.T.Batsford. Horie, S. (1964) The International Monetary Fund, London: Macmillan. Howson, S. (1980) Sterling’s Managed Float: the operation of the exchange equalisation account 1932–39, Princeton: Princeton University. Hudson, N.R.L. (1979) Money and Exchange Dealing in International Banking, London: Macmillan. Institute of Bankers. (1949) Current Financial Problems and the City of London, London: Europa. Irving, J. (1981) The City at Work, London: Andre Deutsch.

Bibliography

195

Jack, D.T. (1927) The Restoration of European Currencies, London: P.S.King. Kiddy, A.W. (1919) ‘The cost of the war to Great Britain as measured by its effect upon our trade and foreign exchanges.’ The Bankers’ Magazine, CVIII: 668–82. Kindleberger, C.P. (1993) A Financial History of Western Europe, New York: Oxford University Press. King, W.T.C. (1972) History of the London Discount Market, London: Frank Cass. Kubarych, R.M. (1978) Foreign Exchange Markets in the United States, New York: Federal Reserve Bank of New York. Kunz, D.B. (1987) The Battle for Britain’s Gold Standard in 1931, London: Croom Helm. Kynaston, D. (1997) LIFFE: a market and its makers, Cambridge: Granta. ——(2000a) The City of London: vol. 3, illusions of gold 1914–1945, London: Pimlico. ——(2000b) ‘The long life and slow death of exchange controls.’ Journal of International Financial Markets, 2 (2): 37–42. ——(2002) The City of London: vol. 4, a club no more 1945–2000, London: Pimlico. Lawson, N. (1993) The View From No. 11: memoirs of a Tory radical, London: Corgi Books. League of Nations. (1944) International Currency Experience of the Inter-War Period, Geneva: League of Nations. Lever, E.H. (1925) Foreign Exchange From the Investor’s Point of View, London: Layton. Luca, C. (1995) Trading in the Global Currency Markets, New Jersey: Prentice-Hall. Marsh, D. (1992) The Bundesbank: the bank that rules Europe, London: Mandarin. McRae, H. and Cairncross, F. (1984) Capital City: London as a financial centre, London: Methuen. May, T. (1995) An Economic and Social History of Britain 1760–1990, Harlow: Longman. Mendelsohn, S. (1979) ‘New rules for foreign exchange brokers.’ The Banker, February: 44–7. Michie, R.C. (1987) London and New York Stock Exchanges 1850–1914, London: Allen & Unwin. ——(1998) ‘The invisible stabiliser: asset arbitrage and the international monetary system since 1700.’ Financial History Review, 5 (1): 5–26. ——(1999) The London Stock Exchange: a history, Oxford: Oxford University Press. Miller, F.R. (1929) The Foreign Exchange Market, London: E.Arnold & Co. Moggridge, D.E. (1972) British Monetary Policy 1924–31: the Norman conquest of $4.86 , Cambridge: Cambridge University Press. Morgan, E.V. (1952) Studies in British Financial Policy, London: Macmillan. Morton, W.A. (1943) British Finance 1930–40, Madison: University of Wisconsin Press. Officer, L. (1996) Between the Dollar-Sterling Gold Points: exchange rates, parity and market behaviour, Cambridge: Cambridge University Press. Palgrave, R.H.I. (1894 and 1899) Dictionary of Political Economy, vols 1 and 3, London: Macmillan. Phelan, M. (1991) ‘Money brokers,’ in R.Weisweiller (ed.), Managing a Foreign Exchange Department, Cambridge: Woodhead-Faulkner, pp. 124–35. Phillips, H.W. (1926) Modern Foreign Exchange and Modern Banking, London: Macdonald and Evans. Platt, D.C.M. (1986) Britain’s Investments Overseas on the Eve of the First World War, Basingstoke: Macmillan.

Bibliography

196

Read, D. (1992) The Power of News: the history of Reuters, Oxford: Oxford University Press. Roberts, J. (1995) $1000 Billion a Day: inside the foreign exchange markets, London: HarperCollins. Roberts, R. (1992) Schroders: merchants & bankers, Basingstoke: Macmillan. ——(2000) ‘Setting sterling free: the impact of the UK abolition of exchange controls.’ Journal of International Financial Markets, 2 (4): 131–7. Roberts, R. and Kynaston, D. (eds) (1995) The Bank of England: money power and influence 1694–1994, Oxford: Clarendon Press. Robertson, J.H. (1947) The Story of the Telephone, London: Pitman. Sarver, E. (1990) The Eurocurrency Market Handbook, New York: New York Institute of Finance. Sayers, R.S. (1956) British Financial Policy 1939–45, London: HMSO. ——(1957) Lloyds Bank in the History of English Banking, Oxford: Clarendon Press. ——(1976) The Bank of England 1891–1944, Cambridge: Cambridge University Press. Scammell, W.M. (1980) The International Economy Since 1945, London: Macmillan. Schenk, C.R. (1994) Britain and the Sterling Area: from devaluation to convertibility in the 1950s, London: Routledge. ——(1998) ‘The origins of the eurodollar market in London 1955–63.’ Explorations in Economic History, 35:221–38. Skidelsky, R. (1992) John Maynard Keynes: vol. 2, the economist as saviour 1920–1937, London: Macmillan. Spalding, W.F. (1925) Foreign Exchange and Foreign Bill in Theory and in Practice, London: Pitman. ——(1928) Dictionary of World Currencies and Foreign Exchange, London: Pitman. Thomas, S.E. (1929) The Principles and Arithmetic of Foreign Exchange, London: Macdonald and Evans. Truptil, R.J. (1936) British Banks and the London Money Market, London: J.Cape. Tygier, C. (1988) A Basic Textbook of Foreign Exchange: a guide to foreign exchange dealing, London: Euromoney. Wake, J. (1997) Kleinwort Benson: the history of two families in banking, Oxford: Oxford University Press. Walmsley, J. (1992) The Foreign Exchange and Money Markets Guide, New York: Wiley. ——(1996) International Money and Foreign Exchange Markets, Chichester: Wiley. Walton, L.E. (1956) Foreign Trade and Foreign Exchange: their theory and practice, London: Macdonald and Evans. Weisweiller, R. (1972) Foreign Exchange, London: Allen & Unwin. Whitaker, A.C. (1933) Foreign Exchange, New York: Appleton. Whiting, D.P. (1968) Finance of Foreign Trade and Foreign Exchange, London: Macdonald and Evans. Wilson, J.D. (1986) The Chase: the Chase Manhattan Bank n.a., Boston, Mass: Harvard Business School Press. Withers, H. (1913) Money Changing, London: Smith, Elder. ——(1915) War and Lombard Street, London: Smith, Elder. Ypersele, J.van (1985) The European Monetary System, Brussels: European Commission. Archives Bank of England (BoE).

Bibliography

197

Brown, Shipley & Co (Guildhall Library). HSBC Group, London. Kleinwort, Sons & Co (Guildhall Library). Morgan, Grenfell & Co (Guildhall Library). UK government reports Committee on Currency and Foreign Exchanges After the War (Cunliffe Report, Cmd 9182), First Interim Report, 1918. Committee on Finance and Industry (Macmillan Report, Cmd 3897), Minutes of Evidence: vol. 1, 1931. Committee on the Working of the Monetary System, (Radcliffe Report, Cmd 827), Principal Memoranda of Evidence: vol. 1, 1960. Committee to Review the Functioning of Financial Institutions (Wilson Report, Cmd 7937), Second Stage Evidence: vols 2 and 4, 1979, and Appendices, 1980. Other reports and journals The Banker. The Bankers’ Almanac. The Bankers’ Magazine. Bank of England Quarterly Bulletin (BoEQB). Bank of England (1987) The Regulation of the Wholesale Markets in Sterling, Foreign Exchange and Bullion. Bank for International Settlements (BIS): —Annual Reports. —Quarterly Reviews. —Triennial Central Bank Surveys. BIS (1986) Recent Innovations in International Banking. The Economist. Euromoney. Foreign Exchange Joint Standing Committee (FXJSC), Annual Review. International Currency Review. Journal of the Institute of Bankers. Midland Bank Review. The Midland Venture.

Index acceptance houses 35 accommodation paper 15 arbitrage 9, 29, 50–1,168; see also foreign exchange; gold; stock arbitrage asset managers 168 Association Cambiste International (ACI) 123 Association of Foreign Exchange Brokers 53–4,143; disbanded 54 Astley & Pearce 71, 106, 146 Atriax 162 authorised dealers 86–7,89, 94,95, 101, 104–5,116, 122, 136 Babcock and Brown 164 Bank of England 2,23–4,58, 59, 80, 103; Banking Department 27; Cashier’s Department 80; dealings in specified currencies 77, 80,83, 86, 88–9,93–5,100; domestic role 175; exchange control management 75, 78–9,80–1,85, 136; foreign exchange department 56, 70; foreign exchange surveys 147, 150, 163, 165, 169; intervention on forward market 56, 113, 121; Issue Department 27, 77; operations during First World War 60–2,80, 92; oversight of market 58, 68, 70–1,74, 106, 121, 133–4,136, 142–5,163, 164, 174–5; use of brokers 71 Bank for International Settlements (BIS) 107, 113, 141, 165; foreign exchange surveys 150, 176 Bankers Trust Co. 29, 50, 86, 166 Banking Act (1979) 136 Barclays Bank 49, 72, 81, 147, 172 Baring Brothers & Co. 28 Beales, Michael 164 bearer bonds 13 Big Five 48, 53, 71, 86 bilateral netting 135, 176 Bolton, George (later Sir George) 41, 53, 56, 71, 74, 75, 78, 80,100, 105 Bretton Woods Agreement 92, 112,115, 125, 132–3

Index

199

Bridge, Roy 116, 120, 123 British Bankers’ Association (BBA) 142, 143, 144, 147, 175 British overseas banks 49, 71, 86, 113 brokerage 53, 54, 65, 73, 74, 106, 142, 143 brokers 6, 37, 52–4,71, 72–4, 80,100, 105–6,121–2,142–,148, 163–4 Butler, Guy 146 cable see telegraphic transfers Cantor Fitzgerald 163, 164 capital controls 30,34 Carter, R.W. & Co. 6 Chase Manhattan 147- 1, 166, 173 Chase National Bank 50, 86 cheap sterling 95, 99, 108 cheque 11, 12, 14, 33, 43–4 Citibank 138, 147, 162, 172, 175; see also National City Bank of New York City of London: domination by foreign banks 3, 146, 178; as Eurocurrency centre 118; as foreign exchange centre 1, 2, 49, 118, 123, 146, 148, 150, 165, 172, 176–9; as financial centre 5, 106, 139, 177 clearing banks 16, 20–1,34–5,69, 81, 95, 104–5,116,146 commercial banks 41, 43, 49, 86,172, 146 commissions 86, 87, 89, 94, 105, 117 Committee of English and Foreign banks in London 34 Committee of London Clearing Banks (CLCB) 73, 74, 79, 143, 147 computers 123, 137–8,179 Continuous Linked Settlement Bank 175–6 convertibility 84, 92, 99, 102, 108; early restoration 93; final restoration 108; suspension 93 Crédit Lyonnais 20, 21, 49 cross border risk 31–2,35 cross exchange rates 37 currency options 139, 141–2,150, 170 currency swap 139 customer dealers 146 dealers 6, 7, 13, 33, 38, 48, 52, 53, 72, 75, 133, 146, 170– see also authorised dealers Dealers’ Association 53, 72 dealing limits 69,104, 116, 119, 133, 136–7,167 dealing lines 69 derivatives 139,142–,169 Deutsche Bank 19, 34, 161, 166, 172 direct dealing 73, 74, 106, 121–2,163;

Index

200

banned 74; restored 144–5 Direction der Disconto-Gesellschaft 19 drafts 8, 12, 44 Dresdner Bank 19, 20, 34, 36 Economic and Monetary Union (EMU) 116, 154, 157, 158, 165, 166, 179 ECU 131 effective rate index 126 electronic brokerage 150, 161, 167, 175, 178 Electronic Brokerage Service (EBS) 161, 163 electronic order matching 161 ethical standards 53 euro 116, 158, 159–60,165–6,178 Eurobond market 117 Eurocurrency market 102, 117, 120, 124 Euromoney: dealers’ polls 146, 162, 172 European Payments Union 107 Exchange Equalisation Account (EEA) 58, 60, 61–2,70, 77, 82, 174 Exchange Control Act (1947) 95, 104, 109, 136, 145 exchange controls: abolition 135, 145; British 30, 59, 71, 76, 102, 104, 106, 107–8,119, 122, 126, 134; German 66–7; London market re-opening 102; other countries 58, 65, 67, 82, 91; in Second World War 78, 82–4, 88, 91 Exchange Rate Mechanism (ERM) 116, 131, 153, 154–7,158, 165; British membership 155; parity bands 155, 157; realignments 155 finance bills 15 financial futures 125, 139–41,170 Financial Services Act (1987) 163 Financial Services Authority (FSA) 175 foreign banks: London branches 3, 16, 18, 33, 105, 116, 118, 146, 166 foreign bills 5, 7, 10–1, 23, 32, 43; long 9, 16, 32,45; trade 11, 16; usance 11 foreign exchange arbitrage 14, 33, 51, 102, 104, 107–8,121 Foreign Exchange Brokers’ Association (FEBA) 72, 74, 79, 142; dissolution 121; reconstitution 105 Foreign Exchange Committee (FEC) 73, 74, 81, 104–5,106, 122, 142, 147, 164

Index

201

Foreign Exchange and Currency Deposit Brokers’ Association (FECDBA) 121–2,142–4,164 Foreign Exchange Joint Standing Committee (FXJSC) 147, 161, 164, 175 forward exchange market 1, 41, 43, 53, 58, 65, 93, 100, 113, 132, 133, 169–70; comparison with futures 139–41; electronic brokerage 161; expansion during 1920s 44–7; links with Eurocurrency market 120; origins 9; problems during 1930s 68–9; re-opening 102–3; during Second World War 89; swaps 170 Franklin National 134 Fulton, Charles & Co 105, 146, 164 FXall 162 FX Connect 162 Garban 164 German banks 19, 34, 49 Godsell & Co. 52, 71, 105, 146 gold arbitrage 14, 33 gold bloc 60, 61, 70 Gold Pool 112, 114 Goldman Sachs 173, 174 gold shipments: banned 37 gold standard 8, 23, 70; breakdown 60–1; during First World War 24, 27, 33; sterling’s departure 56, 58; sterling’s return 37; suspension 37 guaranteed mail transfer 44 ‘Guide to Market Practice’ 147 Gurney, A.W. 72, 79, 81, 88 Harlow, Meyer, Savage 146 Harlow & Jones 71, 80 hedge funds 168–9,170 hedging 139, 141 Herstatt, I.D. 134, 176 Herstatt risk see settlement risk high-yielding currencies 153 Holden, Edward (later Sir Edward) 9, 19, 21, 28 Hotspot FXi 179 HSBC Bank 172; see also Midland Bank Huth, Frederick & Co. 17

Index

202

inter-bank market 91, 94, 102, 104, 139, 160 Intercapital 164 inter-dealer market 160, 161, 166–7,169–70,170; see also inter-bank market interest coupons 13 interest parity 46 International Banking Corporation 18, 50, 174 International Monetary Fund (IMF) 92, 102–3,109; British borrowings 127 International Monetary Market 139 internet 3, 161–2,178 intervention 108, 113, 128, 132; during First World War 25, 26–7,29, 35 investment currency market 108–11; surrender rule 110, 135 investment dollars 109–10 investment houses 136, 146, 161, 171, 172 invisible trade 12 Japhet, S. & Co. 17 Jones, J.K. 80 JP Morgan Chase 162, 173, 174; see also Chase Manhattan Kay, Robert 56,71 Keogh, jim 146 Kirkland-Whittaker 146, 164 Kleinwort, Sons & Co. 14, 17, 51 Knowles, Michael 146 Lloyds Bank 49, 72, 74, 165 Lloyds Bank International 133 London City and Midland Bank 9, 12, 19, 21, 28, 29, 35 London Code of Conduct 147, 163, 175 London and County Bank 21 London County and Westminster Bank 34 London Foreign Exchange Managers’ Committee 72, 73 London International Financial Futures Exchange (LIFFE) 139, 140–1,170 Macmillan Committee (1931) 42, 56 mail 8, 10, 23, 32 mail transfers 43–4 Marshall, M.W. & Co. 6, 52, 55, 71, 80, 105, 163 Marshall Woellwarth 55 Martin, R.P. & Co. 105, 146 Martin Bierbaum 164

Index

203

Martins Bank 16, 21, 73 mechanisation 52 Mercantile House 146, 164 merchant banks 16–7, 34, 41, 48, 50,86, 116 metro business 161 Meyer & Co 80 Midland Bank 49, 72, 117, 146, 172; see also London City and Midland Bank Mills & Allen 146 Minex Corporation 161 Montagu, Samuel & Co. 17, 72, 74, 116 Morgan Guaranty 147, 173 Morgan, J.P. & Co. 10, 13, 20, 28, 29, 166; British government accounts 28, 29, 33 Morgan, J.S. & Co. 10, 13, 14, 17 multilateral netting 176 National City Bank of New York 12, 21, 29, 50, 51, 59, 86, 116 Natwest 116; see also Westminster Bank Non-Investment Products Code 175 O’Brien, Sir Leslie (later Lord) 143 official market 103, 108, 135 open positions 41, 50, 104, 116, 119, 133, 134, 136, 167, 169 option forward 120 options 125; see also currency options over-the-counter (OTC) market 139,141, 142, 170 parity bands 103, 115 passing names 122, 145 pay 147 pension funds 136, 168 portals 161, 162, 178 Prebon Yarmane 164 price discovery 161, 167, 171 principals 95, 102, 104, 136, 163 proprietary trading 14, 167, 169 purchasing power parity 151 Quantum Fund 151, 168 Quin Cope 106 radiotelephony 52 restrictive practices 122 Reuters:

Index

204

Dealing 122161; Dealing 161161; Dealing 3000 161, 163; Monitor 137; Money Dealing 139, 161 Rothschild, N.M. & Sons 18, 56 Royal Exchange 1, 5–6, 24, 50, 123; closure 95 Sarabex Ltd 143–4 Scheduled Territories 96, 106, 135; see also sterling area Schröder, J.H. & Co. 41 settlement risk 134, 176 Siepmann, Harry 75, 79, 90, 94 snake 116, 126; demise 131 Société Générale 21, 49, 72 SWIFT 138–9 Soros, George 139 Souch Jefferys & Spillan 81 specie points 8 speculation 41,68, 102, 112, 116–,116, 167–9 spot rate 43, 68, 161, 170 spreads 16, 73, 74, 94,95, 99, 101, 103, 116, 161, 170– during Second World War 88–9 sterling 1, 8, 23, 25, 37, 61–2,127, 153,178; crises 111, 116, 126–8,156 devaluations 99, 113–5; departure from gold 56; ERM membership 155 free rate 83; during First World War 23–6; during Second World War 77–8; return to gold 37; Smithsonian revaluation 115–6; snake membership 116; volatility after Armistice 37 sterling acceptances 1, 24 sterling area 82, 89–90,95, 106–7,135 sterling bills 5, 13, 23, 24, 33, 34 sterling bloc 65 stock arbitrage 6, 13, 42 swaps 47, 170 Swiss Bank Corp 72, 166 telegraph 7, 23, 50–1,138 telegraphic transfers 10, 14, 32, 35, 43, 158

Index

205

telephone 6, 51, 138, 139; earliest international use by dealers 51; links with Continent 7 Telerate 138 telex 123, 138 ‘tom/next’ swaps 170 trading losses 125, 133–4 Tradition 146, 164 Tullet & Riley 146 Tullets 164 turnover 124, 148,163, 165, 167, 169 UBS 133, 163, 167 United States 23, 27, 37, 56, 68, 82, 83, 84, 91, 168, 177; financial markets 139; high investment returns 13; railroad securities 13; stabilisation fund 62 US banks 18–9,49–50,69, 83, 86, 90 US dollar: importance to London 3, 5, 50, 119, 177 valeur compensée 33 value date 33, 44, 171 volatility 65, 68, 115, 125, 133, 150 Westminster Bank 49, 72; see also London County and Westminster Bank white labelling 162 Wholesale Market Brokers’ Association 164, 175 Woellwarth & Co. 105