Financial Sector Assessment Program United Kingdom Technical Note: Financial Stability Implications of London’s Role as a Global Markets Trading Center

This technical note reviews the Financial Sector Assessment Program of the United Kingdom. It examines the United Kingdom’s public debt management practices using the IMF-World Bank Guidelines for Public Debt Management as a framework. It analyzes the government’s Code for Fiscal Stability, transparency, accountability, debt strategy, and risk management framework. It also provides a detailed assessment of the antimoney laundering and combating the financing of terrorism regime and compliance of the Basel Core Principles of the United Kingdom.


This technical note reviews the Financial Sector Assessment Program of the United Kingdom. It examines the United Kingdom’s public debt management practices using the IMF-World Bank Guidelines for Public Debt Management as a framework. It analyzes the government’s Code for Fiscal Stability, transparency, accountability, debt strategy, and risk management framework. It also provides a detailed assessment of the antimoney laundering and combating the financing of terrorism regime and compliance of the Basel Core Principles of the United Kingdom.

I. Introduction1

1. A unique feature of the U.K. financial system compared to other national financial systems is that trading of sterling-denominated claims is small when compared to cross-border trading activity denominated in U.S. dollars and euros. In the money market, the domestic sterling interbank market is less than half of the total global interbank trading activity that takes place in London between unrelated institutions. The remainder mainly consists of a cross-border market in interbank deposits that are largely denominated in U.S. dollars and euros. Indeed, the trading that takes place in London represents the largest segment of the global market for euro-denominated interbank deposits (Table 1), even though the U.K. is not part of the euro area, and it is the largest offshore center for trading in interbank deposits denominated in other currencies.

Table 1.

U.K. Share of Cross-Border Interbank Claims in BIS Reporting Countries

(December 2001; percent of total global cross-border claims)1/

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Source: U.K. authorities and Bank for International Settlements

Percent shares reflect banks located in the U.K. regardless of country of origin, and include claims against related and unrelated banks.

Other category includes other currencies and unallocated amounts.

2. Over the past decade, the London interbank market has become increasingly dominated by U.K.-owned and other European banking groups. To a large extent this reflects the withdrawal of Japanese banks from the market when their credit ratings slipped in response to events in their home country (Table 2).

Table 2.

Breakdown of U.K. Cross-Border Interbank Claims by Bank Nationality

(Billions of U.S. dollars equivalent; percentages in italics) 1/

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Source: U.K. authorities and Bank for International Settlements

Excludes claims on related banks and those on official monetary institutions. Claims on related institutions accounted for more than 60 percent of cross-border interbank transactions involving U.K.-domiciled banks in 2001.

3. The importance of London as a trading center in the global interbank deposit market is mirrored in the foreign exchange market. London is the most active trading center in foreign exchange, with daily trading volumes in excess of $500 billion in 2001 (31 percent of daily global foreign exchange turnover) (Table 3), even though transactions involving pound sterling only accounted for 13 percent of global market turnover. And, it is typically the most active trading center for currencies outside their home market. Consistent with international practice, most transactions in the London market are conducted as foreign exchange swaps (60 percent), while spot and outright forwards transactions accounted for 30 and 10 percent, respectively (Table 4). As is the case in other countries, most transactions involve cross-border flows between banking institutions.

Table 3.

U.K. Foreign Exchange Market Share of Global Foreign Exchange Trading Activity

(In percent)

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Source: Bank of England and Bank for International Settlements.
Table 4.

U.K. Foreign Exchange Turnover by Transaction Type and Currency

Net average daily turnover in notional amounts ($ billions)

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Source: Bank of EnglandNote: Since two currencies are involved in each transactions, the sum of the percentage shares of individual currencies total 200 percent instead of 100 percent.

4. Fixed-income trading in the U.K. mainly involves trading of foreign instruments. Data on trading activity in global debt markets are not available due to the informal structure of the market. However, bond trading in London is estimated by International Financial Services, London to account for 70 percent of the global market for eurobonds. The International Financing Review noted that the largest borrowers in the 12 months ending April 30, 2001 were mainly U.S. entities, notably Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

5. The international character of U.K. markets is also reflected in the equity market. The market capitalization of foreign companies traded on the London Stock Exchange was £2.6 trillion at the end of December 2001, compared with £1.5 trillion for domestic companies. More foreign companies are listed on the London Stock Exchange than on any other exchange. Daily trading volumes for international equities in London are almost double those for domestic companies (Table 5). London is also the largest center of funds management of institutional equity holdings, with $2.5 trillion of institutional equities under management in 1999; more than Zurich, Paris, Amsterdam, and Frankfurt combined.

Table 5.

London Stock Exchange

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Source: London Stock Exchange

6. The international presence of the U.K. is also reflected in financial derivatives markets. According to a BIS survey in 2001, London is the most active trading center for over-the-counter (OTC) derivatives, with a market share of 36 percent (sterling denominated transactions accounted for only eight percent globally) (Table 6). Consistent with international trends, cross-border transactions in single-currency interest rate swaps and forward-rate agreements (FRAs) constitute the largest segments of the London market, with most transactions denominated in either U.S. dollars or euros (Table 7). Among exchange-traded derivatives markets, Euronext LIFFE is the seventh most active derivatives exchange in the world, the London Metal Exchange was 16th, and the London-based International Petroleum Exchange was 25th. Overall, London is the fifth largest center for exchange-traded derivatives contracts with a 7 percent share of global trading activity.

Table 6.

Geographical Distribution of Reported OTC Derivatives Turnover

(Daily averages of notional amounts in billions of U.S. dollars; percent of total global turnover in italics)

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Source: Bank for International Settlements
Table 7.

U.K. OTC Derivatives Transactions by Instrument in 2001

(Daily averages of notional amounts in billions of U.S. dollars)

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Source: Bank of England

7. The principal market participants in the London wholesale markets are mainly branches or subsidiaries of foreign financial institutions, although several of the largest U.K.-owned institutions (for example, Barclays and HSBC) are also important players in this regard (Table 8). Market participants and U.K. officials noted that foreign commercial banks prefer to conduct wholesale OTC market trading through branches rather than through locally-incorporated subsidiaries in order to economize on the use of capital.

Table 8.

Major British Banking Groups’ Share of Selected Global OTC Markets in 2001

(In percent)

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Sources: Bank of England and Euromoney.

Share of global market trading in London as collected by the Bank of England in its tri-ennial survey of foreign exchange and OTC derivatives markets. Data are adjusted for local double-counting but not for cross-border double-counting, and thus are not directly comparable with Euromoney data.

Share of trading in the global foreign exchange market as reported in Euromoney (May 2001).

Share of debt arrangements in the global debt market as reported in Euromoney (June 2001).

8. A natural question to pose is whether the trading in global wholesale financial markets taking place in London represents a significant source of vulnerability for the U.K. financial system. There is a consensus in both the markets and the official community in London (and elsewhere) that the global financial market activity that takes place in London does not appear to pose significant risks to the stability of U.K. financial markets and to the domestic financial system more generally. It may in fact, at the margin, contribute to more efficient markets for sterling-denominated claims.

9. The remainder of this note is organized as follows. The next section contains a brief review of the reasons why market participants have chosen to conduct a large segment of their trading in global markets in London. Section B summarizes some recent trends in the trading dynamics in global markets, and offers some thoughts on their potential implications for the U.K. financial system. Section C turns to the potential linkages between the global markets and their sterling counterparts. Section D discusses the role played by U.K. authorities in overseeing the activities of global markets, and Section E concludes.

II. London’s Attraction as a Global Trading Center

10. London is an important center for trading in global markets even though the U.K. has generally run a current account deficit since the mid-1980s, and has thus been a net importer of capital.2 Its attraction as a major trading center for global markets reflects a number of factors:

  • London benefited from being the first trading center in Europe to undergo a major deregulation of the financial services industry;

    This gave it a head start over other prospective European cities as a place where foreign financial institutions could conduct their global trading activities in a supportive regulatory environment. Consequently, a number of market participants, including all of the large and complex financial institutions (LCFIs), have devoted considerable amounts of energy and resources toward building their trading operations in London. These advantages would be extremely costly to replicate in other European trading centers, especially given the network externalities that exist with market liquidity in that liquidity tends to concentrate in the most active trading centers.

  • London benefits from the fact that in the global wholesale markets, trading takes place in English and trading practices are governed by Anglo-American law;

  • Market participants see U.K. labor laws as being significantly more flexible than those in other European trading centers, which makes workforce adjustments to changing business conditions possible both in terms of speed and cost of adjusting employment levels; and

  • London offers a highly-trained workforce spanning a wide range of disciplines that can be tapped as needed to support their trading activities.

III. Implications of Recent Trends in Global Market Structure

11. Because London is a major center for global financial trading, financial activity in London clearly reflects the changes that have taken place in trading environments around the world. As has been documented in various IMF International Capital Markets Reports, the microstructure governing trading in global markets is changing in many ways, some of which may have implications for the future resiliency of these markets, including when they are operating in London.

12. One of the structural changes that is most evident in global financial activity in London is the increasing reliance on electronic trading in wholesale markets, including some over-the-counter (OTC) markets.3 In contrast to the traditional telephone dealing arrangements, electronic systems increase the accessibility of wholesale markets to a broader range of market participants. These participants can use these electronic systems to monitor prices in a transparent manner, quickly find a broad range of counterparties in a relatively anonymous fashion, and execute transactions at low transaction costs without the need to deal bilaterally with the major market makers over the telephone. Several market participants suggested that some OTC trading resembles exchange trading in that small to medium-sized transactions are conducted through the electronic systems, while larger trades are conducted by the largest market-makers (the LCFIs) on a bilateral basis by telephone (akin to the informal “off-exchange market” often seen for the large block trades executed by market makers in equity markets).

13. As a result of financial consolidation and market integration, global markets are also experiencing lumpier order flows as the number of market players declines over time and as trade size increases. All things being equal, this makes it more challenging for market makers to manage their order flow because it takes them longer to lay-off positions in the market. Some of the market makers operating actively in London suggested that this might affect their ability to supply liquidity to the wholesale markets when they are operating in London trading hours—and thus possibly the resiliency of these markets—during periods of heightened uncertainty.

14. Market participants operating in London acknowledged that the growing use of benchmarking of investment returns and risk management systems is contributing to an increasing propensity toward herding behavior. The growing use of short-term benchmarks to monitor the performance of institutional investors was cited as a contributing factor to herding behavior because it encourages those investors to invest more passively (i.e., track their benchmarks more closely) for fear of underperforming their benchmarks. It was thought by some that this reduces the diversity of trading strategies used in the market—a key factor in promoting two-way trading flows. In addition, they suggested that as risk management systems become more comprehensive and better able to provide people at all levels of the organization with “real-time” information on a bank’s risk exposures, senior management at financial institutions are increasingly inclined to rely on these systems to reign in their traders when markets are unsettled. This may also contribute to herding behavior in times of market stress as traders all try to reduce positions in response to signals emanating from their risk management systems.

15. Taken together, these observations by market participants suggest that while global markets are deep and liquid in normal circumstances, going forward they might become less resilient in periods of heightened uncertainty. However, market participants and the authorities all agreed that while these trends are evident globally, there is no evidence to suggest that their effect will be any more significant in London than in other trading centers or that they are any more visible in sterling markets than in markets in which trading is denominated in other currencies.

IV. Potential Linkages for Transmitting Financial Risks Between Global and Sterling Financial Markets

16. Channels of transmission for financial stresses and strains between the global financial markets and the U.K. domestic financial system could exist at both macro and micro levels. At the macro level, important issues include the extent to which shocks emanating from the global markets affect their U.K. counterparts, or vice versa, and to what extent the transmission of these shocks is affected by London’s role in the global financial markets. More precisely: Is the U.K. financial system more susceptible to shocks than would otherwise be the case were it not for the fact that a large segment of global market trading activity takes place in London? From a real economy perspective, because U.K. economic activity has been positively affected by London’s international role, a change in the business conditions of this financial sector could have significant effects on the performance of the real economy, and hence on the domestic activities of U.K. financial institutions.

17. At the micro level, the main issue seems to be the extent to which additional demands and risks are placed by global trading activities on the infrastructure that underpins the U.K. domestic financial system. For example, to what extent are U.K. payment and securities settlement systems involved in the processing of global market transactions initiated in London? How easy would it be to relocate this trading activity to another location should the need arise?

Potential macro linkages

18. There does not appear to be any evidence to suggest that, because of London’s role as an international financial center, the U.K. financial system has been disproportionally adversely affected by the large number of financial shocks that have reverberated through the global financial system in recent years. During the 1990s, the global financial system has absorbed a number of financial shocks such as: the September 11 terrorist attack; the millennium date change; the introduction of the euro; the collapse of Long Term Capital Management (LTCM); a number of emerging market country debt crises; and a number of episodes of major bond and major currency market turbulence. While these shocks had significant effects on emerging market countries, and in the case of the failure of LTCM and September 11, on U.S. and dollar-based financial markets, on each of these occasions the U.K. financial system functioned as smoothly as one might expect despite the major role played by London in the global wholesale markets.

19. The problems that have arisen from time to time in the financial markets in the United Kingdom have been home-grown in nature: the failure of Barings in 1995; the small bank crises in the early 1990s; and the collapse of a number of small U.K. financial institutions in the 1970s. While these U.K.-source shocks affected the sterling markets, they did not have noticeable material effects on the global financial system or on London as an international trading center.

20. There are a couple of factors that can help explain the relative insulation of the U.K. financial system from the events that have taken place in global markets. The links between foreign financial institutions operating in London and their domestic counterparts are mainly found in wholesale market activities, in part because the large global and regional institutions generally are not actively involved in providing retail financial services in the United Kingdom.4 Thus, the financial condition of foreign institutions operating in London typically has not had direct consequences for the intermediation of funds in the U.K. An illustration of this general point that has particular topical interest is the operation of the market for risk (especially credit risk) transfers in the U.K. where, to date at least the involvement of U.K.-owned insurers has not been very active (see Box 1). Similarly, U.K. financial institutions obtain most of their profits from their domestic retail operations; hence, their activities in the London wholesale markets do not have an important bearing on the flow of funds domestically.

21. Another potential source of vulnerability is that many large U.K. financial institutions have significant counterparty relationships with foreign institutions through the global wholesale markets, which could be adversely affected by a failure of a foreign counterparty. Some also have important activities overseas, which could expose them to shocks emanating from abroad. However, such exposures are a normal part of doing business in international markets, and there is no evidence to suggest that the activities of U.K. financial institutions would be any different if the European window on the global wholesale markets was located in another European city instead of London.

22. London’s role as a major global markets trading center may make it easier for U.K. residents to invest offshore, and for nonresidents to invest in securities issued by U.K. residents. In fact, compared to other G-7 countries, the U.K. has very large holdings of foreign securities and nonresidents’ portfolio claims against U.K. residents are also large. Both of these items exceed 90 percent of GDP in the U.K. compared to less than 60 percent for other G-7 countries. However, this comparison should be treated with caution, since the U.K. statistics include a large number of foreign financial institutions, which book their global markets transactions in the U.K.

Risk Transfer Markets in the U.K.

The market for risk transfers is an OTC market that comprises different types of transactions designed to transfer different forms of risk from financial institutions to other financial institutions or to the capital markets. Typical forms of risk transfers involve the transfer of credit risk from banks to insurance or security firms (e.g., through a credit default swap or asset-backed securities) and also, on a smaller scale to date, the transfer of insurance risk from insurance companies to the capital markets (e.g., through a catastrophe bond). At the end of 2000 the global market size was estimated in around $893 billion and expected to be around $1,500 billion by end-2002 (a 9-fold increase in the 5-year period 1997 to 2002). However this is still a small market when compared with an aggregate stock of outstanding contracts in the Global OTC markets of around $100 trillion.1/ Banks are the main credit protection buyers (63 percent of the market) in the global market while the main protection sellers are banks (47 percent), insurance companies (23 percent) and securities houses (16 percent). According to the last BBA survey, around 50 percent of the global OTC credit derivatives markets trade in London.2/

As with other global markets in the U.K., transactions between foreign institutions are a large part of the risk transfer activity undertaken in London. For example, a recent FSA survey indicates that to date, U.K. insurers appear to have had a limited involvement in selling credit risk protection, with foreign insurers appearing to have far more appetite for this type of risk. Nevertheless, the limitations of the present reporting system makes the degree of involvement difficult to assess with full certainty, and in any event, given the current stresses in the insurance industry, some U.K. insurers could feel there are incentives for more active involvement in these markets in the future. U.K. banks involved in these markets as protection buyers or sellers are subject to requirements based on an interpretation of the provisions of the existing Basel Capital Accord (developed prior to the appearance of such risk transfer transactions); the proposed new Capital Accord, when implemented, will deal more explicitly with them.

Careful ongoing monitoring of the risk transfer markets, and the involvement in them of U.K. institutions—not least insurers—is therefore required. Further work by the U.K. authorities and supervisors internationally will be needed to develop an improved reporting system for risk transfers. This has proved to be a challenge to date, mainly because of the different types of transactions, which in most cases are not standardized. Apart from some simple statistics such as notional amounts traded, type and number of transactions, an improved reporting system may need to involve institutions reporting the expected and unexpected losses in their portfolio of risk transfers. For this purpose, institutions would have to be allowed to report based on their own internal models.

1/ BIS’s Triennial Central Bank Survey on Foreign Exchange and Derivatives Market Activity in the Global OTC markets.2/ For an extensive review of the market characteristics and participants see Rule, D., The Credit Derivatives Market: its Development and Possible Implications for Financial Stability, FSR, June 2001; and Risk Transfers Between Banks, Insurance Companies and Capital Markets, FSR, December 2001. For a discussion of the London market, see the FSA consultation paper Cross-Sector Risk Transfers. May 2002.

23. A potentially important macro linkage arises from the significant contribution that the global trading activities taking place in London make to the level of U.K. economic activity. The U.K. financial sector is a large contributor to U.K. GDP, employment, and balance of payments. For example, it accounts for about five percent of GDP,5 employed more than one million people in March 2002, and consistently makes a significant contribution to the U.K. balance of payments. And, the financial sector’s net overseas earnings have been rising steadily over the past decade from less than £10 billion in the early 1990s to over £30 billion in the past three years. The buoyant conditions in the London financial sector in recent years are widely cited as an important underpinning to the buoyancy of economic conditions in London and southern England, as manifested, for example, by the rise in the value of housing in London and surrounding communities. Should the global trading activities taking place in London experience weaker business conditions in the future—with a consequent reduction in employment levels—it could pose increased risks to U.K. financial institutions’ domestic lending activities through the deleterious effects on local economic conditions.

Potential micro linkages

24. A potentially important issue is the extent to which the trading in global wholesale markets that takes place in London places extra demands on U.K. payment and securities settlement systems. Overall, market participants and U.K. officials generally believe that London’s role as an international financial center does not appear to place significant additional demands on these systems. An important illustration of this general observation is the very active currency trading that takes place in London each day. London is the most active currency trading place in the world. Despite this trading and the significant amount of trade processing that takes place in the U.K., the U.K. payments and settlement infrastructure is not involved, except if sterling is one leg of the transaction. That is, foreign currency payments associated with London trading involving foreign currencies ultimately reach final settlement through the payment systems of the countries of the currency involved, and not through the U.K. payment systems. For example, the U.S. dollar leg of a currency trade that takes place in London settles through CHIPS, the payment system in the United States, and similarly for transactions in other currencies with the important exception of the euro.6

25. Settlement of the euro leg of transactions is somewhat more complicated as these initially pass through CHAPS-Euro and TARGET in the U.K. on their way to euro area. These systems are considered by market participants and officials to be capable of handling the flows associated with transactions emanating out of London—see the assessment of these systems against the CPSS Core Principles for Systemically Important Payment Systems. Similarly, the transfer of non-U.K. securities ultimately takes place through securities settlement systems located outside of the United Kingdom, such as Euroclear. Thus, while trades may be initiated in London, the final settlement of them generally happens elsewhere, save for some important trade processing work that takes place in the U.K. offices of the relevant counterparties.

26. The second major exception to the general observation that the U.K. financial infrastructure is not significantly affected by London’s role as an international financial center is the London Clearing House (LCH). In addition to its traditional role in serving as the central counterparty in exchange-traded markets, LCH is playing an increasingly important role in serving as the central counterparty for trades conducted in OTC markets as well. For example, LCH now serves as the central counterparty for OTC interest rate swaps, denominated in sterling and other currencies. If LCH became unable to operate normally, it could disrupt, and possibly result in the closure of, all markets that settle trades though it, including the relevant trades emanating from the global wholesale markets. Although important improvements can be made—and progress is indeed underway—in some areas of LCH arrangements, there is nothing to suggest that LCH’s capabilities for risk management and containment are adversely affected by its role as central counterparty in global markets per se. Box 2 summarizes key points relating to LCH, from the FSAP assessment of the U.K.’s securities settlement systems against the IOSCO/CPSS Recommendations for Securities Settlement Systems.

27. In light of September 11, another issue is whether the global market trading that takes place in London could be rerouted to another financial center in the event of operational difficulties in London. While such a transfer of trade negotiation and processing would not be easy, there is a general consensus among market participants and officials that this could be accomplished if necessary without seriously disrupting the global or U.K. financial systems. In the wake of the September 11, market participants have been taking measures to ensure that they have proper backup facilities for their trading operations, and many of them have formulated contingency plans to shift trading to other cities in Europe if necessary. Given London’s past history of terrorist incidents, many institutions have had some form of contingency plans for many years. They also take some comfort from the fact that the global wholesale market community pulled together and overcame competitive differences in the days following September 11 to transfer trading activities temporarily from New York to London, and to ensure that all trades settled following the breakdown of the settlement systems in New York. Whether such cooperation can be counted on again is an open question. Nevertheless, the number of LCFIs—which are the major players in the global financial markets—is small, a factor that can help to facilitate the reaching of a consensus on the need for cooperative efforts when circumstances are dire.

The London Clearing House (LCH)

LCH is the major central counterparty clearer in the U.K. market. LCH act as counterparty to a significant number of trades including those undertaken on derivative exchanges, the LSE’s electronic trading system (SETS) and OTC (swaps and repos). Overall, LCH seems to apply a conservative view in setting margin requirements. The monitoring of clearing members is very well developed with, among other things, daily stress testing of members’ positions.

Despite this conservative approach to risk management, however, at the time of the FSAP assessment, there were weaknesses in LCH’s payment scheme, which the authorities and LCH are currently in the process of addressing. In particular, LCH settles its cash payments across accounts held at various commercial banks, rather than in a default-risk free settlement asset. The resulting intraday risk exposures are material. While the exposures are with large, well capitalised and closely regulated banks, LCH is considering whether there are ways of reducing further the potential risk. LCH is currently discussing with the Bank of England the practicalities of replacing these current payments arrangements with one based on settlement across the books of the BoE, for settlements in sterling and Euro.

Traditionally and in line with many other clearing houses LCH has invested its cash resources in the unsecured deposit market, which brings exposure to credit risk. Again, the exposures are with high quality, well regulated counterparties and LCH has a prudent policy on managing the credit exposures. Furthermore, LCH has introduced an active programme to transfer the placement of funds in the money market from an unsecured basis to a collateralized basis, in order to limit further unnecessary credit risk exposure of LCH.

LCH has had special protection under English law since 1989 and that protection has since been extended twice to cover its OTC business and through designation for the purposes of the EU’s Settlement Finality Directive. There are nonetheless further small changes that could be made to remove any remaining uncertainty as to whether all of LCH’s arrangements are covered by the protections: work is underway to address this.

28. There are also potential benefits that might accrue to sterling financial markets from London’s role as an international trading center. Market participants noted that, at the margin, the fact that a large number of foreign institutions maintain trading operations in London can be a source of liquidity from time to time in the sterling markets. This can occur as financial institutions make use of their global trading operations in London to exploit arbitrage opportunities that may emerge in the sterling markets. This potential benefit should not be overstated, however, because such opportunities could be pursued from offshore. Nonetheless, being physically present in the market may offer some marginal benefits.

29. Similarly, the presence of sophisticated foreign financial trading operations in London can help disseminate new trading techniques and financial instruments to the sterling markets. For example, some participants noted that one of the reasons why the introduction of repo contracts to the sterling market in 1996 went fairly smoothly was because many foreign institutions had experience in using these instruments in their trading operations elsewhere.

V. Potential Implications of London’s Global Market Activities for U.K. Financial Authorities

30. In contrast to the exchange-traded markets and sterling markets where U.K. authorities have well-defined roles for supervising the activities of the exchanges and domestic financial institutions, the roles appear to be somewhat less clear-cut in the case of the global financial trading of foreign financial institutions during the period of time when London is open for trading. In the case of global trading in London, significant reliance on cross-border supervisory cooperation would seem to be important and necessary, since foreign financial institutions operating in London are predominantly chartered and supervised elsewhere. As a result, the FSA will only grant foreign banks branching licenses to non-EU banks when they originate from jurisdictions in which the U.K. authorities are satisfied with the level of home-country supervision and when they have a good working relationship with the supervisor in question.

31. U.K. authorities also play an informal role in the supervision of trading practices in the global OTC derivatives markets, such as the interest-rate and foreign-exchange swaps markets. To a large extent, these are interbank markets, led by the LCFIs, who generally serve as market-makers. While the markets are mostly self-regulated, the major market-maker and dealer institutions are subject to either banking or securities regulations and supervision in their home jurisdictions. Both the Bank of England and the FSA work closely with market participants through various market committees to promote improvements to trading conventions and appropriate trade documentation (see Box 3). For example, the Bank worked very closely with market participants to introduce the necessary changes to the financial market infrastructure in London to handle the introduction of the euro, even though the United Kingdom has not adopted the euro as its currency. The authorities are also in regular contact with market participants to keep abreast of market developments with the aim of spotting emerging issues, such as regarding the prudential standing of a market participant or unusual trading practices.

32. The U.K. authorities believe that the presence of global markets trading in London imposes extra responsibilities on them in that they feel they have a special obligation, together with the U.S. authorities, for safeguarding the stability of global financial markets. As a result, the Bank of England and the FSA devote additional resources to encouraging efforts by other national authorities and market participants to improve the functioning of global financial markets. Moreover, their high quality surveillance of conjunctural developments and structural changes taking place in the global financial system is an important instrument for influencing the evolution of market practices and international policy responses. In this way, the U.K. authorities are part of the evolving informal surveillance of global financial markets. In addition, the presence of the global trading window in London provides U.K. authorities with information on the functioning of global markets that is useful in the surveillance of the major U.K. financial institutions and the potential international threats to U.K. financial stability.

VI. Concluding Observations

33. The U.K. is unique in that a very large share of financial market trading that takes place in London represents the trading of claims between foreign financial institutions denominated in currencies other than the British pound. To a large extent, it appears that this trading activity is insulated from the U.K. domestic financial system, in part because this trading activity primarily involves wholesale market transactions between foreign institutions that have little connection to the U.K. domestic financial system, although several large U.K.-banking groups are important players in these markets. Meanwhile, U.K. financial institutions typically obtain most of their profits from the provision of financial services to the U.K. domestic economy.

34. Thus at the macro level, the most important channel between the global financial markets when they are operating in London and the U.K. domestic financial system is an indirect one and an economic one. The health of London’s financial services industry plays an important role in determining the health of the U.K. economy in the London area, which can have an impact on the quality of loan portfolios for mostly U.K. financial institutions providing loans in this part of the U.K. economy.

U.K. Authorities’ Role in Supervising Global OTC Markets

The global OTC markets are subjected to significantly less supervision than the domestic exchange-traded markets. This is not too surprising inasmuch as the OTC markets are professional wholesale markets involving transactions between sophisticated financial institutions with no direct participation from unsophisticated retail investors. Moreover, trading in these markets does not take place on organized exchanges, such as the LSE or LIFFE. Rather, the OTC markets largely consist of a network of financial institutions, which informally negotiate customized large-value transactions between themselves using telephones and electronic dealing systems.

In order for OTC markets to function smoothly, market participants need to have confidence in the prudential standing of their counterparties. The FSA is the prudential regulator for the entities it authorizes, including U.K.-incorporated subsidiaries of foreign financial institutions. However, the FSA does not have prudential responsibility for U.K. branches of passporting EEA institutions, some of which are major participants in the London segment of the global OTC markets. Prudential responsibility for these institutions lies with the authorities in the country of incorporation, although the FSA may take responsibility for supervising branch liquidity. Under the EC Banking Investment Services and Insurance Directives the U.K. authorities rely on the prudential regulation of the home country in respect of EEA-incorporated banks and investment firms. In the case of ‘third country’ incorporated institutions, the U.K. authorities must be given comfort that the foreign institution is properly supervised by its home regulator before it is granted permission to operate a branch in the U.K. If it is not content with the level of supervision provided by the home regulator, the institution in question is only allowed to operate in the U.K. as a locally-incorporated subsidiary so that the U.K. activities come under formal supervision by the FSA.

Even though OTC markets do not operate on formal centralized trading platforms, U.K. authorities work with market participants and foreign regulators to ensure that these markets are deep and liquid, and able to function smoothly under a wide range of trading conditions. This reflects their view that the smooth functioning of the global OTC markets is an important contributor to the stability of the U.K. financial system as well as the international financial system more generally. The Bank of England and the FSA maintain a continuous bilateral relationship with key market participants, and liaise with them through various local committees chaired by Bank of England staff, such as the Foreign Exchange Joint Standing Committee, the Sterling Money Market Liaison Group, and the Stock Lending and Repo Committee. These committees include a wide range of private and public sector participants, and minutes of their deliberations are posted on the Bank’s website. Examples of some issues that they have recently dealt with include: preparing financial markets for the millennium date change and the introduction of the euro, and the formulation of good trading practices for wholesale markets. These activities have no statutory basis, but appear to be well accepted and effective.

At a more formal level, the FSA has issued material on Inter Professional Conduct as part of its Handbook of rules and guidance. This material was prepared on a collaborative basis with market participants, and is aimed at securing good market practice by institutions undertaking bilateral dealings in the OTC markets. It contains special rules as to suitability and advice, communication of advice, clarifying whether one is acting as agent, arranger, or as principal, and rules as to inducements: such as soft commissions, entertainment, and the like. But the scope of the rules can be quite limited, reflecting the light touch of regulation which market participants have had in the past, and are happy to continue. On the other hand, the Handbook does have extensive provisions designed to ensure that these markets are not used improperly; for example, by ensuring that transactions are not undertaken at prices other than market prices.

35. At the micro level, the nature of global financial markets activity in London is such that the location of trading in London is to an important extent divorced from the settlement of transactions. Although a significant amount of trade processing takes place in the U.K., the global market trading activity in London does not place much of an additional demand on the U.K. payment and securities settlement systems. There are two major exceptions: the London Clearing House, which is playing a growing role in serving as the central counterparty to global OTC market transactions, and the RTGS payment system for the euro, which has an important node in London. It is critical that these parts of the U.K. payment and settlement systems maintain their efficiency and risk containment systems to ensure that they can handle the demands placed on them by the global financial markets activity that takes place in London.

36. Overall, the presence of global financial market activity in London does not pose undue risks for the U.K. domestic financial system beyond those that would normally accrue to the cross-border activities of U.K. financial institutions. Nonetheless, this global activity in London does seem to require some additional surveillance and informal supervisory responsibilities for the Bank of England and the FSA, who, together with central banks and supervisors in other major international financial centers, play an especially important role in promoting and fostering the smooth functioning of global financial markets. The presence of the trading window in London for global activity also provides U.K. authorities with a valuable perspective on developments and trends in the global financial markets, which can be invaluable when assessing the potential sources of strain that could affect the U.K. domestic financial system.


This paper was prepared by the FSAP mission team as part of the background work for the U.K. FSAP in the summer-fall of 2002. The primary contributor to this paper was Mark Zelmer of the IMF’s Monetary and Financial Systems Department.


See the article by Stephen Senior and Robert Westwood in the Winter 2001 Bank of England Quarterly Bulletin on the U.K.’s external balance sheet.


For example, see the 1996 International Capital Markets Report published by the IMF.


Some exceptions include Deutsche Bank, which is actively involved in lending to the property market, and Citibank, which operates a small retail banking network. However, it is not clear that such activities are linked to the fact that London is a center for trading in global markets.


The financial sector definition here incorporates banking, insurance, fund management, securities, derivatives, and venture capital. The contribution to the GDP reaches 8 percent if a broader definition including professional and support services related to the sector is used.


The settlement of foreign exchange market transactions changed somewhat with the introduction of continuous-linked net settlement later in 2002.