Chris Skinner is the Chair of The Financial Services Club, he is also The Complete Banker
By the 1970s, the City had re-established its position of prominence thanks to trading in Eurocurrency and the increasing volume of trading in securities, but it lagged behind the rest of the world, particularly New York, due to its very traditional way of operating.
The markets were based upon a structure that was 150 years old, where gentlemen stockbrokers dealt with client needs and gave orders to jobbers who would make the trades.
The system started when many members of the Stock Exchange began to specialise in one of the leading types of securities during the 19th century. These players were defined as ‘market-makers’ or jobbers, and the brokers who dealt with them on behalf of the public had a clear-cut separation.
Jobbers and brokers
This separation was made a formal one, when it was embodied in the Stock Exchange rules in 1909. The rules had been created to ensure that those taking orders were not creating dishonest trades, by inflating prices or concentrating investments through conflicting market making interests.
By 1914 there were over 600 jobbing firms as well as many one-man jobbing operations. These numbers then steadily declined as the institutional investor supplanted the private one, which meant that the scale of capital required to be a jobber – as you had to cover your trading positions with collateral – increased dramatically.
On the eve of 'Big Bang' there were five major jobbing firms on the floor of the Stock Exchange: Akroyd & Smithers, Wedd Durlacher, Pinchin Denny, Smith Brothers, Bisgood Bishop and Charles Pulley.
Meanwhile, the large stockbroking firms were Seligman Harris, Phillips & Drew, Capel Cure Myers and Quilter & Co. Their business was based upon schmoozing clients over long lunches, and the City was renowned for imbibing, massive entertainment bills and general high-life activities.
Philip Augar tells the story well in his book The Death of Gentlemanly Capitalism, where a broker hears that his secretary lives on an estate in Romford, and replies: “How splendid. Do you keep horses there?”
No wonder the gentleman brokers were stereotyped as public school-educated oafs from Harrow or Eton, whilst the jobbers were viewed as all being cheeky cockney boys who were loud and brash. A very old world [to see the world of the old stock exchange, click here which links to a 47-minute BBC documentary from 1964 on the Stockbroker’s World].
Both the jobber and broker made money. The jobbers made money by making markets, as every stock transaction had to be recorded in their books; the brokers made money through commissions from their clients, which were fixed; and both functions were firmly separated.
The real focus of the separation was made with the best of intentions: to avoid conflicts of interest, where a broker might falsely make trades in stocks where they had an interest themselves. This is important as some feel that today's issues are caused by the fact that such separation was removed.
This is similar to the view that the repeal of Glass-Steagall by the Gramm-Leach-Bliley Act of 1999 in the US, which removed the separation of investment banking from retail banking, was a mistake.
The separation of market maker and stockbroker caused issues for the City of London’s competitiveness, particularly by the 1980s when the volume of trading through London’s markets was just 1/13th of that being traded in Wall Street.
The future is in derivatives
This was down to the innovations coming from across the Atlantic. In particular, the rise of technology had given way to new ideas about finance, and derivatives began to emerge as a way of creating futures markets.
The theories were based upon the work of two professors, Fischer Black and Myron Scholes, who modelled risk equations and, in 1973, published a paper: ‘The Pricing of Options and Corporate Liabilities’, which articulated a theory that any asset could be perfectly offset in risk terms by another investment. A hedge, so to speak.
The markets embraced the concept immediately and this became known as the Black–Scholes equation, the mathematical theory that governs the price of an option over time.
The way the theory works is that you can create a derivation of an asset, and perfectly hedge the risks of that asset in a way that will ‘eliminate risk’.
So I can take part of an investment in the stocks of General Electric, and hedge this with an option in oil commodities for example, in the belief that GE stock price will fall when oil prices rise and vice versa; or I can take an FX trade in Dollars and hedge this with an option in yen for the same reason.
The pairing of risks on the basis of options for the future, using the Black-Scholes formula, combined with trading in parts of related assets and instruments – derivations – forms the basis for much of all market trading today.
It led to the rise of derivatives and over-the-counter (OTC) derivatives; the creation of new exchanges like the Chicago Mercantile Exchange, the London International Financial Futures and Options Exchange (LIFFE) and Eurex; and is a huge part of the volume of trading that goes through today’s high-frequency trading automated systems.
The Rise of OTC Derivatives Contracts, from Zero Hedge
Wall Street adopted the derivatives markets rapidly, and also introduced automation for programming trades to allow more complicated mathematical models to operate as part of this new, more complex world. These developments pushed London into a backwater.
It used to be “absolute hell with a wooden floor. You’d come back to the office at 3pm and blow your nose, and clumps of brown wood dust would come out.” Fred Carr, Partner at Capel-Cure Myers in the 1980s.
By 1986, London trading volumes were a thirteenth of New York’s and a fifth of the size of Tokyo; Frankfurt and Paris were rising as serous European alternatives; and London appeared fusty and old. It was time for change.
The Financial Services Act
Margaret Thatcher’s Government and her Minister for Trade and Industry, Cecil Parkinson (a former guest speaker at the Financial Services Club) introduced the Financial Services Act of 1986. This had a dramatic and profound effect upon City life.
The aim of the Act had many implications but, for the City, it was driven by four key principles:
- Internationalisation, allowing overseas firms to compete in the London markets;
- Deregulation of the fixed commission rule, so that stockbrokers had to become far more competitive;
- Proprietary transactions allowed, eradicating the separation of the broker and market maker and encouraging trading off your own book of business; and
- The opening of ownership of Stock Exchange members to outsiders, encouraging a wave of acquisitions and mergers.
In particular, the Act created competition between brokers – before Big Bang, commissions were fixed and so brokers did not compete on commission rates – and not only allowed brokers and jobbers to merge, but also abolished any oversight of the law courts on derivative contracts that might be considered speculative or contrary to the Gaming Act of 1845, e.g. ‘betting’.
A flurry of mergers and acquisitions followed, with the best deals going to those who jumped first. For example, Security Pacific bought 30% of Hoare Govett, the top equity broker, in September 1983 at an implied value of £27 million. When they purchased a further 60% ten months later, the firm was worth £80 million.
By 1986, strategies had been chosen and implemented. Stockbrokers left their old premises, typically six-storey 1960s monstrosities, and moved into glass skyscrapers.
The actual day of change was 27 October 1986. It was called the Big Bang because so many changes had to be implemented on one day: the elimination of fixed commissions; a marked increase in the number of market participants; a change in the structure and ownership of trading firms; and perhaps most importantly rapid movement of stock trading off the floor of the Exchange.
This remains the most rapid and complete regulatory reform of any market, and the most striking example to date of a regulatory event engineered to benefit the local financial industry.
A key impact was the introduction of a wave of new technologies. The London Stock Exchange rapidly moved from open outcry – where the jobbers would shout “buy, buy, buy” and “sell, sell, sell” across the trading room – to a completely automated system, with program trading. This led to algorithmic trading and now high frequency trading.
Today's ‘trading floor’, from FinTechIsrael
The end of open outcry meant that trade times shortened from 10 minutes to 10 seconds back in 1986 (today, it’s nanoseconds). Combined with the market opening two-and-a-half hours earlier and closing two hours later, this meant that trading volumes rocketed up 72% in 1986 and 56% in 1987. London was rocking.
The Big Bang allowed London to follow Wall Street into automated trading of more and more complex instruments – the exotics as many derivatives products are termed – and, since the early 2000s, the City has been back on top of the Global Financial Centres Indices. This is all down to the Big Bang of 1986.
The Big Bang made London a completely free and open trading location for all, with overseas firms welcome and all of the skills required to create liquidity based here – accountants, lawyers, technologists, auditors, advisors, consultants and more. Over a million people work in the City today, and much of the Big Bang’s changes hailed the systems and structures that operate today, including those that allowed the credit crisis to occur.