International Financial Market And Modern Capitalism - Case Study Example

International Financial Market And Modern Capitalism Table of Contents 1. International Financial Market: The History of Innovation 1 2. Debt Based monetary systems 8 Reference 12 Bibliography 15 1. International Financial Market: The History of Innovation History of innovation in financial market is not an old chronicle. To start with, it is better to have a look at the market itself. Financial market mainly includes capital market, derivatives market and currency market. Each of the above market has certain responsibilities towards their investors. For example capital market enhances capital raising while derivative market enables people to transfer financial risk as per their risk appetite. Simply put, financial market is a platform where financial transactions take place to make business and people grow. Starting several years ago, the market has evolved to inject more liquidity in global economy. In between certain developments have taken place but the evolution is still on. Many people argue that this kind of money helped in creating inflation in the economy. Today the major stock markets are London Stock Exchange, NYSE Euronext, Hong Kong Stock Exchange, NASDAQ and Shanghai Stock exchange. The recent one is NYSE Euronext, headquartered in New York, was established on 4th April, 2007 (NYSE, 2009). London Stock Exchange, being the oldest among these major stock exchanges, has a history of 300 years; though in 1801 it was formally formed under the name of London Stock Exchange. Starting its business in a coffee shop in London, now this exchange has its own TV studios for live financial broadcasts through out the day. In October, 2007 this exchange was merged with Borsa Italiana to emerge as Europe’s foremost exchange business, London Stock Exchange Group. The exchange is having the largest number of countries admitted to trade there, making it the most international among all the stock exchanges of the world (London Stock Exchange, 2009). The very first financial market evolved was Amsterdam stock exchange, in 1600. In 1602 the Dutch East India Company pioneered trading with issuing the first share on this exchange. Even in 1960s Amsterdam was the first mover to introduce currency swaps in financial markets .Then the 1970s came with innovation of some new instruments. Floating rate instruments, trading of futures on foreign currency, interest rates and on stock market indices were introduced within this period. Whenever one instrument is introduced, the market remains mostly unregulated. After a certain time, regulatory constraints get introduced to make market more regulated and more liquid. For an example when floating rate instruments came into picture, it was the first instrument that was linked to a floating interest rate (LIBOR). These instruments were introduced in such a period when due to inflation risk the nominal rate used to fluctuate radically. So to cut on this risk, floating rate preferred stock was introduced. The dividend yields of these stocks were correlated to the variations in the LIBOR rate. In early 1980s these floating rate instruments had mostly got popular in European market. Another type of debt instrument which got familiarity in international capital market was zero coupon bonds. At that time US tax system had some loopholes which used to allow a discount on bonds in respect to their par values. So there happened to be a significant amount of tax savings whenever interest rate went high or the security happened to be with longer maturity. Soon the loopholes had been detected and removed to make the market more preferable to the investors. Risk averse investors mostly became inclined to zero coupon bonds as they did not have any re-invest risk. In1980s another important event that occurred was the debt crisis in the year 1982. During that time the oil prices rose extensively. Oil producing countries from Middle East made huge dollar money by exporting oil to different countries (Korasko, n.d). They parked their huge liquid money with US and European commercial banks. Now the commercial banks were keen to lend the money to developing countries as well as even those countries were eager to borrow cheap money for their own interest. The whole lending and borrowing came to a pause during the global recession of early 1980s. Borrower countries found it very difficult to cope up with the payments for their foreign loans and started defaulting on their outstanding, keeping the creditors in bad state. Government regulators were shocked to find these creditor banks had a very little amount of capital to take in these losses. After such huge turmoil, in 1989 U.S. Treasury Secretary Nicholas F. Brady announced the ‘Brady Initiative’. Given the increasing high debt level this initiative focused on market based debt reduction (Korasko, n.d). In this new era, derivatives have been an integral part of the financial market. In 1960s the currency swaps were the first swaps innovation. This evolution came into existence when countries were not allowed to invest in other countries directly. For an example an US firm have US funds but wanted to invest in UK and an UK firm with the opposite problem, having surplus but would like to invest in US. This led to the birth of currency swaps that enabled cross currency changes. Soon it was found that this kind of swapping had huge counterparty risk attached to it. Some question also evolved from this innovation. Would one country still pay the obligations when its counterparty is in default? The regulators brought ‘Netting’ to solve some of them. It worked in this way: both the parties have to make a cash payment to their counterparties as per the respective floating interest rates. Now their payment would have been netted together and hence the counterparty obligations, in other way the risk would be lessened by ‘Netting’. So long from this discussion the observable would be that most of these reforms were made to inject more liquidity, more structure to the financial market (Allen & Gail, 1994). Evolution of standardized future contracts are not so old happening, though forwards were in place almost from the very beginning of the financial market. Futures had been great investment for investors who would not like to park much capital with their investments. Investors only have to pay the initial margin to trade in futures. But it also had counterparty risk, the risk that the counterparty would default. The solutions came with the reformation and regulations. The daily trading was accounted under ‘Marked to market’. Traders have to maintain a certain threshold amount of money in their accounts to take part in future trading. If any party had been able to make profit in any day, the profit would be paid to him from the account of the other counterparty. The counterparty has to fill up his account to certain threshold level to take part in next day’s trading. As such counterparty risk had been minimized to a greater extent. This made the market to become more and more investor friendly. Another incident to speak on happened in eighteenth century. A number of European stock markets observed a sudden and huge rise in share prices of certain companies or industries. The phenomenon later got its name as stock market bubble. For an example let’s take the example of South Sea Company. The price of its stocks rose from 31% above par in February, 1720 to 850% by 23rd June and then fell back to 200% by. Worried regulators came up with ‘Bubble Act’. As per this it is illegal to form a company without having authorisation from royal charter (Korasko, n.d). Coming to recent downturn, it had adversely affected the whole financial market. Many financial institutions went bankrupt within a few days. Stock markets have seen some lowest statistics in its whole lifetime. In such a scenario investors were mostly attracted towards government bonds as they were seemed to be less risky instruments. Corporate bonds, below investment grades, were giving yield of 15% higher on average than yields on US government debt of similar duration at the start of 2009. To recover from the losses in equity markets investors increased their holdings in bonds. With such a course, in 2008, the outstanding amount on the global bond market crossed $23.9 trillion. The amount was 5% more from the prior year’s value. International bonds issuance fell to $2.4 trillion from $3 trillion in 2007.The slowdown was more visible in second half of the same year. The snapshot gives an idea about the market share of the major international debt markets in 2002. In 2002, USA consisted of around 31% of the total international debt market with around 2637 billion dollars (Butler, 2004). Source: IFSL Research, Bonds Market 2009. The statistics have been changed. In the year of 2008, the UK market was the leader with the largest share of 30% of overall international bond issuance. The US, with 23% share in bonds outstanding was at top in outstanding bond segment and was followed by UK, Germany respectively. Government has taken many monetary procedures to inject liquidity in the whole economy. The world economy is recovering. There are lots of activities those resulted in recent downturn. But the question that still remains unanswered is: Did extreme financial re-engineering of products become the main reason behind this current downturn. And if yes, then what steps need to be taken to prevent such situation. Regulations and reforms are still to come up. 2. Debt Based monetary systems In 1971, the money supply in UK economy was under £31 billion; just after 25 years, in 1997 it went up to £665 billion, by a shocking growth rate of 2145 %. Analysts and economists were perplexed regarding the cause of this growth. Most of the people have an idea that money is being created by the central government or by Bank of England. But originally in UK most of the money is created by commercial banks through issuing loans, mortgages, credit card or overdrafts. 97% of the money supply is created through giving debts. This phenomenon is called “fractional reserve banking”. Only 3% of the money is created by the government and the authorities and the rest billions of pounds are injected into economy by the individual or institutional borrowers. That is why this monetary system is called ‘Debt Based Monetary Systems’. Starting from 1913, it has been 96 years since the debt based monetary system is taking breath in world economy. Historically in post-barter societies physical commodities like gold, silver were used as currency in business trade. Some economy had money but that was redeemable against other commodities. A previous form of money was bills of credit, produced by the Government. People were supposed to pay taxes on this money they were holding. Their obligations had being paid by using this money. Mainly British colonies in America specifically Pennsylvania, Virginia and Massachusetts were using such kind of notes. From the first issuance till date, this kind of money had always created controversies (Jones, 2007). Today paper money is used for paying taxes, repaying debt and in every business trading. Commercial banks are creating this money and giving those as loans to others. Now, they have created the loans but have not created the interests that would be paid against the loans by the borrower. Naturally, the interest had to be adjusted from others’ principal. That means borrowers are repaying loans with other loans. All the people are battling to get hold of more money than those exist in the economic system. Many people think that this is at heart of the credit crisis (SimonDixon, 2009). Institutional and individual debts are regarded as assets to the banks. Every time borrowers pay interests against their loans, the money is observed as new money in banks’ portfolio. This ‘new’ money is then again given to somebody as debt. Thus a credit boom stimulates itself until things get worsen enough to bring the economy towards credit crisis. Now to tackle the credit crisis more liquidity i.e. money is injected into the monetary system. The result is inflation. Thereafter to handle inflations banks increase their interest rate, thus pushing the economy towards another default, another credit crisis; and the vicious cycle goes on. So it seems the growth of the economy totally lies on the amount of debt it is able to support (SimonDixon, 2009). People are paying interest on our own money. In 1971 government notes contributed to 14% of the money supply. After 25 years, in 1996, it dropped down to 3.5%. So as the government has refrained itself to create money, even it has to pay interest to create debt money. In 1996 the annual interest amount that was paid by the Government was over £30 billion. So how did the things evolve; Government has created certain amount of money which is moving in the economy and creating money as loans, debts. Government is borrowing this money, which was created from its own money, and paying interest on the same (Brown, 2007). Graph Showing UK National Debt In November 2009, UK public sector was accounted for around 59.2% of National GDP with a net debt amount of £829.7 billion. Source: Office National Statistics Excluding Financial sector intrusion, public sector debt is £681 billion or (48.7% per cent of GDP) (Office for National Statistics, 2009) New money is being created through interest paid by one person at the expense of another’s income/savings and the whole economy is getting stuck in the vicious cycle of recession and inflation. Debt is piling up as time is moving away. It is high time to think about a new monetary system, which is not debt based. For this, first of all the monetary systems need to be nationalised. Government authorities should take hold of the charges of money supply. The currency can be of anything, it can be paper, gold, silver or some another commodities; but this currency should not carry any debt or interest component with it. Even in history silver, gold and other necessary commodities have shown such utilities (Schroon, 2008). This does not matter as long as there is right amount of currency to meet the needs of the economy, to carry on the businesses of the country. So we need not to pay any interest on our own money. Today, such an economy is needed, in which income parity would be maintained, people would not lay hands for others’ money. To get rid of the ever going cycle of deflation and inflation, a changed, better, revolutionary, transparent and more controlled monetary system needs to get introduced in near future. Reference Carrasco, R. E. No Date. The 1980s: The Debt Crisis & The Lost Decade [Online]. Available at: http://www.uiowa.edu/ifdebook/ebook2/contents/part1-V.shtml [Accessed on December 18, 2009]. LondonExternal. No Date. The history of financial markets. [Pdf]. Available at:http://www.londonexternal.ac.uk/current_students/programme_resources/lse/lse_pdf/further_units/invest_man/23_invest_man_chap2.pdf [Accessed on December 18, 2009]. SimonDixon. February, 2009. What is a debt based monetary system. [Online]. Available at: http://www.simondixon.org/what-is-a-debt-based-monetary-system/2009/02/02/ [Accessed on December 18, 2009]. IFSL. 2009. Bond Market 2009. [Online]. Available at: http://www.ifsl.org.uk/output/ReportItem.aspx?NewsID=287 [Accessed on December 18, 2009]. Allen, F. and Gale, D. 1994. Financial Innovation and Risk Sharing. London: MIT Press. Maximliian, J. B. 2003. The international Handbook on financial reform.UK: Edward Elgar Publishing limited. Office For National Statistics. Decemeber, 2009. Economy. [Online]. Available at: http://www.statistics.gov.uk/cci/nugget.asp?id=206 [Accessed on December 18, 2009]. Brown, H. E. 2007.Web of debt: the shocking truth about our money system.US: Third Millennium Press. Crom Alternative Exchange Association. No Date. [Online]. Available at: http://cromalternativemoney.org/ [Accessed on December 18, 2009]. Schoon, D. June, 2008. The United States Fiat Money. [Online]. Available at: http://www.financialsense.com/fsu/editorials/schoon/2008/0623.html [Accessed on December 18, 2009]. Preda, Alex (2009). Framing Finance: The Boundaries of Markets and Modern Capitalism. University of Chicago Press. Jones, N. 2007. Fiat Currency: Using the Past to See into the Future. The Daily Reckoning - Agora Financial. IMF Stuff Team. 1997. International capital Markets :developments, prospects and key policy Issues. U.S.A: International Monetary Fund. Butler, C. K. 2004. International Financial Market. [Pdf]. Available at: http://www.swlearning.com/finance/butler/butler3e/powerpoint/handout03.pdf [Accessed on December 20, 2009]. NYSE. 2009. About Us. [Online]. Available at: http://www.nyse.com/about/1088808971270.html [Accessed on December 20, 2009]. London Stock Exchange. 2009. Company overview. [Online]. Available at: http://www.londonstockexchange.com/about-the-exchange/company-overview/company-overview.htm [Accessed on December 20, 2009]. Bibliography The Earl of Caithness. June, 2001. Our Debt-based Money System Will Break Us. [Online]. Available at: http://www.prosperityuk.com/prosperity/articles/earl.html [Accessed on December 18, 2009]. Walsh, C. E. 2003. Monetary Theory and Policy. The MIT Press. Sickler, M. No Date. America's greatest problem: Its debt-money system. [Online]. Available at: http://www.biblebelievers.org.au/debtmone.htm [Accessed on December 18, 2009]. Fama, F. E. 1976. Foundations of Finance. New York: Basic Books Inc. Groz, M. M. 2009. Forbes Guide to the Markets. New York: John Wiley & Sons, Inc. Read More