Joachim Wuermeling: Collaboration instead of rivalry - thoughts on
a digital financial centre of Europe
Text of the SAFE Policy Lecture by Prof Joachim Wuermeling, Member of the Executive Board of
the Deutsche Bundesbank, at the House of Finance, Goethe University, Frankfurt am Main, 15
February 2018.
* * *
1 Introduction
Ladies and gentlemen
I am delighted to have been invited to speak to you here today. I can scarcely think of a better
platform for my lecture than Goethe University's SAFE Policy Center - and I say that for three
reasons.
First, programme directors Jan Pieter Krahnen and Hans-Helmut Kotz have made it their priority
to provide more opportunities to bring academics, policymakers and market participants closer
together in the field of financial market development. I am very much in support of such an
approach. I myself have moved, and continue to move, in all three circles, and I am aware of the
concerns in some quarters. Truth be told, however, academics, policymakers and market
participants are natural bedfellows, even in the debate on Europe's future financial centre, which I
would like to talk about today.
Second, universities have always been a key factor to consider when choosing where to locate
major financial centres. In London, for instance, it is commonplace to drop by university research
institutions and think tanks over lunch to discuss the latest financial market developments.
Goethe University has long since recognised the wealth of potential waiting to be tapped by
bridging the gap between theory and practice. In this sense, we are also doing our bit today to
add to Frankfurt's appeal as a location.
Third, I have had the honour of being appointed to the SAFE Policy Council. With that in mind,
this talk is a debut of sorts.
So what is my lecture about? In a nutshell, it's all about whether the rivalry between financial
centres in continental Europe is a zero-sum game, especially with respect to Brexit. Does one
financial centre's loss have to be another's gain, or is there another way? I can't give you a
definitive answer to that question, but I can feed in some food for thought for a variety of
stakeholders.
I would like to proceed in three steps with three key messages:
First, Brexit marks a turning point that will weaken the City of London's role as continental
Europe's financial centre. On a side note: Incidentally, I will be using the term "continental
Europe" throughout this lecture to refer to the EU after Brexit, which includes the Republic of
Ireland.
Second, a global financial centre - or, as Britons would call it, a "City" - can come into being in
the EU even after Brexit. Information technology is opening up the possibility of financial centres
in the rest of the EU becoming a networked digital city of Europe, which would, to a large extent,
overcome the existing fragmentation.
Third, if this became the new horizon of continental financial markets, a lot of stakeholders would
need to pool their resources for the project to establish a digital city of Europe. In this context,
policymakers can serve as a catalyst.
But let us now turn our attention to the heart of the action by setting our sights across the English
Channel, on London.
2 Brexit - a turning point for the financial systemof the EU
London has long been not only the most important global financial centre, but also the main hub
for Europe's financial system. Enormous amounts of capital flow in from investors on the
continent. And from there capitals flow back out to the EU: to governments, financial institutions,
enterprises and households.
The City benefits from what are known as economies of agglomeration. In fact, the metropolis on
the Thames is often regarded as having its own financial ecosystem. The local concentration of
banks, funds, private equity firms and insurers, but also related service providers such as law
firms, auditors, consultancy firms and IT specialists makes for a wide range of financial products
and high market liquidity. With that in mind, there is virtually always demand to feed supply and
supply to feed demand in the City. Countless options are on offer to cater for the widest range of
tastes with respect to the magic triangle of return, risk and liquidity.
1
It is not for nothing that London tops the widely recognised Global Financial Centres Index ,
closely followed by New York. Continental European financial centres trail behind in these
rankings, with Frankfurt in 11th place, Luxembourg in 14th, Paris in 26th, Dublin in 30th and
Amsterdam in 33rd.
London's significance is also corroborated by hard structural data on individual financial market
segments.
The United Kingdom and London in particular host around 43 percent of euro trades on the
foreign exchange market, which is more than twice as much as the share accounted for in the
rest of the EU as a whole.
The United Kingdom plays a major role as an issuing and trading centre on the bond market, too,
not least for international bonds that were not issued in the borrower's home market. The
outstanding volume of securities issued in the United Kingdom by non-resident borrowers,
primarily financial institutions, stands at around US$3 trillion. That's the highest value worldwide,
and more than a quarter of that figure is euro-denominated.
On the equity market, market capitalisation on the London Stock Exchange is around double that
on the Deutsche Börse, the leading continental European exchange. Comparing monthly
exchange trading volumes, London outstrips Frankfurt by over 60 percent.
Around 70 percent of euro-denominated OTC interest rate derivatives trading takes place in
London. And an even greater percentage - some 90 percent - of these instruments are cleared
there.
With total assets amounting to the equivalent of around €9.3 trillion, the British banking system is
the largest in the EU. One indication of its close ties with continental Europe is the fact that
around 20 percent of British banks' balance sheet assets are denominated in euro.
It's no coincidence that, of the 160 foreign bank branches operating in the United Kingdom, 77
are from the European Economic Area. Banks headquartered in continental Europe contribute 17
percent to British banks' aggregate total assets, which is slightly more than the 16 percent
attributable to US banks. Only roughly half of British banks' total assets come from British
institutions.
Other financial market segments in which London plays a prominent role are easy to find and
include funds, insurance, commodities and private equity.
Essentially, the City brings the demand and supply of capital together from all over the world.
These days, its distinctive role as a connecting and distributing point is of paramount importance
for Europe's investment and financial flows.
But what will the relationship between the United Kingdom, or London, and continental Europe
look like in future once Brexit has been implemented? Signs are pointing to a watershed moment.
Many observers suggest that it will not be possible for London to remain the EU's financial centre
once the United Kingdom has left the single market. The Wall Street Journal wrote recently:
London's position as Europe's financial centre is definitely under threat.
A fairly logical and highly probable legal consequence of Brexit is that the United Kingdom will
probably lose its EU financial services passport, meaning that banks domiciled there would no
longer have access to the European single market. As a result, it would no longer be possible to
sell a financial product approved in the United Kingdom anywhere in the European Economic
Area without barriers.
Of course, the same would hold true in reverse: Continental European institutions will also no
longer be able to provide their services in the United Kingdom without those same barriers.
In such a scenario, they might even be forced to establish a subsidiary in the United Kingdom so
as to continue to be able to serve their British customers. If no such arrangements were put in
place, it would be necessary after Brexit to establish separate legal frameworks in individual
jurisdictions, be they in the form of licences for market participants or product approvals, in order
for the United Kingdom and the EU to conduct cross-border business.
The British want to strike an ambitious free trade deal with the EU under which the cross-border
trade in financial services would continue under the most favourable terms possible. However,
EU negotiators resoundingly rejected British calls for such a deal in late January.
In any case, conventional trade agreements have thus far not covered financial services to the
degree desired by the United Kingdom. The freedoms provided by the WTO are rudimentary at
best. Globally, the following rule still applies: all players need to comply with all locally applicable
regulations - regardless of the regulations in place at home.
Up to now, mutual recognition has been selective at best, only one-sided and, above all, only
made possible when it has been in the interest of the recognising country. For instance, the EU
has made 17 and 19 case-by-case decisions on the equivalence of US and Japanese financial
products respectively. However, all this means is that markets open up for individual financial
services. It has nothing to do with comprehensive passporting rights. Such rights would be
conditional on joint European rules and regulations also applying to, and being enforceable in,
institutions domiciled in such non-euro area countries.
As yet, virtually no one across the globe has ever taken the objective of liberalising financial
services seriously, which is why financial services have thus far largely failed to feature in trade
agreements. I doubt whether it is realistic in the EU-British case.
Look at it from a supervisor's point of view: The EU will, at any rate, no longer be able to
adequately pursue financial market policy objectives such as financial market integration and
financial stability in the City of London.
As the Financial Time stated a few weeks ago: Why would the EU give up any measure or
regulatory control over finance?
What this makes clear is that London will not, as some have suggested, maintain its current role
as the financial centre of the EU after Brexit. Even with the best will in the world, there is no
substitute outside the EU for the freedoms, rights and obligations that come with being part of the
single market.
In various scenarios, financial institutions in London and the EU have a wide range of options
open to them. At this stage, most discussions simply centre on how to overcome the negative
effects of Brexit. But the current situation could also provide a good opportunity to look at the
suitability of business models from a more strategic point of view.
As regards the many options for financial institutions, just let me say this much: financial
institutions domiciled in the United Kingdom must be prepared to shift any continental business
that can no longer be carried out from there to the EU. Other business may well migrate to other
global financial centres if London's attractiveness fades as access to the EU's financial markets
becomes more difficult. Large foreign institutions could also move parts of the value chain back
to their home countries, or business with continental European clients could simply be
discontinued entirely if an EU presence is not worthwhile.
Conversely, market participants who have, until now, conducted transactions with British
counterparties while based in Europe may have to look for business partners in the EU.
Alternatively, they might have to be prepared to face additional legal hurdles if they wished to
remain active in London. But in this case, London would then be competing with other global
centres since it would no longer be able to take advantage of the benefits provided by the single
market. Ultimately, it all depends on institutions' individual cost-benefit analyses.
As a result, Brexit could, at least in theory, reduce the range of financial intermediation services
available in the EU, weaken institutions' productivity, and reduce market depth. In a nutshell, it
could entail higher costs. And there is not the slightest guarantee that business will move to the
continent after Brexit. A fair number of people suspect that it may well be the financial centres
outside the EU that will emerge as the real winners after Brexit. New York, in particular, could
well benefit from Brexit, as could other global financial hubs such as Singapore or Hong Kong.
Frankfurt, Paris and Amsterdam are by no means in the second division in this tournament, but
neither are they candidates for the Champions League. As things stand, it is unlikely that any
financial centre in continental Europe could take over London's role on its own. Although
Europe's national financial centres are more than capable of processing day-to-day financial
transactions, all of these locations lack the capacities on the required scale to handle global
transactions, not to mention the service providers, consultants and infrastructure that surround
these.
So let's not be under any illusions: no other financial centre in continental Europe can fully
replace the City of London. Brexit could have a detrimental impact on and fragment the EU's
major funding channels. From the point of view of financial market efficiency, financial market
integration, financial stability, but also real economic development, a scenario such as this is
clearly harmful.
Initiatives are therefore needed. The most far-reaching objective would be to strive for a globally
significant financial market in continental Europe.
Until now, this has not been one of the EU's objectives. The single market was intended to
increase competitiveness within Europe, the banking union was created to strengthen the
resilience of the European banking system, and the capital markets union was aimed at
increasing the possibility of cross-border risk sharing via the equity markets. With Brexit, we
could now face a new strategic challenge: setting up an alternative financial centre on the
continent.
3 Even after Brexit, the EU will still have what it takes to become its own global financial
centre
That brings me to my second step: What does a globally competitive financial centre require?
The Global Financial Centres Index, or GFCI, I referred to earlier lists five factors for success:
1. Business environment: Financial centres perform well in this regard if their framework
conditions mean that it is easy for (international) market participants to relocate there. Such
conditions include a stable political system that includes a reliable legal system and a
consistent institutional framework, efficient regulation, low levels of red tape, a lack of
corruption, cost competitiveness as well as favourable and reliable fiscal conditions. The
macroeconomic environment also plays a role.
2. Human resources: How many people with the required level of education are available at the
respective financial centre? The more complex financial transactions become, the more
qualified employees will have to be in order to continue generating business potential.
Another element is the flexibility of the labour market.
3. Infrastructure: In terms of infrastructure, the GFCI assesses the quality of many components
that are often taken as read in financial centres in modern economies. These include the
supply of residential and commercial real estate, the electricity and water supply etc., the
telecommunications and IT infrastructure, transport links and connectivity, in particular to
other international financial centres, educational establishments and, increasingly,
environmental factors, too.
4. Financial sector development: The depth and breadth of clusters of resident market
participants with similar or complementary features as well as sufficient availability of capital
and market liquidity are the preconditions for good market access and intensive trading
activity. They include. A high level of or dynamic economic activity at the relevant financial
centre is an advantage, although not decisive.
5. Reputation: Reputation as a factor for success depends on the attractiveness of the
financial centre as a brand, how its creative potential and cultural diversity are perceived,
and what it has to offer in this regard compared to other financial centres.
Simply listing all these ingredients would not be doing justice to the GFCI. The index is not simply
a set of static building blocks. It is, in fact, a complex and dynamic system.
The importance of a particular success factor can vary depending on the level of development of
a financial centre. For example, while the business environment and infrastructure of a financial
centre tend to form a basis for success initially, human capital is more important at centres in
more advanced stages of development. At the top end of the scale, the smallest differences in
infrastructure can then start to play an essential role again.
The EU and, in particular the euro area, already tick the most essential of the boxes listed above.
For instance, we live in strong, diversified economic areas with high living standards and a broad
cultural landscape. Our political systems are stable and our legal frameworks are reliable. We do
business in a single market with a harmonised regulatory framework within which people, goods,
services and capital can move freely and quickly.
As a single currency, the euro enjoys global confidence. Around a fifth of the world's currency
reserves are held in our shared currency. Investors in the euro can draw on a huge array of
financial products.
The regulatory requirements that apply to financial products are largely standardised. With its
single supervisory mechanism and extensively harmonised regulation, the banking union has
continued to deepen trust in the European financial system. The emerging capital markets union
may move European financial integration even further forward. And we also have efficient market
infrastructures - for both payment and securities transactions.
What's more, the Eurosystem, and the Bundesbank in particular, is heavily involved in many of
these aspects - the single monetary policy, banking supervision, or market infrastructures such
as TARGET2 or TARGET2-Securities, which, to a certain extent, form the backbone of our
European financial system.
As the second strongest economic area in the world, the European single market easily has the
required global pulling power in any case. It offers financial market services and leads the way
worldwide in certain areas of research and (information) technology.
However, Europe's overall potential is spread over various locations across the whole continent
and therefore does not have a cumulative effect. During the financial crisis, fragmentation along
national borders became even stronger. Its financial centres are competing with each other for
market shares, tax revenues and jobs. They do not pool their expertise and resources to face
global competition, but instead serve regional needs and niches.
Individually, each of the larger continental European financial centres has at least some of the
factors needed to become a global financial centre - just not enough.
Take market liquidity, for example. Supply and demand are not available in the required quantities
to be able to offer the entire range of products. The numbers I gave you earlier for London as the
main hub for Europe's financial system are telling.
The units at the various sites are too small to provide a globally competitive cost structure
through economies of scale.
The required services are insufficient to establish a comprehensive, fully functional ecosystem.
Specialist knowledge, for example relating to investment and financing, accounting, tax, law,
information technology or consulting, is scattered across various locations that are hundreds of
kilometres apart.
As I already mentioned, a glance at London reveals that economies of agglomeration made an
important contribution to its growth as a financial centre. Ultimately, all market participants
benefited from the concentration of different - but complementary - stakeholders, even if they
were competing with each other. This concentration at a single location provided easy access to
a wide range of financial services which, in turn, attracted more market participants. London
became more important, thus further boosting the city's attractiveness - a self-reinforcing cycle.
This makes it clear that it is spatial proximity, above all, that has made successful financial
centres like London possible in the past. In addition, uncomplicated and direct personal contact
was also made easier by the use of English as the "lingua franca" of the global financial system.
The resulting trust among those trading made it possible to make fast, sound decisions, leading
to commercial success.
However, digitalisation could mean that geographical proximity may become less and less
important. By fully exploiting the possibilities and potential of current and future information
technology, it might be possible in future to overcome distances in space and time almost
without any losses in directness and efficiency in the financial markets, too. This creates a totally
new opportunity for the geographically fragmented continental market. But - my third step - how
to seize those opportunities?
4 Many stakeholders will have to join forces
In a competitive environment, a leading role as a global financial centre is not set in stone.
Looking back over the past three centuries, the balance of power has clearly shifted among
Europe's financial centres. For instance, in the 18th century, it was Amsterdam that held the
leading position for a long time. As of the 19th century, London began to emerge as a leader
driven by Great Britain's position as a colonial power. Over the past 60 years, the City of London
has continued to cement its dominant position, boosted by stringent US regulatory requirements
and tax regulations in the 1950s and 1960s, Britain joining the European Community in the
1970s, the Big Bang of the 1980s under Margaret Thatcher and the controversial "light touch"
approach adopted by the UK Financial Services Authority around the turn of the millennium. The
Eurodollar and Eurobond markets were born in London, international - especially US - banks
relocated, securities trading business expanded and, later, London went on to become a centre
for - partly contentious - financial innovations. However, in the period of recovery following the
financial crisis, the City of London demonstrated its power of innovation. Yet this does not have to
spell the end of the story. And Brexit is not the only force of change at play. Digitalisation has
unleashed a period of upheaval that is calling into question the way in which established financial
centres usually function. New competitors with innovative technologies and business models are
challenging the traditional financial system. Digital platforms enable the supply of and demand for
financial services to be matched much quicker. The use of digital instruments, such as
distributed ledger technology, is changing value chains; automated securities trading is gaining
ground.
With old structures becoming less rigid, a new opportunity is opening up for the financial centres
on the European continent; they can pool their potential and work together as a single financial
centre on the global market - not as a replica of the old systems, but in a new, forward-looking
way.
The new digital technologies provide a whole host of ways to overcome the geographical
distance between individual locations. Various (financial) locations can connect as if they were all
in the same place, coming together to form an agglomeration. Real-time communication,
distributed leger technology, platforms and co-working are just a few ways of reducing the
importance of physical distance. Digital intermediation helps suppliers find customers, and vice
versa. Just as value chains of services can today be forged across continents, the
innerEuropean financial metropolises could work together. Regional markets could be merged on a
European financial platform to create a networked economy. With time, it may even be possible
to develop or at least maintain strong and stable personal relationships online.
The digital, decentralised market is definitely part of the future, and it is calling traditional financial
centres into question. The European continent has an incredible opportunity to set up a
technologically first-class, networked financial hub from scratch and to become a highly relevant
global player. But what would this require? Let me briefly address five relevant issues.
First, specialisation and cooperation: The utmost challenge is for the financial centres in
continental Europe to limit their own range of services, to find a specialisation and - at the same
time - to cooperate online with other financial centres despite all the other competitors. However,
political competition among financial centres is likely to stand in the way of this approach of
specialisation and cooperation. Market-driven specialisation could help to create economies of
scale and increase the potential for innovation which would, in turn, optimise cost structures and
strengthen competitive positions. Complementary cooperation could ensure the necessary range
and quality of the financial services provided decentrally. The principle of cooperation also
requires a culture of openness towards other international financial centres and players - which
is a prerequisite for successful global competition.
Second, digital infrastructure: Specialisation and cooperation require a digital infrastructure. The
financial centres in continental Europe need to be digitally networked in such a way that enables
the agglomeration effects I mentioned earlier to be generated.
For high frequency trading, a separate cable was installed in the Atlantic to connect London and
New York. Nothing similar exists between Paris and Frankfurt.
But we will not be on an equal footing with other global financial centres until digital intermediation
on the continent matches supply and demand in a more effective way than traditional trade
practices. We need to create digital hubs and platforms that are more effective than in the
analogue world. This requires not only future-proof digital infrastructures but also a pooling of all
parties' digital power of innovation, be it financial institutions, infrastructure providers, IT service
providers or FinTech. This takes place already, as we could see in the recent past.
Third, a competitive legal framework: The principle of specialisation and cooperation as well as a
high-performance digital infrastructure are only two components of a whole range of elements
that a "digital finance hub of Europe" requires. In spite of all efforts aimed at harmonisation in the
EU, in many areas continental Europe still does not have a joint, internationally applicable legal
framework that can compete with English common law.
There are debates at the EU level as to whether the 28th regime could be used as an alternative
to the traditional harmonisation of legal provisions. This refers to a private law which does not
replace national legislation but provides an alternative at the European level, such as the legal
form "European company" (Societas Europaea, SE) instead of a public limited company. The
contractual parties can decide independently whether they want to apply such a law. This is of
particular interest in areas in which complete harmonisation does not appear possible or is not
easy to achieve. A 28th regime for business on a continental platform could be an option.
The aim of further harmonising the legal framework must be to ensure that there are no
additional costs for cross-border transactions within the EU - either in a direct form, by means of
taxes or fees, or in an indirect form, for instance by requiring legal advice.
Fourth, compatible IT structures: The merging of existing IT architectures with the least possible
friction represents another challenge. This requires a high level of standardisation. Ideally,
technical or administrative issues within the EU should not play any role in investment decisions.
Fifth, market forces have to take effect: Specialisation and cooperation, digital networking, a
competitive legal framework, and compatible IT can help a digital city of Europe to grow.
However, a project like this can only succeed if it is market driven. The market has to set the
agenda.
Policymakers could assume the role of a catalyst, sitting the main players down at one table. In
addition to market participants and representatives of financial centres, these could also be
operators of market and IT infrastructures or consultancy firms. One key is to strengthen the
links between the finance and IT industries - in the same way as has been seen in recent years
for FinTech.
There are numerous challenges to overcome in this context. As profit-driven companies, market
participants will naturally have different and, sometimes, clearly opposing individual interests, a
varying degree of motivation and a variety of target coordinates. However, it is essential that
inner-European competition is not seen as a zero-sum game where the win of one financial
centre is a loss for another, but instead that all financial centres develop their potential together
with everyone reaping the benefits.
5 Conclusion
Ladies and gentlemen
Let me conclude: It is clear from this initial outline that the digital city of Europe is a very
ambitious project.
There is - of course - no guarantee for success. But I would like to cite an example from recent
financial history which illustrates the power of technology on the financial markets: the "battle of
the Bund". Maybe some of you can remember it. At the end of the 1990s, the Deutsche
Terminbörse - the forerunner for today's Eurex - succeeded in beating the London International
Financial Futures and Options Exchange to win option trading for German Bunds, which is still
important to this day. Years later, an English account of this episode from financial history states
"... Frankfurt leapfrogged us with better technology". And it is just this type of "leapfrogging" that
we need again now, in a team of continental European financial centres, on the digitalisation race
track.
The effort will be worth it, also from the specific viewpoint of a central banker. Our viewpoint is
made up of those targets - in addition to that of price stability - that we, along with the other
Eurosystem central banks, are pursuing, notably safeguarding the stability of the financial system
and promoting financial market integration. It is a great deal easier to do so if the majority of
European financial market operations take place within our European jurisdiction. Yet that doesn't
change the fact that open, globe-spanning capital flows and financial markets are still highly
desired and necessary.
A self-assured digital city of Europe project requires the input of many stakeholders, all working
together in a new direction. The Eurosystem and the Bundesbank may not by any means be at
the fore but it can make recommendations and suggestions and help where possible to make the
project a success. However, the stimulus has to come from policymakers and the markets.
1
The GFCI is published twice per year by Z/Yen Group in London, and the China Development Institute in
Shenzhen since 2015.