Networked financial centres
Guest contribution published in "Handelsblatt" on 02.03.2018
In just under 400 days, the United Kingdom will leave the EU. Irrespective of the effect this will have on the global landscape, one thing’s for sure: there will be a void in the EU 27 where there was once a globally relevant financial centre.
Continental Europe’s major funding channels could dry up or, at the very least, take a heavy hit. But it doesn’t have to be this way: EU financial centres such as Frankfurt, Dublin, Paris and Co could become digitally networked to work together as a single financial centre – a "digital city of Europe".
Liquidity, product diversity and expertise would then be pooled on one EU financial platform with the aim of being globally competitive and efficiently providing internal and external financing, both on the continent and beyond.
What would be needed to establish such a digital financial platform in Europe, and what can we build on?
If we take stock, the outlook is encouraging. Even after Brexit, the EU will remain the world’s second strongest economic area, and it is clearly big enough and attracts sufficient demand to warrant its role as a global financial centre. People, goods, services and capital can move freely and quickly in the single market. Our political systems are stable and our legal frameworks are reliable.
Continental Europe has a common and highly stable currency in the form of the euro, which, as the number two reserve currency, enjoys global confidence. Regulatory requirements are largely harmonised. The banking union is boosting the financial system’s resilience to crises. The capital markets union is moving European financial integration further forward. Efficient market infrastructures – not least those made available by the Eurosystem – are in place to make cross-border transactions quick and simple.
Rivalry between financial institutions
However, the EU 27’s overall potential is spread across the entire continent and does not have a cumulative effect. Its financial centres are currently competing with each other for market shares, tax revenues and jobs. Individually, each of the larger financial centres possesses some of the traits necessary for global success – but no one financial centre has all of them in the right measure.
Take market liquidity, for example. In no single financial centre are supply and demand available in the required quantities to be able to offer the entire possible range of products and provide a globally competitive cost structure through economies of scale. The limited number of agents at each location is not enough for a comprehensive financial system. Physical distance has previously prevented any confluence of regional success factors that would ensure global competitiveness.
However, geographical proximity will become less important as digitalisation becomes more widespread – provided the technological potential is exploited. The financial markets find themselves in a disruptive period of upheaval that is causing the way in which traditional financial centres work to be fundamentally called into question.
As digitalisation has taken hold, financial centres’ factors for success have evolved. Economies of agglomeration and geographical proximity – the factors that made London great – are no longer the name of the game. Instead, the tone is being set by state-of-the-art technology and fast-paced digital cooperation.
As a result, a brand new opportunity is opening up for continental Europe in which local trump cards add up and can be laid on the table together – in the interest of all EU financial centres. This could give rise to a European financial network that functions as one financial centre in a single location – not as a replica of the old systems but rather as a highly innovative, forward-looking project.
In particular, IT innovations provide a whole host of ways to overcome geographical barriers. Distributed ledgers, otherwise known as the technology behind blockchains, together with global internet hubs for worldwide data exchange, and 5G networks, the next generation of mobile communications technology: these are just a few relevant key terms here. Suppliers and customers could band together on platforms as though they were all in the same place. All of this is made possible by the networked economy.
Just as, in industry today, value chains can be forged across continents, inner-European financial metropolises could work together digitally. With time, it may even be possible to develop or maintain strong and stable personal relationships online.
It’s difficult to boil down what remains to be done to establish an EU 27 digital financial centre. First and foremost, we must overcome three hurdles.
The first is cooperation and specialisation. It goes without saying that EU member states and national market participants have different, and occasionally opposing, interests and motives. However, it is essential that inner-European competition is not seen as a zero-sum game where one enterprise or financial centre’s loss is another’s gain, but instead that all parties reach their full potential together so that everyone may reap the benefits.
This could also involve financial centres limiting their own range of services and, at the same time, cooperating online with other financial centres. Instead of becoming bogged down as they compete with each other, market-driven specialisation could help financial centres create economies of scale and increase the potential for innovation, which would, in turn, optimise cost structures and establish global competitive positions.
The second is digital networking. Cooperation requires a digital infrastructure in the form of platforms that can be accessed throughout Europe and internationally. Financial centres must be networked in such a way that enables agglomeration effects – in other words, benefits stemming from market participants being clustered together, as can be seen in London and elsewhere in the physical world – to be generated in the digital world.
There is some catching-up to be done in terms of establishing a digital infrastructure. For instance, a separate cable was laid across the Atlantic to connect London and New York for the purpose of high-frequency trading. There is nothing comparable connecting Paris and Frankfurt. But we will only stand a chance of competing with conventional global financial centres if digital intermediation matches supply and demand faster, more effectively and less expensively than "analogue" trade practices.
Existing IT architectures need to be seamlessly combined. This requires a high level of standardisation. Ideally, technical or administrative issues within the EU should not play any role in investment decisions.
The third is a competitive legal framework. In spite of all efforts aimed at harmonisation, there is still no joint, internationally applicable legal framework in the EU 27 that can compete with English common law. One solution could be the 28th regime, which is used by the EU in other areas. This refers to a private law that does not replace national legislation but rather provides a new alternative at the European level, such as the legal form "European company" (societas Europaea, or SE for short) instead of a public limited company.
The contractual parties can decide independently whether they want to apply such a law and would thus find themselves, legally speaking, on a reliable level playing field. The aim 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, such as charges for legal advice.
The power of the market
The idea of a "digital city of Europe" and the political impetus for such a project is one thing. However, a project like this can only succeed if it is market driven. This is where financial institutions, in particular, have a role to play. But the onus isn’t just on them. Invariably, the IT sector and FinTechs are also driving forces when it comes to digital innovations.
Policymakers can assume the role of a catalyst to sit the main players down at one table, and they can shape the landscape. And this is precisely what they should do. Coming in the wake of the financial single market, the banking union and the capital markets union, a "digital financial market union" would be a highly ambitious new project that would be worth the effort to make it work.
From a central bank’s perspective, too, a successful outcome would be ideal, as it would mean that the lion’s share of Europe’s financial business would also be done on our turf. As a result, we would be better placed to safeguard the stability of the financial system in normal times, but above all in times of crisis. We would not be reliant on transactions outside continental Europe to fund our real economy. At the same time, we would have a share in open, globe-spanning capital flows and financial markets – as a relevant player in our own right.