It's no coincidence it's called “the market”.
The big question I'm often asked is “Who or what really are ‘the financial markets’?” The best definition I have ever found was given to me by my good friend Marc Garrigasait, a fund manager at Koala Capital. It is this: “Your mother's savings.” More precisely, the financial markets are the savings of the entire world's fathers and mothers, although the savings with the most sway belong to the fathers and mothers from countries that have the most assets and can loan them to, or invest them in, other countries. The pension funds, which are charged with ensuring that a lifetime's savings are not lost, invest the money they hold via the “financial markets” in bonds, stocks, commodities and currencies as core assets. The managers of these huge pension funds must ensure they get a reasonable annual return so that when families retire they receive the highest amount possible. So if they fear that the money loaned to (bonds), or invested (shares or stocks) in, a country or specific company may be lost, they immediately withdraw it and invest in or loan to another country or business that conveys more confidence and greater seriousness. Another part of the market are countries that hold vast sums of money as a result of their surpluses, such as China, India, Brazil, Russia or Norway, which invest astronomic sums in bonds and shares from the leading Western countries.
My son Daniel, upon learning that his grandmother was about to publish her first book, coined the slogan “Make my grandma happy: buy her novel.” This simple expression allowed me to fathom the soul of the market. It's a selling process and there are two parts to this business: the supplier and the customer. The seller appeals to our emotional instinct to win clients. Make my grandmother happy. Buy government bonds for the good of the country. Buy shares in company X for their contribution to society.
Companies, governments, investment banks and analysts are all sellers in this market. They sell their product to the buyers, that is investors and ordinary people, who are themselves consumers of the “goods” that these entities sell. It's very important to understand this, because failure to understand the selling nature of some agents can lead us to misinterpret or overestimate the information we receive.
In a shopping centre with many different displays, intermediaries and end customers, the seller always strives to showcase the best qualities of their product. The seller is optimistic and tends to offer us a positive outlook. Similarly, and though today we don't perceive it as such, the market functions according to positive impulses. It's something that stems from human nature itself, which needs both to believe in the long term in order to survive and to feel optimistic and receive encouraging news, even in the face of adverse events.
Therefore, the market, rather than trying to deceive, appeals to human nature's yearning for growth and betterment. So sellers put on their best face for their product, as people do for family snapshots where they always look happy, or in advertising, which always displays an attractive image. They are like the father who thinks his child is the brightest and the one who will go furthest in the world.
Between the sellers and buyers, there are a number of agents or intermediaries who facilitate financial trading operations. First, there are the brokers, agents who are charged with finding a counterparty for their clients. These agents are mere intermediaries who just match buy and sell orders and take a commission on both transactions. Brokers may be small firms or big banks. Then there are the dealers, or negotiators, who have a more active role in the process. These agents trade with their clients, that is they buy and sell securities. What they've bought from or sold to one client they can then sell to or buy from another. Brokers offer their clients liquidity, and run the risk that prices move against them before they are able to pass on their products.
Many of these intermediaries are concentrated in investment banks – the main ones being Goldman Sachs, JPMorgan, Bank of America, Merrill Lynch and Citigroup, yet they also operate in traditional banks like Santander, Barclays and HSBC. These banks also offer fixed income and equity analysis, economic studies and corporate assistance services to companies who want access to the markets in order to be able to issue shares and debt.
Inside this machinery, the banks act like oil for the engine. They are essential to ensure the financial system's smooth running. We forget about them when everything is going well, because we take for granted the liquidity and the instant access to financial transactions we enjoy. When a client decides to sell or buy, they never doubt they will find a counterparty. It is taken for granted.
Banks actually do a very difficult job. They put together the savings and deposits of participants with short- to medium-term liquidity needs and return expectations with the demand for credit from participants with longer-term requirements.
We forget the basic importance of the banks as intermediaries because we assume that liquidity is guaranteed and that it will always exist. We only remember the banks for the problems they cause, which of course must be recognised and solved. And we forget that the banking system is the most regulated of sectors.
Yes, the European financial crisis is not a crisis of deregulation or private banks; 50 % of European financial institutions were semi state-owned or controlled by politicians in 2006. There have been thousands of pages of regulations published every year since the creation of the European Union and the European Banking Authority (EBA). Regulation and supervision in Europe is enormous. Since 1999 and based on documents produced by the EBA, EU and European Central Bank (ECB), that's 180 new rules a week.
And as I will come on to argue, the crisis was born of an economic model too dependent on commercial banks with total assets that exceeded 320 % of the eurozone's combined gross domestic product (GDP) within a deeply integrated system. Excessive, complex and bureaucratic regulation has prolonged the agony of the industry for many years, instead of facilitating market conditions for the capital increases and asset sales needed.
Despite the detailed and complex regulation of the eurozone, between 2008 and 2011 Europe spent €4.5 trillion (37 % of the GDP of the EU) in aid to financial institutions, many of them public and highly regulated.
More regulation will not solve the problem.
Europe's banks suffer what is called an “endogeneity problem” (read the excellent analysis Regulation of European Banks and Business Models published by the Centre for European Policy Studies). It is precisely this excessive intervention which prevents a quick and surgical solution to the financial sector's difficulties. Regulation must be effective and simple. In Europe, it is not.
Banks play an essential role in a market driven by the perception of growth and prosperity.
The market simply reflects that human nature of which we spoke earlier, regardless of whether we see things from the point of view of the sellers or intermediaries. So I find it hilarious when people speak of “attacks” by the market. More than 67 % of the funds under management are exclusively “long-only”, so they only enter the market as buyers. And in hedge funds, which we will analyse later, the average net long exposure (bullish) rarely goes below 30 % of total funds.
Just as governments, companies and investment banks play the role of sellers and intermediaries, so do investors play the role of customers. And as such, they can make a mistake when choosing a product. So they also take on certain levels of risk. And as clients, they have every right to expect a lot from what they buy. When we forget that the market is a triangular seller–product–client relationship, and assume that we are within our rights to expect to find a seller for poor-quality products, the chain of value and confidence begins to break.
Understanding that the seller–client relationship in the financial markets is identical to that of any other business activity has been invaluable for me to carrying out the transition from the business world to banking and investment management. Be your product a sovereign bond or a company share, it's absolutely imperative to understand and evaluate the needs of your clients and to strive to offer competitive, quality goods and then attract clients and capital, and not wait for it to rain down from heaven.
What was it that fascinated me about those investors who came to see our company? In the meetings with the senior