Brett Scott is a campaigner and former broker who has worked on climate change, food security and ethical banking campaigns. He is a Fellow at the Finance Innovation Lab and has written for the Guardian, Ecologist, openDemocracy and New Internationalist. He blogs at www.suitpossum.blogspot.com.

The Heretic's Guide to Global Finance

Hacking the Future of Money

Pluto Press

Contents

Putting on Financial Goggles

In a poem in The Lord of the Rings, Tolkien writes, 'All that is gold does not glitter, not all those who wander are lost.' It refers to the drifting, scruffy Rangers who patrol Middle Earth, moving openly in the face of power, understanding the signs and signals of the wild, and watching things. Financial rangers need to sketch some basic stylised maps, and to develop some exploration principles, so let's go straight in.

A FIFTEEN-MINUTE MAP OF FINANCE

The British £5 note is inscribed with the words 'I promise to pay the bearer on demand the sum of five pounds.' Money is so culturally engrained in us that we tend to not notice how mysterious that statement is. When asked what a pound is, we might resort to a form of circular reasoning, explaining that it is worth something because other people accept it for payments. In other words, it is simply a claim on goods and services from other people within a certain geographic area. A Brazilian Real has little value to a French shopkeeper. These currencies form the basis of local financial systems, and thus, within the overall global financial system, there is a Russian ruble financial sub-system which can be quite different from the Indian rupee financial sub-system.

Our relationship with money leads us into a relationship with financial intermediaries – such as banks and funds – that offer us services in dealing with it. A typical middle-class individual in a Western country might have access to the following financial services:

• Current account for bank deposits: When she's a teenager, she opens a current account at a high street bank, depositing money that her grandparents have given her.

• Payments services: She uses her bank to transfer money to others with bank accounts. She pays concert organisers for concert tickets. Other people pay her for music tutorials via their banks.

• Foreign exchange services: She takes a gap-year and purchases Mexican pesos from her bank with British pounds.

• Insurance: She buys travel insurance for her trip by paying a premium to an insurance company.

• Unsecured long-term credit: She returns from abroad, and decides to study, obtaining a student loan to pay for the tuition. She doesn't own much, so can't pledge collateral to secure the loan.

• Unsecured short-term credit: She starts working full time, and upgrades her account to include an overdraft facility. She also gets a credit card. Both of these are short-term loan facilities, allowing her to buy things she doesn't have immediate money for.

• Savings and investment: In her late 20s she has extra cash. She wishes to invest it, putting some into a mutual fund that invests in company shares. Her employer also offers her a pension plan, paying part of her salary into a pension fund.

• Secured long-term credit: In her early 30s she borrows money to buy a house, obtaining a mortgage loan from a bank, which is secured on the house.

This is where many younger individuals' association with the financial sector stops, give or take a few more bank accounts, loans and insurance products. The overriding impression is of a one-way relationship with bland retail branches advertising apparently great financial deals, behind which exists an opaque world. To this day, a surprising number of people still believe their money is stored in vaults in banks, waiting to be collected. Few who deposit money in a bank think of themselves as lending the bank money. This pervasive information asymmetry is one reason why banks are able to sell the inappropriate financial products that occasionally lead to mis-selling scandals.

Our personal dealings with 'small finance', though, do provide us with a vital stepping stone to understanding high finance. A huge company uses financial intermediaries for the same things we do, only they do it on a much greater scale.

Financial Sector Meets Real Economy: The First-hand, or Primary, Markets

There is a common distinction made between the financial sector and 'the real economy'. The real economy comprises individuals and companies within industries that produce things like cars, oil, soap and guns, or that offer non-financial services like advertising and entertainment. The textbook view presents the financial sector as a neutral intermediary between such firms or individuals, acting to facilitate investment flows between them.

Investors are people or institutions that have built up excess money they have no immediate use for, and who are looking to put it into economic ventures in exchange for a cut of what those ventures produce over time. They include:

• Individuals with savings: Often called 'retail investors'.

• Companies with savings: Perhaps they've had a good year and have built up cash.

• Governments with savings: For example, Gulf states with large excess oil revenues.

• Institutional investors: Huge funds – such as pension funds and sovereign wealth funds – that collect and pool these savings in order to invest them on behalf of individuals, companies and governments, often by parcelling the money out to the fund management industry (which includes, for example, mutual funds, hedge funds and private equity funds).

Our society is also full of 'investment opportunities' created by individuals or institutions that need money in order to engage in production, exchange or consumption. They include, for example:

• Small businesses that need start-up capital.

• Large companies that need money to expand operations, or to ship goods abroad.

• Multinational corporations that need money to acquire a competitor.

• Governments that need money to build a high speed railway, or to fight a war.

• Individuals who need money to buy a house, or to study at university.

Investors with savings invest in such investment opportunities. If an investor exchanges money in return for an ownership claim on a venture, they are engaging in equity investment – for example, your friend is trying to start a design company, so you invest in it and become a co-owner. If an investor exchanges money in return for a debt claim that entitles them to interest repayments, they are engaging in debt investment – for example, you lend a local farmer in your village some money, thereby indirectly investing in their productive activities.

Much investment though, takes place via intermediaries, and this is where banks fit in. Commercial banks, for example, facilitate debt investment by taking money from individuals and institutions, and using that as the basis from which to extend credit to borrowers in the form of loans. Commercial banks are connected together via a central bank, which attempts to influence their debt investment activities. Investment banks also facilitate debt investment, but they do it by arranging for investors to lend to companies and governments via 'bonds'. Investment banks also facilitate equity investment, whereby they arrange for investors to transfer money to companies in exchange for stakes of ownership called shares. Investment banking culture is thus one of corralling investors into actively investing via bonds and shares, whereas commercial banking culture is one of providing a more passive interface between investors and investment opportunities.

A debt claim like a bond or an ownership claim like a share are financial instruments or 'securities'. They entitle me to future returns stemming from economic ventures. Future perceptions of the real economy are thus a vital element of investment. Investment is unlikely to be steered into a factory producing chocolate-coated potatoes in Afghanistan, but it may be steered into Arctic oil exploration if there is perceived to be a future demand for that. In facilitating such investment, financial intermediaries run ahead of the real economy, activating industries by guiding money into them via financial instruments, or deactivating them by redeploying money away as circumstances change.

The Second-hand, or Secondary, Markets

Once financial instruments have been created, investment bank traders and specialist brokers help to redistribute them by pushing them around in second-hand markets. Many popular images of finance – for example, those of red-faced men standing in a pit shouting or holding two phones to their head – are drawn from secondary markets. A vast amount has been written about these markets; in the end though, they are just a redistribution system for investments that have already been made. A 'structured credit trader', for example, might buy up pre-existing bonds from original investors, in order to resell them in the form of a structured package to new investors.

Risk Management ... and Risk Amplification

Investment in ventures comes with many uncertainties, or risks. Insurance companies thus offer insurance for the purposes of protecting against that risk. Investment banks, on the other hand, deal in derivatives, which are effectively bets on things like bonds, shares and commodities, and which can be used for risk management, or 'hedging'. They are, however, equally used for risk amplification and speculation, as will be discussed in Chapter 2.

Cross-cutting Services: Advisory and Auxiliary

All of the above services are underpinned by professional advisors. Investment banks, for example, have whole divisions devoted to offering advisory services for mergers and acquisitions (M&A), helping companies to buy each other or rip each other apart. Ratings agencies like Moody's provide quality assessments of financial instruments, and data providers like Bloomberg and Reuters provide raw information on market prices for such instruments. The system is underpinned by laws and regulations, calling for accountants, lawyers, regulatory advisors and back office administration staff. The system is also underpinned by a huge technological infrastructure, manned by large cadres of IT, hardware and software professionals.

That's Financial Sector 101. Now let's problematise it.

DECONSTRUCTING THE FERAL FORCE OF FINANCE

In the framework presented above, the financial sector is rooted in the existence of all the other industries and economic activities. However, the view that financial intermediaries are merely the grease that makes other aspects of the economy work is the view most readily embraced by apologists for the financial sector. In contrast, many outsiders to mainstream thought argue that the system is not neutral at all. Those coming from Marxist traditions, for example, may argue that financial intermediaries extract rents from the real economy and gradually usurp it via 'financialisation'. During the 2008 financial crisis it emerged that much financing had been steered into an artificial bubble with little or no connection to the real economy at all, creating credit with no corresponding creation of goods and services. Much financing goes towards other financial intermediaries rather than non-financial firms, like banks lending to hedge funds to buy bank shares.

There are many more critiques coming from heterodox economic schools, such as followers of Hyman Minsky, ecological economics, or Austrian economics. These feed into the mainstream policy battles around changes to the system of rules that underpin financial activities. The political process sets out what the system 'should do', and the web of regulation is supposed to guide financial institutions towards that politically defined vision. Policy debates are thus another area in which ordinary individuals can interact with finance, perhaps via campaigns asserting that 'the banking sector has failed us' and calling on the public to pressure MPs to support a regulatory bill. Such initiatives butt up against financial lobbyists, who push back with dire warnings about the effects of new regulations on competitiveness, liquidity (ease of undertaking financial transactions), or credit availability (ease of borrowing).

Many mainstream financial sector workers are captured by the internal pseudo-scientific discourse of finance, failing to recognise the politicised nature of apparently pure economic rationality. They frequently brush off public concerns about finance, claiming that outsiders don't understand how the system actually works. Indeed, it can be the case that outsiders to mainstream finance are often captured by their own systems of thought. They might reveal a lack of holistic perspective when they criticise the sector without being aware that their own bank deposits support it. Public reactions against the financial sector may stem from deep intuitive concerns, but frequently take the form of loosely expressed condemnations that fail to really deliver a point to a professional who doesn't perceive the sector through an outsider's eyes.

Part of the problem is that many of us are often trying to imagine global finance as one component of a broader global economy. At such levels, it appears abstract. We bend our minds trying to understand hyperbolic statements like 'trillions of dollars slosh back and forth in global currency markets every day'. In the course of working on ethical banking, food speculation, and climate change campaigns, I have run workshops attended by members of the public. Many perceived the financial sector as something 'out there', out-of-kilter with their sense of what is normal. It may appear as a complex of intangible concepts, numbers, impersonal glass buildings, and people in suits, often tinged with an atmosphere of alienating 'wrongness'. To begin to break this down requires bringing one's view of finance back down to earth. This entails:

1. Putting finance into geographical context.

2. Identifying intuitive areas of concern.

3. Connecting personally to the system.

Grounding Finance 1: Geographical Context

Global finance is more like a collection of financial city-states. Financial intermediaries based in London, New York, Frankfurt, Zurich, Tokyo, Hong Kong and Singapore steer money around the world, but remain bounded within local and regional political systems that have different regulations, tax laws and business environments. Their activities are supplemented by offshore financial centres, such as the Cayman Islands, that make money by selling access to their sovereignty to multinational firms. The system works, via interlocking geographies and subsidiaries, to facilitate the flow of money within and across national borders, into diverse economic situations that play out over time.

London is arguably the world's most important financial centre. It is a giant market for hired financial guns spread over three financial districts – Canary Wharf, Mayfair and the City of London (referring to an independent borough within central London, often called the 'Square Mile'). The physical clustering of financial firms within these districts creates economies of agglomeration, stimulating information flow and personal relationships. London straddles three global time-zones – Asia and Australia in the morning, Europe, the Middle East and Africa (EMEA) during the day, and the USA, Canada and South America during the night.

New York is the other top contender for world's most powerful financial centre, hosting a cadre of Wall Street banks like Goldman Sachs, J.P. Morgan and Morgan Stanley. Chicago is a powerful commodity trading centre, and Connecticut hosts many hedge funds. The USA and UK are sometimes portrayed as close financial relatives, specialising in red-blooded 'Anglo-Saxon capitalism' with a focus on capital markets (stock markets and bond markets), while 'continental capitalism' in Europe leans more towards traditional bank lending. The financial culture of Japan is even more conservative than Europe, and the focus of countless Western business books puzzling over its traditional norms.

Some financial centres are the historical result of a national policy, or a side-effect of other economic activities. Swiss banking, for example, came to prominence through the country's bank secrecy policies. Hong Kong and Singapore developed from trade ports into powerful financial centres for Asian clients, such as Chinese companies that raise money via them. Emerging market countries – such as India, China, Brazil, Mexico and Russia – all have important financial sectors with unique characteristics, often focused on national economic activities. The financial community in Johannesburg has a focus on the financing required by South Africa's natural resources sector.

In less wealthy countries the financial sectors are often very inward-looking and offer more basic services. Uganda, for example, has a very rudimentary stock market, with less than 20 listed companies and no electronic trading. Such countries often host networks of informal financial services that are 'invisible' – such as family members giving each other loans, and loan sharks who lend money at exorbitant interest rates. One niche area of international development efforts is financial inclusion, aimed at widening and deepening access to formal financial services. Even in a country with a very advanced financial sector, like the UK, there are still poorer adults with no bank accounts.