The Evolution Of Modern Day Finance

The Evolution of Modern Day Finance : A Brief History The financial crises of the last 20 months has changed the face of the global financial markets and humbled the staunchest advocates of free market economics and financial de-regulation as some of the biggest names of the Wall Street either disappeared or could be kept just breathing with the tax payer’s money. Hence it is of interest to have a brief look at how this modern day finance evolved over the last few decades. The Beginning –End of the Bretton-Woods and it’s consequences The end of fixed rate exchange regime and beginning of currency futures.

It all began in 1971 with the abandonment of the Bretton –Woods fixed exchange rate system by the then US President Richard Nixon which meant that dollar could no longer be converted into gold .Also this resulted in the easing of the Capital flows because now the currencies could float.

With the coming of the floating exchange rate regime companies which had cost in one currencies and revenues in another needed to hedge the exchange rate risk. And this led to the launch of the currency futures in 1972 on the Chicago Mercantile Exchange by Leo Melamed. Perhaps Chicago also became the centre of free market economics. The economic turmoil of the 1970’s further strengthened the Chicago School of thought’s view that government intervention was not the best means of financial and economic development and rather the markets would be better at allocating the capital. This was supported by the Reagan’s Presidency. As credit controls were abolished more lenders entered the home loan market which made life easier for the home buyers. Also as a consequence of the floating rate exchange system capital controls were not strictly necessary. As a result institutions such as pension funds and insurance companies could move their money across borders. In 1986 in Britain the distinction between brokers and jobbers was removed and foreign firms with more capital were allowed to enter the market. It was similar to what New York had done in 1975.This in turn resulted in higher volume of transactions where broker dealers had to commit

The Evolution of Modern Day Finance: A brief History Abhishek Misra;[email protected]

their own capital to deals because the commissions were reduced but this became an attractive source of revenue and hence trading increased. The abolition of Glass-Steagall Act.

The preceding changes also had an affect on the industry structure where the investment banks increased their size and commercial banks muscled their way out in the underwriting of securities. In 1999 the Glass-Steagall Act which separated the investment and commercial banking during the Great Depression was abolished.

The Evolution of Modern Day Finance: A brief History Abhishek Misra;[email protected]

Financial Innovations-Riskier Business The Birth of Swaps :In the backdrop of the above developments with the banks role getting broader the financiers saw an opportunity in separating the various components of risk and trade them separately .One of the first creations of this rising risk taking appetite was the explosion of the options contracts in the 1970’s and setting up of the Chicago Board options Exchange and development of Option pricing theory by Fischer Black and Myron Scholes as per which the options value depends on the volatility of the underlying assets. After the formation of Chicago Board Options Exchange Swaps came into existence and next to come was interest rate Swaps and further step was Credit Default Swaps

And as the appetite for this risk taking increased with rewards became more luring in the liberalized markets next was the birth of Swaps. This created an opportunity for arbitrage i.e issuing bonds in one currency and swapping them for another creating lower interest rates for both borrowers. And as the currency swaps market boomed the next to come was of course interest rate Swaps. This enabled companies to change their risk exposure by taking a view on where the interest rates would go .Borrowers on floating rate could Swap them with those on the fixed rate. And the next was the development of the Credit Default Swaps(CDS) which separated the interest rate risk from the risk that the borrower would not repay.

Securitisation : This involves bundling loans into packages that are sold to outside investors .The first big market was American Mortgages. In this when the borrowers pay their installments these are passed through to the investors as the interest payments on their bonds. This was encouraged by the authorities as a means of spreading risk. Eventually securitization led to the development of the Collateralised Debt Securitisation led Obligations (CDOs) ; sophisticated instruments that bundled together packages to the development of different bond and sliced them into tranches according to the investors risk of CDOs which have been at the appetite. center of the current crises.

The Evolution of Modern Day Finance: A brief History Abhishek Misra;[email protected]

Securitisation became popular with the bank as it allowed them to borrow in the markets and reduce their dependency on the slow and costly business of raising retail deposits.

What had the regulators done in past to avoid crises of this magnitude: Rather than questioning deregulation in principle many governments redesigned the regulatory structures for example in 1997 Britain formed the Financial Services Agency (FSA) taking even the banking regulation away from the Bank of England. Another more fundamental attempt was to regulate the banks with the Basel Accord which in it’s first version in 1988 established the minimum Capital standards.

The Basel Accord was designed to deal with the problem of default by big borrowers. It required banks to set aside capital for such contingencies. This was a costly affair for banks. And way to get around this was to shift assets off their balance sheets. And various methods available to them were Securitsation, CDSs or Structured Investment Vehicles that held many sub-prime mortgages. But when the markets collapsed then these assets threatened to come back on their balance sheets which became the root cause of the current financial crises.

The economic prosperity of the last 25years and the future of finance: The prosperity and the rapid economic growth that world enjoyed for the last 25years, a lot of credit for that goes to the Financial deregulation and also the innovations upto a certain extent and hence it can cannot be said that the what all was done during that last few decades was of no benefit. The history of finance has always been plagued by crises whether systems have been open or closed ; simple or sophisticated. Though the modern day finance is unstable and excessive but it should not be banished altogether .Rather it requires a reformation by which their comes into being a right mix of stability and private initiative. The Evolution of Modern Day Finance: A brief History Abhishek Misra;[email protected]