The Power Equation and the Financial Rise of the UK
It was “45 minutes of hell”. On August 1st 2012, Knight Capital went from having $365 million in available cash to $460 million in losses. In less than one day, Knight went from being the largest equity trader in the US to bankruptcy. The loss resulted from poor management in updating and replacing computer code designed to manage Knight’s high speed trading activities. (For the full details, read Doug Seven’s account.)
This mini flash crash demonstrated the central role computer technology has come to play in helping traders execute huge numbers of orders in a short period of time. The modern trading market is no longer thousands of traders executing a handful of orders, but dominated by advanced computer programs, known as algorithmic trading, executing thousands of trades, microseconds apart. Of course, as in Knight Capital’s case, improper management of the algorithms that enable this trading can quickly create a disaster. In these days of high frequency trading, it’s not just the algorithms that matter, geography is increasingly important.
Wired noted in its coverage of Knight Capital that it takes approximately 8 microseconds (.000008 seconds) for 1 trade to travel 1 mile. Obviously, the closer one is to the market the greater the frequency of trades a prospective trader can make. Consequently, traders and markets are constantly looking for ways to increase the speed in which they can conduct trades. For example, the Hibernia Express, a fiber optic cable running between New York and London, will help execute trades 10% faster between London and New York – delivering trades at the speed of light. Therefore, the key equation traders consider is: Time (T) = Distance (D) / Speed of Light (c).
Given this power equation’s (T=D/c) influence in trading markets, the UK is in a prime geographical position to expand its already dominant position in the foreign exchange market. Currently, the UK handles approximately 40% of all foreign exchange transactions, trading more dollars than New York and more euros than all of Europe. Additionally, the London market handles the largest portion of RMB transactions outside of China; these RMB transactions will continue to grow given London’s preferential status as the first market outside of China to process government bonds.
The UK’s status in both its management of existing foreign exchange transactions and the increasing RMB business is a crucial factor of T=D/c. Conducting a trade from New York to Frankfurt takes almost ten times as long as conducting that same trade between New York and London (see the table below). Additionally, London is far closer to Shanghai and Hong Kong than New York, making London a geographically advantageous location to execute global RMB trades for the long-term. While Frankfurt beats London in distance to China, it only does so by about 400 miles and it lacks the UK’s proximity to New York and the UK’s pre-existing scale in the foreign exchange market.
Trade Times From London, New York, and Frankfurt
|From||To||Miles||Time to Transact 1 Trade (seconds)|
The proximity of the UK to Asia is not the only reason we should be watching the country. It’s important to follow all the money. The UK was the first major Western power to join the Asia Infrastructure Investment Bank (AIIB). While this action sent the UK’s ally, the US, into a tizzy fit, it made immeasurable sense from the British perspective. The AIIB will provide the UK the opportunity to expand its financial services industry exports (comprising 29% of UK exports) to Asia. Now that the former number two at the UK treasury is a vice president at the bank, the UK has both a seat at the table and a pulse on the intricacies of infrastructure investment projects in the region that it can service.
This expanding Asian financial role for the UK is important when looking at foreign direct investment (FDI flows). The UK is already the largest Foreign Direct Investor in the United States, and in Africa it US as the leading FDI investor by projects. In 2013 the UK led investment into Africa with 104 FDI projects totaling $4.6 billion. In 2015 this figure dropped to 53 projects – putting it in second place behind the US. It is also the prime inward FDI market in Europe as reflected by UK Trade and Investment’s figures showing 1 trillion pounds invested into the UK in 2014. Simply put, London manages a lot of foreign currency and debt – along the lines of $2 trillion per day, and that measure is the most recent figure in a downturn in the market. This centrality between the European, African, and American markets makes the UK the best destination for Chinese RMB to enter the international market. The deal the UK reached in October 2015 with the Chinese government to host bond issuances in London only further strengthens its hand in the foreign exchange market.
Through the combination of their geographical proximity to markets and the advantages that technology provides in quickening the pace of trade, British politicians and financers are looking to cement the UK’s role as an indispensable international financier. While some worry that the UK’s recent actions toward China are turning the country into a supplicant of the former, these critics ignore the influence the UK will gain by being the central gateway for RMB to enter the African, European, and American markets. As a measure of the UK’s maneuver space with China, the nomination of Sir Danny Alexander to a vice presidential role in the AIIB frustrated Beijing, but that frustration did not stop his recent appointment to the bank. It seems that the Chinese put some value on their relationship with the UK; otherwise one might have expected Beijing to have lobbied more publicly for a different candidate.
Ultimately, UK politicians are attempting to make London indispensable in the financial market by raising the disadvantages of doing business elsewhere. It is this disadvantage that the UK will attempt to use in leveraging its financial position in international relations. With particular reference to China, the UK appears to be seeking a position through which it can facilitate the growth or contraction of Chinese global investment projects that are critical to the success of China’s One Road, One Belt. If the UK successfully pulls this feat off, it will be able to shape the global economy through its financial service’s influence on Chinese investment and debt servicing.
Therefore, in the near future, the UK may possess an enviable position: a special political relationship with the United States, the financial service provider to China, and the leader in the foreign exchange markets. Building this reality is no fool’s errand. UK politicians will have to demonstrate a high degree of diplomatic astuteness to manage the relationship with the US, while simultaneously pursuing an influential role with China, like joining the AIIB, which goes against American geopolitical interests. If UK politicians bungle the effort, however, they risk long-term strategic consequences with America and the loss of credibility in its markets from its relationship with a state capitalist China. All this opportunity and risk exist for the UK because of the confluence of geography, time, and technology related to the global financial system.
At the time of Queen Victoria’s death in 1901, it was said that the sun never set on the British Empire. The UK’s dominance developed out of the country’s combined proclivities toward commanding the seas for the purpose of enabling commerce and colonization. Today, the UK is set on marrying its geographical location with the wave of technological progress in the financial markets to shape the future of the international system. Assuming they are successful, the results of this achievement will place the UK in a leading position to influence the expansion of a rising power, mediate between existing great powers like the US and China, and play a critical role in shaping the future of the overall international system.
T=D/c is a simple equation with global implications.
Nicholas Iorio is a private-sector international security affairs consultant specializing in the Asia-Pacific. He has previously been published in The National Interest.