By Andrew Sheng, guest economist of Caijing and former Chairman of Hong Kong Securities and Futures Commission

(Caijing.com.cn) We grow up thinking the world is balanced – that good cancels out evil, assets equal liabilities, and life is a simple, bell-shaped curve. But it is not. There is a lot of inequality around. We like buying, but we do not sell that often, unless forced to. Risks in the financial world are like that.

George Soros recently noted a simple fact I had taken for granted, until I realized that common sense is not so common. The reason why financial markets are dangerous is because the risks of going long (buying only but not selling) is not the same as going short (selling or borrowing what you do not have). If you buy something and the price goes to zero, all you lose are your assets. However, if you borrow or short a product, you can lose not only everything you have but wind up owing far more than you ever expected.

This was the common sense that AIG failed to appreciate. If you insure cars or lives, you are working with the law of large numbers.  As long as your premiums cover losses, you are making money. But if you insure banks (which are highly leveraged) or borrowers, which is what the derivatives trading subsidiary of AIG did in London, the losses are amplified by embedded derivatives. Imagine anyone trying to insure recent bank losses of nearly US$ 3 trillion. The banks lost a lot because they are highly leveraged institutions. The lower the prices of the assets they held, the closer they moved toward bankruptcy. So AIG needed more than US$ 180 billion for a bailout – much more than its initial funding request of only US$ 10 billion.

This brings us back to the use of any domestic currency as an international reserve currency. When a nation's currency circulates only within its own domestic boundaries, one citizen lends to another. The left hand is borrowing from the right hand. If someone does not pay his debt, laws protect the lender. Even if the corporate sector over-borrows and collapses, the state can intervene by either nationalizing debt or taxing the rest of the population to pay for the losses. Asians have not forgotten that, in the 19th century, foreign debt was enforced with gunboats and military invasions. So owing too much to foreigners is dangerous, because a central bank cannot print foreign currency.

But actual benefits accrue when a reserve currency becomes a standard for trade and commercial services. That can exceed seigniorage. In the days of the British Empire, London benefited as a financial center for sterling, a trading center for commodities and international loans, and for its related legal and commercial services. Although sterling lost its place as a major reserve currency to the U.S. dollar, London became after the 1960s a center for an offshore, euro-dollar market, as well as an important complement to New York. The largest commercial banks, brokers, fund managers and insurance companies had offices in London and New York because they shared a language, legal system and business practices.

So what makes an international financial center? While working in Hong Kong, I learned that an international financial center must satisfy three basic conditions: It must protect property rights, lower transaction costs, and have high transparency.

The first condition is obvious and yet not so obvious. Most Western economists say London and New York have superior property rights because they function under well-accepted common law with excellent, fair judicial systems. But protection of property rights is more than just a matter of laws and enforcement. Protection of property rights also means political stability along with an aversion to nationalization and predatory taxation, but with support from a strong military. To put it bluntly, no successful international financial center operates in a war zone or a banana republic.

The second condition -- low transaction costs -- is also important. A financial center cannot succeed unless low regulatory costs and a good communications infrastructure make it convenient to do business. The best financial centers have excellent telecommunications, transportation and living conditions. Transaction costs are also associated with geography: New York is in America's eastern time zone, and London time is pivotal for Europe and Africa.

The third condition is transparency. Markets thrive on information. If information is inaccurate, ill-timed or inaccessible, investors don't know how to protect their funds or make good decisions.

Asia has no dominant financial center, for reasons I will discuss in a future column.

Full article in Chinese: http://www.caijing.com.cn/2009-08-19/110227089.html