Which city is the real financial capital of the world? In one corner, the IPO champion and derivatives king. In the other, the investment-banking titleholder. The battle isn't over - and new contenders are vying for a shot, says Fortune's Peter Gumbel.

To understand why London thinks it's beating New York in a race to become the financial capital of the world, walk across the Millennium Bridge toward St. Paul's Cathedral and count the number of cranes that clutter the skyline. The City, London's financial district, is in the midst of its biggest redevelopment boom since the Blitz, one result of the $100 billion in foreign investment pouring into the British capital annually.

The money is coming from the Middle East, Russia, India, China, and the U.S., and it's padding wallets, filling restaurants, pushing real estate prices through the roof, and fueling a feeling of self-confidence that spreads from coffee shops to Mansion House.

That's the ornate official residence of the Lord Mayor of the City and the scene of an annual black-tie dinner for bankers. This year's banquet in June seemed more like an Olympics celebration (yes, London beat New York in landing the 2012 games) as Gordon Brown, just days from becoming Prime Minister, rose to declare victory.

"Today over 40% of the world's foreign equities are traded here, more than New York," he said. "Over 30% of the world's currency exchanges take place here, more than New York and Tokyo combined. And while New York and Tokyo are reliant mainly on their large American and Asian domestic markets, 80% of our business is international." This is an era for London, Brown boasted, "that history will record as the beginning of a new Golden Age."

New York is hardly in a Dark Age. But by comparison it seems stricken with self-doubt. Mayor Michael Bloomberg and Senator Charles Schumer commissioned a McKinsey report earlier this year that highlighted weaknesses in the city's position as a financial center, including too much litigation and heavy-handed regulation, and warned that New York will lose its global preeminence in a decade if they are not addressed. Governor Eliot Spitzer has convened a blue-ribbon commission to figure out solutions. In Washington, Treasury Secretary Henry Paulson is calling for significant changes aimed at strengthening the competitiveness of U.S. capital markets, and Christopher Cox, chairman of the Securities and Exchange Commission, is talking bluntly about the need for the SEC to rethink the way it works.

There's no shortage of evidence to underpin the contrasting moods in the two cities. Statistics about the amount of funds raised by foreign firms are especially jarring: In 2001, 12 of the top 20 global IPOs were listed in the U.S., according to Dealogic; last year, just two of them were. An upstart over-the-counter market in London called AIM raised as much in IPOs last year as Nasdaq. MasterCard is just the latest organization to publish a study, in June, which ranked London ahead of New York as the world's top center for commerce. Even Hollywood is getting in on the act: 20th Century Fox is reportedly basing the sequel to Wall Street, the hit 1987 movie in which Michael Douglas declared "Greed is good," in London.

How come? The view from the British capital is that while New York has been riding the now faltering U.S. economy, London is riding an even bigger tiger, the booming global economy. While the U.S. is weighed down by the 2002 Sarbanes-Oxley Act and other post-Enron financial regulation - so the argument goes, although it's far from clear that the controversial act itself is the main problem - London has put in place a new, lighter, and altogether more flexible regulatory approach that makes it easy to do business, regardless of nationality, currency, or accounting system. While the U.S. built walls after 9/11, London is wide open and welcoming, notwithstanding its own concerns about terrorism.

The U.S. has class-action lawsuits, frivolous or otherwise, that act as a deterrent. Britain has a fiscal system that attracts well-heeled foreigners. (Residents not officially domiciled in Britain are taxed only on their British income, not their worldwide earnings.) "It's going to be very difficult for New York to get back into the game," says John Ross, financial advisor to London mayor Ken Livingstone. Only half-joking, he adds, "Someone said the other day that all New York needs is a total change of the U.S. political system and a total change of the U.S. legal system."

So is this triumphalism justified? Is London really beating New York at its own game? The short answer is yes, in some ways, but in other ways, not at all. London has become a magnet for firms from emerging economies looking to raise capital and is the most important financial center in Europe. In fields including over-the-counter derivatives, foreign exchange, and metals trading, it has taken a worldwide lead. And it is catching up in private equity and hedge funds - 21% of global hedge-fund assets are now managed out of London - pumping new wealth into Mayfair and St. James, two smart West End districts that used to house the British upper class. New York still towers over London in the total amount of funds its firms manage and in the size of their compensation packages, but Gotham is discovering for the first time that it is not indispensable. As capital flows become global and competition heats up, it needs to fight to retain its role.

Yet not everything is going London's way, as financial markets adjust to a fast-changing world. Just ask Henk van Dalen. He's the CFO of TNT, a $17.4 billion Dutch mail and express-delivery company that announced in May it had decided to end its listing on the New York Stock Exchange. Several other big European firms, including British Airways, have also taken advantage of a change in SEC rules that makes it easier to delist from U.S. exchanges. TNT says it can satisfy its current and future capital requirements outside the U.S. and that it made the decision "after taking into account the regulatory, legal, reporting, and governance complexity" of maintaining a U.S. listing.

But in this case, New York's loss wasn't London's gain. TNT had pulled its listing off the London Stock Exchange a year earlier and is focusing all its efforts on its home market of Amsterdam. TNT still depends on international investors, especially U.S. institutions, but in these days of electronic trading and increased investor sophistication there has been an important shift. "Most investors now buy their positions in Amsterdam," van Dalen says, "so there's no need to be listed elsewhere. It's just a cost burden."

TNT isn't alone. Since 2000 the number of foreign companies listed on London's main exchange has dropped by almost 200, or 40%, and some of those withdrawing, including Nestl?and Nokia (Charts), have done so for the same reason as TNT: At a time when capital markets have become increasingly global, large firms can be selective about their geography. Even lesser-known firms such as Poland's Millennium Bank are pulling out. It says most of its stock trading takes place in Warsaw.

The reason London's IPO numbers look so good - and New York's, by comparison, so poor - is that the British capital has been nimble in attracting hundreds of smaller firms from around the world, including the U.S., to its less prestigious markets, especially the AIM exchange. It has also moved aggressively to capture listings from firms in Russia and other former Soviet republics. About 17% of London's IPO volume last year came from the flotation of Rosneft, a Russian oil company that became the country's biggest by acquiring the assets of Yukos, a private-sector rival driven out of business by the Kremlin.

For the moment Chinese entrepreneurial firms still seem to prefer New York as the place to get their international exposure, while Indian firms split down the middle. It can get complicated: One of the big New York Stock Exchange IPOs this summer was of Sterlite, the subsidiary of an Indian company that is listed in London.

The battle is far from over. In fact, it's just heating up. NYSE and Nasdaq are moving aggressively to extend their global reach through mergers with London's European rivals. They are being helped by the SEC's recent acceptance of International Financial Reporting Standards that differ from U.S. Generally Accepted Accounting Principles and by an official clarification it issued in May relaxing the costliest and most controversial part of Sarbanes-Oxley, Section 404, which requires that outside auditors monitor internal controls. Senator Schumer is relieved. "We feel very good about the progress," he says. "It'll be a big shot in the arm for New York."

In some ways, however, casting the shifts in global finance as a battle between New York and London is missing the point. Much of the expertise and part of the money helping fuel London's boom is American. Four of the top five dealmakers in Europe last year were U.S. investment banks, and KKR was easily the most active private equity firm. Moreover, U.S. institutional investors are buying a significant share of the stock offerings in London and elsewhere in Europe through private placements that bypass SEC regulations and that now dwarf IPOs in volume. Last year about $40 billion was raised on NYSE in public offerings; so-called 144A private placements, by contrast, raised a total of $137.7 billion, or more than three times as much.

"London has a creative energy that far outstrips its international infrastructure," says Hendrik du Toit, chief executive of Investec Asset Management, a South African firm. "Yet the U.S. capital market is still half of the world's money, so you can't avoid it if you want to do big things."

The real question facing New York and London is not about which city is winning a two-way race but how both can position themselves to continue prospering even as a legion of wannabe financial centers around the world try to grab that international business. Those are places like Mumbai and Shanghai, but also Warsaw, Dubai, and S鉶 Paulo - all growing fast in both volume and sophistication. That's the story the big international investment banks are monitoring closely. "New York has had its day, London is having its day, and Shanghai and Dubai will emerge," says Michael Philipp, who runs Credit Suisse's business in Europe, the Middle East, and Africa.

Jonathan Chenevix-Trench, chairman of Morgan Stanley International, agrees: "There's a natural and inevitable tilting away from New York because the world is more global. But it's absurd to call London the global financial center. We'll end up with an orbit of perhaps four to five dominant centers and some key ancillary ones around them."

How quickly that happens will probably depend on what happens to the global economy. One of the dangers to London is that it has become so reliant on international flows that it's particularly vulnerable to a downturn. Dominic Rossi of British fund manager Threadneedle Investments reckons that any significant correction in world capital markets "will hit London instantly - and we're talking about days not weeks." Jim Gollan, chairman of electronic exchange Virt-x that trades Swiss blue-chip stocks, concurs: "It's always worth remembering Warren Buffett's dictum that it's only when the tide is out that you can see who is swimming naked."

The front line in the battle for global IPOs runs through Rue Cambon in Paris, near Place de la Concorde. This is where Catherine Kinney, who oversees the listings business for NYSE, has her new office. As of July she has been based in the French capital, one of the changes arising from the Big Board's merger this year with Euronext, the French firm that groups the Paris, Amsterdam, Brussels, and Lisbon bourses. The combination is supposed to provide a range of options to companies looking to go public. One of the big selling points is the "SOX-less" listing: the opportunity to be on a market affiliated with NYSE but not policed by the SEC or subject to Sarbanes-Oxley corporate-governance rules. Nasdaq is trying to pull off a similar feat with a proposed merger with Stockholm's OMX, which groups seven Nordic exchanges.

Listings have become a huge focus of attention in the New York vs. London battle, unlike, say, derivatives, because it's easy to add up the numbers and see how New York is losing. One chart in the McKinsey report speaks volumes: It shows that the U.S. accounted for 57% of IPOs valued at more than $1 billion in 2001; in 2006 that share was just 16%.

Kinney flips through a presentation she has just given to the board. One slide highlights the value of stocks traded daily on NYSE and Euronext together. It is almost triple the volume of the London Stock Exchange. Another boasts that 79 of the world's 100 largest public companies have their home on NYSE Euronext. Then comes the slide marked "The Center for Global IPOs." It's rather less convincing: Measured by the total capital raised, NYSE narrowly beat London in 2006, but that's only by including Euro-next, which it didn't own. And the U.S. missed the three biggest offerings of the year - Rosneft in London and two Chinese bank IPOs that went to Hong Kong. "It's clear that the U.S. has lost some ground," Kinney says. "The regulatory environment in the U.S. has made it less competitive."

Across the English Channel, in London's Paternoster Square, Tracey Pierce turns the same argument to her advantage. Pierce is in charge of international listings at the London Stock Exchange. When she and her people are on the road pitching to prospective companies, she says, they always start by stressing the advantages of a London IPO. Only then do they stick the knife into New York. "We believe in the highest standards of corporate governance, but we have a principles-based model, which is more flexible than one that is rules-based," she says. What she means is that the London regulators, unlike the SEC, do not impose a one-size-fits-all regime on prospective listing companies. She's unmoved by the recent U.S. initiatives to tinker with Sarbanes-Oxley requirements. For New York to fight back, she says, "they would have to make large headway in repealing or diluting these rules and regulations, and I don't see much political will for that."

How big a deal is all this for listing companies themselves? That depends on what they're looking for. When Chinese solar-power company Suntech Power decided to go public in 2005, chairman Shi Zhengrong had no hesitation about picking New York, because he hopes the U.S. will become an important market for the firm's products. Yes, complying with U.S. regulations costs a bundle. But being able to meet the stringent standards makes Suntech shine. "It's good for companies to have strong internal controls," Shi says. "It helps them live longer, and we want to live to be 100."

For Kishore Lulla, by contrast, New York was never an option. "The general consensus is that a U.S. listing is more cumbersome than a London one," he says. An Indian, he runs Eros International, a Bollywood movie-distribution company that does a lot of business in the U.S. But he had no hesitation about listing on AIM last year. "London was the obvious choice," Lulla says. "It's the financial capital of the world."

AIM is a big selling point for London. It focuses on small and midsized growth companies that have difficulty raising capital in more established markets. Listing is a deliberately simple procedure, with no prospectus, no minimum float, and no financial history required. AIM firms aren't even subject to the Financial Services Authority, the London regulator, but instead are vouched for by an approved financial firm known as a "nomad," or nominated advisor. If something goes wrong, the nomad's reputation is at stake. Big Board CEO John Thain and others in the U.S. grumble that regulatory standards are too lax, but so far the number of failures is in line with more regulated markets.

Liquidity is a bigger issue, as Aqua Bounty, an aquaculture biotech firm in Waltham, Mass., that makes a feed additive for shrimp, has discovered. Aqua is one of 63 U.S. firms on AIM, and CEO Elliott Entis says he is "very pleased" with the listing, which raised $40 million. "When you try to work with Wall Street, you get 15 minutes to tell your story, and very few firms are interested in the size of the deal that interested us," he says. "You get a better opportunity to tell your story in London." But Aqua's stock is so thinly traded that when one big investor sold its stake, the price collapsed. "I would be upset if we were looking for a follow-on listing," Entis says, "but we think that over time the price will recover."

Nasdaq, which failed in its bid to acquire the London Stock Exchange last year, has taken the hardest beating from AIM but claims not to be fazed. "Those $5 million to $10 million companies - we don't do that in the U.S.," sniffs Charlotte Crosswell, who's in charge of global listings for Nasdaq. Instead, the exchange is going after the much larger 144A private placements by creating a new trading platform for them. NYSE is taking the competition from the small fry more seriously. Through its merger with Euronext it can now offer a European small-cap listing that directly rivals AIM, although the regulatory rules are slightly more stringent. London isn't sitting still either. Last month it agreed to acquire the Italian bourse and, working with authorities in the City, has been spreading the word about its advantages. In the past year big British delegations have visited China and India. Next up: Brazil. "We are targeting the cream," says Pierce.

London hasn't always been so cocky. In the 1990s, in the aftermath of scandals that included the collapse of BCCI and Barings Bank, it worried about losing its preeminence in Europe to Frankfurt, the German financial center that became home to the European Central Bank. Canary Wharf, built as an alternative to the City in the East End Docklands, even filed for bankruptcy. Today it's bursting, with an occupancy rate of 96%.

Howard Davies says a key to London's changing fortunes was that it deliberately geared itself toward attracting international business. He's dean of the London School of Economics, and he played a major role in regulatory reforms in the late 1990s as head of the FSA, the single London regulator that emerged from that era for banking, insurance, and all other financial activity.

"The whole mindset here is that international business is an important part of the national economy," Davies says, "so we'd better make sure the regime is conducive to it, or it might go away." Until recently, he says, that attitude has been absent in New York and Washington. But it's changing. "I don't expect Goldman Sachs to close down in New York, and I don't think properties in the Hamptons will plunge in price," he says. "The two markets will coexist comfortably for some time to come."

That may be true, and there's no guarantee that the current self-confidence in London will last forever. But the City is sure of one thing: It has found the magic formula for today's increasingly global capital markets. It has opened up to the world, and the world has come flocking. The question is how long it will be before New York and a host of other cities follow suit.

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