Fear of the orphan bond is stalking Europe. This is the fear that, after the introduction of the euro in 1999, bonds in the national currencies whose exchange rates are locked will lose liquidity. They will have no benchmarks to trade over.
With the elimination of exchange and interest rate differences, investors will gravitate towards the biggest euro benchmarks. Market makers will lose interest in classes of bonds destined sooner or later to disappear. By 2002 all payment of interest and principal must be made in euro.
A foretaste is given by a City of Munich bond still denominated in wartime Reichsmarks. This 4% bond of 1944 was never redenominated but is being serviced at a rate of Dm1 to 10 Reichsmarks by the government debt agency the Bundesschuldenverwaltung - an orphan to beat all orphans.
To keep investors loyal, governments of euro states, especially the smaller countries, will want to redenominate their benchmark national currency bonds into euros "as quickly as possible", says Kari Nars, Finnish executive director at the European Bank for Reconstruction & Development.
The bigger member governments will also want to redenominate to give their own financial markets maximum opportunity to maintain or increase trading volumes. Paris, Frankfurt, Brussels, Amsterdam are vying to be centres of trading in euro securities. None of these cities wants trading volume to be sucked away to continental rivals, or London.
Under the Maastricht Treaty, wholesale markets have three years from 1999 to switch their instruments to euro - according to the principle of "no compulsion, no prohibition". Competition is the driver, liquidity is the goal.
The French government has said it will redenominate all its government bonds into euros from January 4 1999. Germany is expected to do the same, at least to redenominate its Bunds (government bonds), but probably not its federal savings certificates (Bundesschatzbriefe), mostly retail, or its rarely-traded Schuldscheindarlehen.
But the cliffhanger for the financial markets is, how will the redenomination technically be done? Only when the French and German governments have decided, will the markets be able to see the legal and economic implications clearly enough to shape their own response. Paradoxically, the governments appear to be waiting for the markets to come up with a model for redenomination first, although German finance ministry sources says they expect a decision from their minister Theo Waigel in early July. The French finance ministry and the smaller French banks cannot agree on a method.
Non-government issuers are waiting for a market practice to be established before committing themselves to one method or another. Time is slipping away. "There's very little project management about the whole thing," says one participant in the European Commission's informal working group. "There are big gaps between meetings, we're now looking at October 4 for the next one." The longer the protagonists dither, the less chance there is of creating a large body of tradable euro securities in the first few trading days of 1999.
So, how do you turn a Dm1 billion or ffr5 billion bond issue into a tradable bond denominated in euro?
First, the obstacles. Many market practitioners argue that, unless you're a government with a political axe to grind, it will be simpler, and cheaper, to let your bonds run to maturity in their original currency. After January 1 1999 the currency becomes a fraction of the euro, and coupon and principal payments can be in euro. After January 1 2002 all coupon and principal repayments must be in euro, but bond trades can still be done in nominal amounts of Deutschmark, francs, guilders or whatever. The bonds will be orphaned, but they will still have value. According to article 109l (4) of the Maastricht Treaty, after that date all national currencies will be "read as" euro, although nit-pickers wonder what exactly "read as" means. Under these circumstances, why not leave existing bonds alone and concentrate on new issues? The hassles of redenomination outweigh the benefits, many market practitioners warn.
Certainly redenomination will bring a cost, to the issuer or the investor, or both. There may also be legal problems. If the economic nature of the bond is affected there may be grounds to call a bondholders' meeting.
If the issuer is determined enough to overcome these two obstacles - either to demonstrate its commitment to European economic and monetary union (Emu), or because it sees liquidity as vital - then the challenge is to find the best and simplest method of conversion.
Experts have identified six or seven possible ways. They first distinguish between three basic approaches to redenomination, which could be called "the three Rs". (These definitions are adapted from the Bank of England's Practical Issues Arising from the Introduction of the Euro, April 1997.)
1 Redenomination. A change in the currency unit in which the nominal value of a security is expressed at the conversion rate, rounded to the nearest euro cent (ie preserving exactly the economic value of the security).
2 Renominalization. After redenomination, a change in the minimum nominal amount in which the security issue is held and traded (to simplify trading and clearing). This may be achieved either by a reduction in the minimum nominal amount to one euro cent, or by the repackaging of an odd amount, to achieve a round amount in euros (eg E53.23 might become E50). The process of renominalization creates rounding errors, especially when the rounding is to the nearest euro rather than the nearest euro cent. These differences could be compensated for by cash payments.
3 Reconventioning. A change in the terms of a security issue to reflect the different conventions (eg frequency of interest payment) prevailing in the market for securities in the new denomination (to make the securities more comparable with or fungible with new euro securities).
In early March, because so little seemed to be happening at the official level, a group of trade associations calling itself the Forum - noting that there were fewer than 500 business days to Emu - published some recommendations on redenomination. Recommendation number one was: don't do it. The Forum warned against the possible legal obstacles, and the fear that redenomination might reduce rather than enhance an issue's liquidity. If redenomination was considered absolutely necessary, then, the document urged, "the minimum denomination should ideally be 1,000 euro to facilitate liquidity in the secondary market. However, the minimum denomination should in no event be lower than one euro, in order to avoid the use of decimals in the nominal amounts".