Agincourt, Orléans, Austerlitz, Waterloo. These are the names that spring to mind as one considers the great sweep of European history that is about to culminate in a final conflict: for mastery of a pan-European currency, the euro.
The battle has already begun. And some observers believe that only one of the major European financial centres London, Paris and Frankfurt will emerge victorious.
Others are less bloodthirsty. They foresee a Europe in which various financial centres cooperate to serve a stable trading area as large as the Americas and Asia, backed by a currency as powerful as the dollar, more powerful than the yen.
But that’s a long way off, and tribalism and nationalism are hardly dead.
Last month the chevaliers of the Marché à Terme International de France (Matif) unveiled their plan to make Paris the “benchmark market” for the new currency when it is born on January 1 1999. There were no great surprises: a drive to perfect French franc interest rate futures contracts all along the yield curve, so that they will have a critical liquidity when the franc is exchanged for the euro. The Matif will introduce a one-month Pibor (Paris interbank offered rate) future, relaunch its five-year bond future probably in June (it was launched unsuccessfully in 1993), refine its highly successful 10-year Notionnel bond contract, narrowing the maturity band and lowering the coupon from 10% to 5.5%, to match that of its ailing 10-year Ecu bond contract. Matif may launch a 30-year contract in French francs or euro, and is even considering an overnight interest rate future.
Critics say this is just rearranging the deckchairs on the Titanic. Matif is doomed to third place because of the liquidity of the mighty Deutschmark contracts in London and Frankfurt, which will also convert to the euro. The real battle, they believe, is between Frankfurt and London.
Another school of thought, counting the wide range of short-term European interest rate futures on the London International Financial Futures Exchange (Liffe) and its dominance of the German 10-year Bund contract, says London has already won the battle.
But Matif chairman Gérard Pfauwadel is undeterred, telling his audience in Paris last month: “We have the cards in our hand, and the political will, to produce a coherent strategy of transition to the euro. We aim to be the benchmark market for euro interest rates.” Matif could be ready this year, he declared: “I have the feeling everything will be played out before 1998.”
Pfauwadel is probably right the battle will be fought and won this year rather than next. By March 1998 the exchanges will have to launch their first credible quarterly contracts to be settled in euro. It will be known by then which countries will be joining the first wave of European economic and monetary union (Emu), so a basket of the “in” currencies, or a synthetic instrument, could be constructed whose behaviour will anticipate that of the euro. (The Ecu basket, because it also contains non-Emu or “out” currencies, could be extremely volatile close to the Emu date, even though it will be exchanged for the euro one-for-one. For this reason, although the basket of “in” currencies may be known, the exact value of the euro won’t be known until the non-Emu currencies are thrown out on January 1 1999.)
Parisian euro-centrism
Pfauwadel is right about another thing. More than the Germans or the British, the French authorities have the political will to promote Paris as a centre for the euro. Top officials from the Banque de France and the treasury, along with economy and finance minister Jean Arthuis, got star billing at the Matif meeting last month. Liberalization of the domestic market has gone further in France than in Germany or the UK. “The Matif’s advantage,” concedes Jörg Franke, board member of the Deutsche Börse, “is that the treasury and the Banque de France are right behind it.” There are huge, liquid benchmark issues in 10-year government bonds (Oats), the repo market is deep and efficient, and there is separate trading in underlying Oats and coupons stripped from them. All this is only just beginning in the German and British markets. Even Bund issues are subject to squeezes on delivery dates for futures contracts because they are too small and closely-held. The French government has continued to issue debt in Ecus, at a cost often much higher than it would pay in any of its component currencies, to keep alive the notion of Emu. Matif’s new plans partly rely on the French government continuing to issue out to 10 years in an effort to revive the Ecu basket future. Other governments are scarcely interested at the moment: if Emu occurs, repayments in Ecu become repayments in the euro, which is expected to be a harder, more costly currency to repay.
Matif’s main strategy is to convert the liquidity of its Oat Notionnel contract into liquidity in an identical French government bond contract denominated in euros, in the hope that it will become a major benchmark, if not the benchmark, for 10-year government bonds in euros issued by Germany and other highly rated Emu countries.
But nobody today knows whether the market will demand a future for each nation’s government bonds, or whether a generic benchmark future will do. That depends on the volatility of the credit spread between, say, a German government bond and an Italian or Spanish government bond. If the spread were stable the basis risk would be low and the market could develop a single, highly liquid 10-year future like the US Treasury bond future. If the spread were unstable there could be a plethora of futures, one for each government benchmark. If a generic future into which bonds of two or more governments are deliverable were to emerge there would be a further problem. The contract would tend to favour the bonds that are cheapest to deliver and could result in lesser credit bonds enjoying liquidity at the expense of the higher credits bad money driving out good.
Matif is hedging its bets. It has already had experience with its 10-year Ecu bond contract, into which French and Italian bonds were deliverable. It was not successful, and today no Italian bonds are eligible, since they don’t have sufficient maturity.
But if the market favours a multi-issuer bond future, Matif will back its Ecu bond future alongside its notional Oat future and see which develops the strongest demand in euros. “We have to cover all cases,” says Jacques Werren, deputy managing director at Matif, “including the collapse of monetary union. We’re not here to make bets on the future.” Is this a deliberate pun?
But others question the French scatter-gun approach. “It shows the French have their backs to the wall,” says a foreign investment banker in Paris.
Things might have been different had five years of Matif negotiations with the DTB, the electronic German futures exchange, ended in a pact. But in August it finally became clear that the courtship was off. At the root of the differences is the French commitment to open outcry and the German belief in electronic trading. “The Germans were asking Matif to use their trading system,” says Werren, “that is, to close its pits.” He noted a change of heart in 1994 when the DTB merged into the stock exchange to form Deutsche Börse AG: “The day the Bourse took them over, the priorities changed. The equity culture is different.”
Franke, who is also general manager of the DTB, outlines the German position: “If there’s no commitment by members of Matif to take the electronic system then there’s no future in [cooperation].” Is this another deliberate pun? DTB sources suggest the breakdown of the talks robbed Pfauwadel of a strategy, adding: “All the things the Matif say they will do are like a copy of what we’re already doing here.”
A cynical view of the French position, and the strategy developed by Matif and a working group of 20 member firms, is that it is a bid to save jobs. Pan-European financial institutions with operations in Paris don’t have to decide yet whether to stay or leave. “If we pull out, and we’re wrong, it’s expensive to start up again,” says the head of futures at a London-based firm. Even if the major market for euros is London or Frankfurt there will still be client business in Paris, he adds.
Over in Frankfurt, DTB chief Franke seems relaxed. The one-month Deutschmark future based on Libor, which the DTB introduced on November 12, now has a bigger market share than an identical rival that Liffe launched nine days later. But Liffe has a 70% market share for its rival 10-year Bund contracts, and the DTB expects to wrest only 20% to 30% market share from Liffe’s three-month Deutschmark future when it launches a rival on January 14. “Market share isn’t the issue,” says Franke. “It’s important that trading in the contract is liquid.”
With its five-year Bobl (German government bond) contract, the DTB has already shown that it can create liquidity and beat Liffe into second place. Liffe’s rival contract, launched 15 months later in January 1993, was delisted within two years.
Franke points out that while nearly all futures exchanges suffered a downturn in 1995 volumes fell 30% at Matif, and 14% at Liffe the fall at the DTB was less than 2%. Trading on the DTB soared 30% between January and November last year, whereas turnover on Liffe rose only 25% and the Matif recorded a decline of a further 3.9%.
“The DTB will not disappear,” says a derivatives dealer at a US investment bank in Frankfurt, “although it might have been artificially kept alive by German banks in its first years.” But he believes that the DTB’s future lies in cooperating with Matif to create “a large electronic trading centre for Europe”. A potential strength for the DTB is the variety of regional and private sector debt, such as joint jumbo issues by several Länder, the states that constitute the German federation, and the spate of jumbo Pfandbriefe benchmark bond issues from mortgage banks which could be deliverable into various custom-made futures contracts. They would be difficult to replicate outside Germany.
Kept under wraps
The biggest difference between the DTB and Matif is in their marketing strategy. While Matif went for pomp and fanfare last month, the DTB is doing its work internally. “We’ve decided not to publish every idea we have,” says Franke. “We might have to improve our publicity, but you risk confusing the market.”
Some observers were surprised by the DTB’s new policy of cash inducements to market-makers of new contracts: to defray start-up costs before the launch of Deutschmark/dollar currency option and Euromark contracts last year, it offered market-makers Dm400,000 and designated brokers Dm200,000. Christian Klapproth, director for derivative product development at the DTB, denies foul play: “What all other exchanges did before is give a reduction in fees. We decided on an up-front payment.”
The DTB has six people working on new products, and another team working on their electronic implementation. It also has an Emu project team “covering all aspects”, says Klapproth, plus a small group “looking at [euro] derivatives in great detail”. Apart from the three-month Deutschmark Libor future, the DTB will launch a two-year government bond future early this year, and from April will introduce spread trading against the Bobl, Bund and other instruments. “This is a real spread trade,” says Klapproth. “You can’t do it on Liffe.” (Technically there is a gap on Liffe between executing one leg of the spread and executing the other, unless the broker momentarily takes a position.)
Liffe supporters believe open outcry remains more efficient for highly liquid fast-moving markets and for complex trades: the human brain in the dealing pit can handle more diverse information and read market conditions better than via a terminal. But the race isn’t over, and electronic trading can only improve. Liffe doesn’t rule out introducing electronic trading for the less liquid contracts, as it already has for its Japanese government bond (JGB) future, which is traded exclusively on its electronic APT (automated pit trading) system. It believes that the APT system, also used for the Bund contract after normal trading hours, is better than the DTB’s six-year-old electronic exchange. “APT has handled over 30,000 contracts in 90 minutes’ trading,” says Ralf Herklotz, managing director for business development at Liffe. “Its functionality is richer than the DTB’s.” A broker who uses both systems comments: “Each has its own virtues. APT is more transparent you can see who’s dealing. With the DTB you can see the depth of the order book. The APT software is newer, the DTB system is harder to use, but upgrading your own software and putting it onto a windows system can solve that problem.”
Like Matif, the DTB is aiming to provide liquid interest rate contracts in its own currency, to complete a benchmark yield curve which will then translate effortlessly into a yield curve for the euro. But, fears a futures head in London, once you start adding to the DTB’s good contracts the five-year Bobl and the 10-year Bund “you detract from liquidity”. Launching a two-year contract “may be a duff approach,” suggests Graham Bishop, Salomon Brothers’ chief adviser on European economic affairs. But, if economic convergence continues, he envisages governments issuing “longer than 10 years, back to 20 and 30 years, in large size”. The DTB’s 30-year government bond (Buxl) contract, launched in March 1994, became illiquid because the government is not issuing at that maturity these days, and it was delisted last summer.
Battle of the benchmarks
The main benchmark contracts are the ones over which Liffe and the DTB are expected to collide head-on. Liffe believes it controls the short end of the market. In addition to dominating three-month Deutschmark, it also leads in three-month sterling and three-month lira. “We couldn’t be better served on the money-market side,” says Herklotz.
For longer-term instruments there could be more of a battle. The DTB and Matif each has one enviably liquid product the five-year bond and the 10-year Notionnel which fills an important part of the yield curve. But for Herklotz Liffe’s crucial advantage is the homogenous settlement that it offers members: “We allow for delivery at the Central Gilts Office, Cedel, Euroclear, the Kassenverein and the Italian Monte Titoli.”
The essence of the futures business, says Graham Newall, chief executive of BZW Futures, is leverage. And the key to that is an efficient clearing mechanism. “If I can have all my positions sitting in the London Clearing House (LCH), that’s better than having open positions on three or four exchanges.” He notes that the LCH, with new shareholders brought in last year, now has the vision to serve the futures business.
Links with the US, which accounts for half of worldwide turnover in futures, are also important, says Newall. Since the 1995 Barings debacle on the Singapore International Monetary Exchange (Simex), US users have been reluctant to use foreign exchanges unless there is some US regulatory link. Most exchanges are putting them in place. Liffe’s links with the Chicago Board of Trade (CBOT) are perhaps the most convincing, with cross-trading of products in the pits due to start in May if they can find space. Last November Liffe and Matif signed separate agreements with the Chicago Mercantile Exchange (CME) to trade their products in the north American time zone. Liffe will trade its short-term products there and Matif the 10-year Notionnel. Outsiders think Liffe has the better deal: “The competence of the CME is currency and short-term instruments. Who will trade a 10-year Notionnel based on French francs on the CME?”
Links with Chicago exchanges “are an option”, hedges Werren at Matif. “We’re not expecting a lot.” Werren says Matif has “gained a certain experience” with its 24-hour trading link to the Globex system run by Reuters. “Globex is an outdated trading system,” counters a member of Liffe. Comments a broker: “Globex and the DTB are very similar. Globex has brought transparency to what had become a less transparent over-the-counter grey market in the Notionnel.” (But transparency is relative on the Matif, the broker complains, since the French brokers are allowed to match trades privately between themselves: “Around 20% of the trades don’t reach the floor,” he says.)
The DTB has taken a different route in the US, setting up screen access in Chicago, which means that pernickety US users have the illusion of regulatory supervision by the US Commodity Futures Trading Commission (CFTC). In fact there is no supervision, only a memorandum of understanding between US and German regulators.
Liffe has broader preoccupations than the battle for the euro. It is developing its links with Asian exchanges. Last year it set up links with the Tokyo International Financial Futures Exchange’s three-month yen future, having linked trading of the Tokyo Stock Exchange’s JGB future for nearly 10 years. And before it can launch potential new euro products it must sort out the trading of CBOT contracts. But, whether or not the UK joins the first wave of Emu, London is strongly placed to remain the premier financial centre of Europe. Direct access to the planned pan-European payment system, Target, with real-time gross settlement across borders, would be nice. But it is not vital. London has thrived as a centre of offshore trading in dollar and Deutschmark instruments and securities without direct access to those currencies’ domestic payment systems. It would probably thrive as an offshore centre for the euro, although the euro area would suffer if restrictions were to drive international euro trading offshore. So a compromise may be reached whereby London clearing banks, viathe Bank of England, have intra-day access to European Central Bank (ECB) funding through Target; but they would be severely penalized if they ran an overnight overdraft since that would be creating euros outside ECB control. This at any rate is the Bank of England’s suggestion which will be chewed over by its continental counterparts. The French and Germans would prefer to see EU countries excluded from direct access to Target unless they join Emu.
The UK and German authorities decided only recently that upgrading their domestic markets might help them win the battle for the euro. Last month the Bank of England conceded that it had to widen access to the gilt repo market, to assist market liquidity and bring its open market operations closer to those of the future ECB. Similarly, the Bundesbank put years of prejudice behind it and abolished minimum reserves for banks’ repo transactions of maturities of up to a year. The Bundesbank’s minimum reserve requirement, maintained as a blunt but effective instrument of monetary policy, was for years responsible for driving repo, floating-rate-note trading and deposit business offshore and for stunting the commercial paper market.
“This move has come 10 years too late,” says a derivatives trader in Frankfurt. “It’s the right thing to do, but the effect will now be negligible.”
Bundesbank sources say the reform sought “to meet the urgent need of the banking community”. A 1995 questionnaire to banks yielded conflicting answers on how lifting the reserves would affect trading. But finally the Bundesbank satisfied itself that the measure would reduce minimum reserves, presently Dm40 billion, by only 5%. The Bundesbank is quite capable, through quick tenders into the money market, of fine-tuning the money supply. But, with the luxury of minimum reserves, it is “happier just looking out of the window each week,” quips a Bundesbank source.
Minimum reserves will be one of the tools available to the ECB although some central banks, notably the Bank of England, are against their use. The Bundesbank, by making its own minimum reserve policy less Draconian “may make others more prepared to accept minimum reserves than before,” says the Bundesbanker.
The quest for Euribor
But an aspect of the Deutschmark that Germany may not be able to wrest back to Frankfurt is interest rate fixing. By launching its own one-month Libor contract in October, the DTB conceded that the Libor fixing is more credible than the Frankfurt interbank offered rate (Fibor). It is launching a three-month Libor contract as well this month.
Matif’s Pibor contract for the French franc on the other hand is successful. And the French exchange has announced plans to extend the interest rate fixing to a panel of European banks when it converts to the euro, to create Euribor the European interbank offered rate. London-based bankers doubt the Matif’s chances. “You need 16 or 17 banks across Europe active in money markets,” says one. “We’ve got that many in London.” Moreover, most swaps and forward rate agreements (FRAs) are priced off Libor, points out Herklotz at Liffe. “The markets should have a right to chose a fixing where they like. If it ain’t broke, why fix it?”
Pibor, and France’s other domestic fixings such as T4M and Tam are effective because they reflect the market. Frankfurt fixings, such as Fibor and Fiona (Frankfurt interbank overnight average) haven’t yet won credibility.
The Paris, London and Frankfurt financial centres are pitted against each other in four major disciplines: political support, marketing, infrastructure and research & development. On the political level the French win hands-down. The great and good in Frankfurt, led by stock exchange chairman and Deutsche Bank speaker-elect Rolf Breuer, have just launched an initiative to promote Finanzplatz Deutschland the idea of Germany challenging London’s position as Europe’s leading financial centre. But Bundesbank president Hans Tietmeyer declined to take part. “The Bundesbank is not a promoter of Finanzplatz Deutschland,” explains Franke at the DTB. “They play a neutral role. Their argument is that the best promotion of a financial market is a stable currency.” Although the Bank of England and the UK treasury have been keen to support the City of London, until recently they have not seemed to feel the need to open up the domestic market. The threat of the euro has concentrated their minds.
In marketing and market infrastructure the British are probably ahead, unless you believe that electronic trading will finally drive out open outcry. Even if it does, Liffe argues that it could shift to full electronic trading without disruption. “We’re pretty convinced our membership supports open outcry trading,” says Herklotz, “certainly for the very big contracts. But we’re an exchange of choice. If there were to be a commercial benefit, we’d have to consider looking at automated trading.”
It is tempting to think that identifying some unique euro product and launching it ahead of the competition could secure victory for any of these centres in the battle for the euro. But most participants believe it won’t be like that. The big, liquid contracts will win the prize. Creative work on new products cannot be kept secret for long, since market participants involved in consultations tend to bestride all three centres. Ideas of spread contracts, futures based on the zero-coupon swap curve, indexes on European industry sectors or sub-groups of bonds are pretty common to each research and development team. Nevertheless, they may surprise us. The Germans and the British have each hinted, perhaps as part of the psychological warfare, that they have a secret weapon under wraps.
Market participants cannot be neutral, even among the pan-European firms. In each centre there are futures dealers and their families keen to hang on to their jobs. The European Monetary Institute (EMI), forerunner of the ECB, is keeping itself out of the frame, anxious to let market forces create the new futures and derivatives landscape for Europe. The only neutral but engaged party is possibly the London-based Futures & Options Association (FOA). “Our argument is straightforward,” says chief executive Anthony Belchambers, “London, Paris, Frankfurt and Amsterdam are valued financial centres. London is as much a jewel for Europe as the others. They shouldn’t just be seen in a national context, because we’re competing outside Europe too.”
Survival tactics
But there will be a diminished role, or no role at all, for some of Europe’s lesser exchanges. In the Netherlands, Austria and perhaps Sweden, the stock and futures exchanges are merging in order to survive. Their business will concentrate on equities and their derivatives. Austrian futures exchange Ötob is bidding to become a safe clearing and trading centre for derivatives on central European equity indices. Critics say that won’t work unless Vienna also becomes a centre for trading the underlying stocks (see article, page 83). Peter Schedling, a board member at Ötob, believes there might be scope for a spread contract to trade the spread between German and Austrian bonds. There are also plans to launch a five-year bond future.
Meff, the interest rate futures exchange in Barcelona, launched futures in June on the spread between Spanish and other European government bonds. The only reasonably successful contract has been the spread against German Bunds where volume in good months ranges between 500 and 1,500 contracts a day. “It’s a very domestic product,” admits Enrique Vidal-Ribas managing director at the Meff responsible for markets. But the market-makers maintain a tight bid-offer spread, he says, making it cheaper to use the Meff contract than to create the spread synthetically. Meff’s future looks bleak if Spain joins Emu. But that’s a short-term view says Vidal. Joining later could make it even more difficult for Meff to enter the international marketplace. “We’re developing our domestic potential to the maximum,” he says.
The EMI may be trying not to be drawn into the battle. But it is faced with a decision that could shape the futures markets and the development of a euro benchmark contract. This month it will propose a list of types of collateral eligible for discount at the ECB and national central banks. Government bonds of Emu members will be eligible, as will some high quality private-sector paper and some foreign currency bonds. But there are many areas of contention: will this paper be priced uniformly across the Emu region by the various national central banks? Won’t those banks favour, or at least value more accurately, their own domestic private sector paper? It is on such arcane points that the development of euro derivatives could become snagged. But not for long. Investment bankers would surely turn this into an opportunity to arbitrage one central bank view against another or even to sell them credit derivatives.
