The US government staged a last-ditch attempt in November to convince European leaders to delay economic and monetary union (Emu) until the next century, arguing that the scheme in which they had invested so much political capital was just too risky.
But venture into the capital markets and you will find few more ardent supporters of the planned single currency than the London offshoots of the major US investment banks. They believe Emu will transform Europe’s fragmented fixed-income markets into the world’s closest replica of the US domestic bond market. The product range will be similar to that in the US as European governments cut deficits and a wide range of corporations issue in the public bond markets for the first time.
The efficiency benefits of a single currency may even lift European debt markets to a size close to that of the US. Further down the road, pension reform in Europe could well create an investor base for debt not dissimilar to the spread of pension and mutual funds that are the top buyers of bonds in the US.
Most important of all, the US investment banks foresee a bulge bracket developing in Europe – with their names at the top of the list. They point to the balance of power in the Eurodollar bond market, where US investment banks occupy six of the top 10 spots. Add to that the other global Euromarket players – the three major Swiss houses plus Deutsche Morgan Grenfell, Paribas and ABN Amro – and you have the main candidates for the bulge bracket in Euroland, they believe.
“Compared to the US, the European bonds markets have been highly fragmented until now,” says Cyrus Ardalan, global co-head of bonds at Paribas. “After Emu, you are going to see a bulge bracket emerging. I expect that fewer than 10 houses will dominate the market.”
He foresees many smaller players ceasing to be traders of debt once their national currencies are replaced by the euro. Instead, they will become niche distributors of securities to smaller institutions and retail customers. And as investment in Europe becomes increasingly institutionalized, the market share of houses such as Paribas will increase. Many of these smaller institutions will come under severe pressure since Emu will also erode their earnings from forex trading and trade finance.
“Emu will create more homogeneity with the result that it will be much easier to achieve economies of scales in government bond trading as well as credit markets,” says Eric Bertrand, managing director at JP Morgan in London. “That will put niche players at risk.”
Admittedly, much of the global banks’ vision for the structure of European bond markets after Emu is already materializing, as evidenced by the proliferation of new products. The decline in interest rates in 1996 and early 1997 prompted European investors to take a more sophisticated view of risk. There have been the first issues of callable bonds – previously disliked by most Europeans – in several European bond markets this year while there has been a large number of structured issues with embedded interest-rate options in lire and pesetas providing above-market returns. The credit spectrum on offer to investors has also widened with the first major issues of European-currency-denominated junk bonds.
“Many of these developments are going to happen with or without Emu,” says Clive Parry, vice-president at Morgan Stanley Dean Witter in London. “The Single Market Act is the powerful driving force. Emu merely accelerates the process as capital is not truly mobile in Europe while you have exchange-rate risk. The removal of that exchange-rate risk combined with the Single Market Act will free capital over Europe. It is going to mean huge consolidation in the financial services industry as a whole: not just traders of securities.”
Yet although the global houses have made some headway in European bond markets, domestic players still have maintained a stranglehold. ABN Amro, Rabobank and ING dominate the guilder bond market, for instance, with a combined 88% share of the market. Four of the top five bookrunners of the international Deutschmark bonds are German, with a combined 35% in market shares. In French francs, by contrast, JP Morgan was the top underwriter this year up to mid-November, although Merrill Lynch in fourth place and Deutsche Morgan Grenfell in 10th spot were the only non-French houses among the top 10.
“It is very hard to set a blanket strategy for after Emu,” says Bertrand at JP Morgan, “because each country in core-Europe offers different sets of opportunities. It is driven by the nature of the public sector and the structure of the banking sector.”
The best opportunities
What’s clear, however, is that many of the best opportunities for global investment banks will occur in countries where the deregulation of the capital markets hitherto has proceeded the slowest. Spain, where the government still restricts the range of borrowers and local investors have invested little abroad, is regarded as probably the most extreme example of this.
“Emu is going to put massive pressure on Spanish banks,” says one London-based banker. “They have had it far too easy for too long. Spanish institutional investors have been heavily regulated and they have hardly any foreign-currency assets under management. But that will change after Emu, because they will have a large number of new instruments available to them in euros. The opportunity for bankers lies in distributing products that did not exist in Spain before and that immediately plays into the strengths of global houses.”
He expects Spanish institutional investors to start diversifying their portfolios post-Emu – by selling Spanish government bonds (bonos) and moving into government bonds of other Emu participants, for example.
Spanish banks retort that they have come up with exactly the same idea. “We have already developed the skills and risk-management capabilities for trading government bonds in our domestic market,” says a Madrid-based banker. “We will build on that experience by starting to trade German and French government bonds from London. Our clients are not going to desert us.” He concedes, however, that his house will be at a disadvantage when it comes to distributing non-Spanish corporate-debt products.
The global players are also targeting Italy, although the Eurolira bond market has been largely deregulated in the 1990s and there are few barriers to entry. The attraction of the country is that it has one of the highest savings rates in Europe while the investor base in Italy is expected to be rationalized over the coming years as retail investors start to channel their funds through institutions.
It is in credit products that global houses believe they have a natural advantage. “We feel that credit markets are going to expand,” says Paribas’ Ardalan. Like many major houses, Paribas has been building credit-trading and credit-analyst capabilities in recent years. For their part, US banks are quick to point out that many of the new products emerging in Europe post-Emu – high-yield debt, government bond strips – are ones they have been pricing and trading at home for years.
But clearly the global houses will not be immune from rationalization, though they reject suggestions that there will be staff cuts as a result. “If you look at government-bond trading in European currencies, the headcount is going to decline,” says JP Morgan’s Bertrand. “We have already redeployed traders into emerging markets, which has been a major growth market.”
“The trading of credit instruments is growing more sophisticated and will consume more headcount,” says Bertrand. “All in all, we don’t expect a contraction.”
At Paribas, Ardalan expects trading increasingly to be centralized while he says he believes offices around Europe will retain much of the responsibility for sales and client coverage.
Adds a banker at one of the top German houses: “Right now, we have one guy in Frankfurt trading GMAC in Deutschmarks and people in London trading GMAC debt in other European currencies. It would at least make sense for all those traders to be located in the same country, if not the same office. Until recently, investors have not made the comparisons between the same credit in different currencies. But once all those securities are traded in euros, it will be so much more clear.”
The major houses say that the structure of their headcount will depend greatly on how European governments issue debt post-Emu. “There will be a big change in the relationship between governments and dealers,” says Parry at Morgan Stanley Dean Witter. “Until now, each country has had its national market with its own national character. Dealers want to be part of that market because they want to take those national characteristics and use them to sell to investors. If you lose those national characteristics, dealers will ask: ‘Do I still want to trade this country’s government bonds? Do I still want an office in the country at all?'”
During the early 1990s, many global investment banks eagerly bid to become primary government bond dealers in European markets, such as France, Italy and Spain. As primary dealerships were exempted from single-market legislation, it was possible for governments to place restrictions on dealers, for instance requiring local offices.
Reconsidering local presence
Bankers were willing to accept such obligations because they believed it gave them the perfect way to enter markets otherwise hard to break into. But some say they will reassess whether these dealerships make sense after Emu. That reflects an important difference between fixed-income markets in Euroland and the US bond market. The US treasury serves as the unique risk-free rate in the US but in Europe there will probably be several sovereign borrowers, none of whose securities will provide the clear benchmark at all maturities.
“You will see the French and the German markets assume the equivalent of the US treasury,” predicts Parry. “You may well find that in certain sectors of the yield curve the German government becomes the benchmark – at 10 years, for instance. In the front end, the French government will probably be the benchmark because they have a much more active bill market and short-term bond market. At the very long end of the maturity spectrum, the French market is also somewhat more developed.”
JP Morgan’s Bertrand foresees other possible benchmarks. “Since there will be no single government benchmark, you could make a case for the swap market and other derivatives to become the trading instrument for duration purposes. By definition, the swap market in euros is likely to be bigger relative to the bond market than in the US domestic market.”
Although bankers expect the French and German governments to preserve their present methods of government bond issuance at least in the short run, smaller countries such as Austria and Portugal are expected to be forced to be more flexible in their approach to issuance.
“They are too small to be in any position to make demands on the market,” says one banker. “In the past, they could decide on their own how to issue – there was not much competition between different governments. But if they are too inflexible after Emu their cost of funds will rise as a result.”
That might mean that the best way for them to raise funds in the future is by launching syndicated bond issues, rather than through auctions.
“We expect that the smaller European government issuers will trade at a spread to the French and German benchmarks,” says Parry at Morgan Stanley Dean Witter. “The best comparison would be to the agency market in the US.”
