Euro Bond Trading: How liquid can you get?

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Government bonds, outstanding at March 31 1999
Ten-year benchmark bonds, outstanding at March 31 1999
Source: Salomon Smith Barney
Former head of the European Monetary Institute Alexandre Lamfalussy has lent his name as chairman of EuroMTS, the euro benchmark government bond trading system that started trading on April 10, because he strongly believes in what it is trying to achieve: a liquid, efficient and transparent market in euro government bonds. The ultimate prize is the establishment of the euro as a reserve currency to match the dollar.

"We've seen an accelerated move to a market-centric system from the bank-centric system that has tended to prevail in Europe," Lamfalussy said in London last month. "I have no doubt that a market-centric system is more efficient, but there's a question whether it is stable." The key to stability, he concludes - for the pricing of corporate as well as public debt - is a liquid and transparent government debt market.

EuroMTS, with 24 primary market-makers as shareholders, is taking a shot at providing this with pan-European electronic trading of initially 27 leading German, French and Italian government bonds. Like the Italian domestic MTS system on which it is modelled, it is offering cheap, efficient trading that's difficult to match over the counter. "Italian primary dealers save an average of $1.5 million a year in inter-dealer broker commissions by trading electronically," says Gianluca Garbi, chief executive of EuroMTS.

EuroMTS is aiming only at wholesale, high-value trades - of at least €5 million and then multiples of €2.5 million - in liquid bonds of at least €5 billion outstanding. Domestic systems would continue to handle the smaller trades. At least five market-makers are committed to trading each security, allocated monthly, at tight spreads according to maturity.

The major firms - including Merrill Lynch, which for internal reasons didn't become a founder shareholder - are enthusiastic about the trading platform, which is UK-registered and FSA-approved. But they would like it to do more - for example, handle repos and basis trades against futures. The Italian MTS system does handle repos - around €20 billion a day, says Garbi. But he questions the need to incorporate cash-against-futures trading. There's not much of a saving in having them on one platform, he says. Au contraire, ripostes one market practitioner who values every pip he can save.

Other market sources comment that liquidity doesn't depend on having one unified trading platform ("That is a dirigiste Italian concept for a controlled banking environment," says one). In the complex world of euroland, traders have many choices and will continue to exploit them.

EuroMTS is designed to feed into the major clearing systems - Sicovam for French OATs, Banca d'Italia for Italian BTPs and Euroclear and Cedel for Bunds. There might be an argument for going with one clearing system, but says Garbi: "Today to commit our system to one clearer would be rash. Let's see what happens."

Competition between clearing systems is hotting up. On March 15 Euroclear and the US Government Securities Clearing Corporation (GSCC) announced an agreement to develop joint netting of repo and cash trades. The collaboration "will allow us to design the most efficient and cost-effective sovereign debt netting service possible", GSCC president Sal Ricca was quoted as saying. Other contenders for the euro cash and repo netting crown are London Clearing House, Matif's Clearnet (which includes cash and futures) and Eurex. On March 29, Liffe, the London futures exchange and LCH announced that they would establish a joint venture to enhance wholesale trading and clearing services. "They're all making hard arguments about the efficiency of collateral," says a London-based analyst. "On the netting side, LCH and GSCC are really in a dogfight."

Euroland is not yet behaving as a single capital market. National banks tend to stick to their own peer group for repo and other credit-sensitive transactions, often favouring their own government's bonds. That will change gradually. More liquidity and better harmonization of government debt issues will mean that yield spreads should narrow to simply the credit differential, Lamfalussy predicts.

The future euro government landscape has an obvious model in the US treasury market. Euroland fixed-income government bonds, with a minimum size of €500 million and more than one year remaining, already outstrip the US treasury market (€2.3 trillion against €1.8 trillion), says Graham Bishop, adviser for European financial affairs at Salomon Smith Barney. But the US dollar market boasts another $3 trillion of agency, supranational and corporate bonds and Eurobonds, while in euros such bonds, including Pfandbriefe, add a mere €500 billion. "One has to admit that the way European corporates have used the euro has been disappointing," says Bishop. He cites preoccupation with the Year 2000 problem as a possible reason. By the end of 2001 many companies will be changing their balance sheet to euros: "Then we'll see more recognition of the euro as a reserve currency."