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The fight is on for the leading European derivatives exchange.

By Margaret Elliott

While politicians dither over which countries and which currencies will join the European Monetary Union and the new currency unit known as the euro, Europe's derivatives exchanges consider it a done deal. That's evident from the urge to merge that has overtaken the German and Swiss futures exchanges, which announced, in a display of uncharacteristic cooperation, the launch of a joint derivatives exchange, the EUREX, scheduled to begin operations in May 1998. Even more uncharacteristic, the French futures exchange, MATIF, looks likely to join in.

So what's happening here? A cold hard look at the situation reveals the pragmatic approach of the Germans, Swiss and French. There are 22 futures exchanges in Europe. If many of the EU countries join the European Monetary Union and give up national currencies in favor of euros, many of these exchanges will be competing head-to-head with the same products. Even without this impetus, the spiraling costs of maintaining separate exchanges with only a limited range of products would send exchange financial managers to the negotiating table.

Noticeably missing from this conclave of goodwill is the London International Financial Futures Exchange (LIFFE). London has taken the opposite tack, much as the U.K. government has made it clear it won't join the euro in the first wave. In September, LIFFE started trading its BOBL contract, the German futures contract, 45 minutes earlier each day, to match the opening time of a similar contract on the Deutsche Terminborse (DTB). The DTB is merely amused, offering to send the LIFFE traders breakfast instead of kicking up a ruckus.

DTB's calmness in the face of LIFFE's increasingly competitive stance is in one sense understandable. The DTB is a fully computer-based futures market, the most successful of the electronic efforts in this area. EUREX will use its technology and it could form the basis for the first pan-European futures exchange. Earlier attempts to link the MATIF and DTB failed because the MATIF runs in an open-outcry environment. Now the MATIF has agreed to open a parallel electronic exchange next year in order to facilitate the link with the DTB.

For investors, the main benefit of the linked exchanges will be pooling of collateral. Instead of the hassle of placing collateral in clearinghouses for each exchange, collateral will be held jointly, thus greatly reducing the amount required. It is similar to the attempt by the Chicago Board of Trade and the Chicago Mercantile Exchange to launch a joint clearinghouse.

Of course, electronic isn't always best. Liquidity can be scarce in times of trouble. Pit trading is the most responsive trading environment possible, and in difficult markets, any bid/offer spread may be welcome.

Rounding out the Yield Curve in France

Notwithstanding the specter of the euro hovering on the horizon, the MATIF has been making some bold moves. One of the most eagerly awaited was the September launch of its new five-year futures contract. Midway between the existing three-month and 10-year contracts, the five-year sets up real yield curve trading in French francs for the first time.

Last fall, the MATIF shifted the notional bond contract from a seven-year contract to a 10-year one, with the intention of rolling out the five-year this year. "We needed this contract,” says Benoit D'Angelin, an interest rate trader at Lehman Brothers. "You could do spread trading over the counter, but it is expensive and cumbersome, particularly for a market that is relatively liquid like the French franc. The contract is also well-constructed and well-priced and should get a following quickly.”

It may seem strange to start up a new contract in a currency that looks likely to disappear within a matter of years. But the MATIF doesn't have its head in the clouds. Along with the launch, the MATIF rearranged its trading floor arrangements to bring all of its financial products under one roof. This isn't an insignificant step, given that the MATIF, along with the 22 other futures exchanges in Europe, is fully aware of the potential for becoming obsolete with the advent of the euro.

In fact, consolidation of the trading floor will make any kind of electronic link-up with other exchanges viable, whereas it wasn't before. Any advance along these lines, however, will require the MATIF to install a system that is compatible or at least accessible to those used by the new EUREX exchange.

French equity derivatives are not being left behind either. The MATIF and MONEP have set up a joint venture with the Paris Bourse to facilitate cross trading between equity index products and the underlying equities, as well as to develop further additional contracts.

Cash Governments To Trade on CBOT

Not even a last-minute attack could stop the membership of the Chicago Board of Trade (CBOT) from approving the reorganization of the Chicago Board Brokerage (CBB) to trade over-the-counter cash government securities. CBB is a joint venture between the CBOT and international broker Prebon Yamane.

In the days leading up to the September 2 vote, a former chairman of the CBOT, the well-regarded William O'Connor, principal of FCM, O'Connor and Co., sent a letter to the membership suggesting that the CBOT was virtually giving Prebon Yamane its stake in CBB for just $3.4 million. This stake, O'Connor said, was been sold with no demands on the brokerage firm to bring any level of volume to CBB. He also said that "Prebon Yamane is not a significant participant in the cash government securities market” and thus would not be able to deliver a significant customer base to the effort.

O'Connor's letter focused the CBOT membership on the vote, but campaigning by the Board and Prebon Yamane successfully delivered a victory for the CBB, by a vote of 492 to 260. A spokesperson for Prebon Yamane refuted O'Connor's claims, saying that Prebon Yamane "is an internationally significant broker in the repo and over-the-counter interest rate derivatives markets and this experience was of great use in developing the cash government securities market through CBB.”

The history of this project has not been without its hiccups. When the CBB project was announced in December 1996 it featured not two but three partners. The original configuration of the CBB was 51 percent owned by CBOT and 49 percent owned by Hudson Holdings, a joint venture between Prebon Yamane and Liberty Brokerage Inc. As negotiations progressed toward setting up the electronic brokering of fixed-income securities (with cash governments the first leg), Liberty dropped out because it would not sign an exclusivity agreement with CBB. The problem with the withdrawal of Liberty is that it was this organization that was touted last December as having the experience in the cash governments market.

Though O'Connor's letter did not detail technical objections to the new CBB configuration, sources within the CBOT membership point out that CBB will work under a trade-matching system similar to the one used by the unsuccessful Globex system. Those in favor of sending CBB back to the drawing board wanted it to use a trading system similar to that used by the CBOT's successful Project A, which uses algorithms to mimic an open-outcry trading floor (see "Screen vs. Pit: Score One for Project A,” March).

The CBOT's defense against all these objections is simple and pragmatic. The time to launch CBB is now. It couldn't afford to go it alone. It had lost one partner already and could identify no one other than Prebon Yamane with the global reach and specific brokerage expertise. And the CBOT maintains that its research showed that the target customer base wanted a trade-matching system.

It seems that the CBOT was right. Now all that remains is to make the CBB successful enough to challenge its crosstown rival, the Chicago Mercantile Exchange.