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Making EMU Swap-Friendly

By John Thackray

In the middle of last October, Gay Evans, chairwoman of the International Swaps and Derivatives Association (ISDA), made a weird assertion during an interview in Hong Kong. She said that uncertainties in the working of European monetary union (EMU) were so grave as to be "an issue much larger than the year 2000 problem,” the cloud that hangs over all computer users and might cause systemic failure on January 1, 2000, running into the hundreds of trillions of dollars.

What uncertainties had caused the normally level-headed Evans to launch into such hyperbole? She was worried about how government foot-dragging on the transition to EMU on January 1, 1999, would impact a wide range of derivatives quoted in today's European currencies, particularly the price sources of the underlying instruments. Would the old government bonds or quoted currencies disappear, or would they linger on? What new price sources would take their place? Without answers to these issues the swaps world would turn to anarchy.

Evans was clearly frustrated. ISDA had been pushing for clarification since June without much success. And with only 14 months until d-day, time was running out. Huge amounts of work lay in store for the swaps community once future price sources were defined: contracts to amend, systems to adjust, decisions about what data the electronic feed services would carry and in what formats. Nobody could tackle any of these issues unless and until there was a blueprint for the key pan-European Interbank Offered Rate (EURIBOR).

After Evans' Hong Kong fireworks, ISDA officials went around Europe tiresomely expressing disappointment at governments' and regulators' inaction. Just before Christmas, it got what it wanted. The Banking Federation of the European Union (FBE) issued a code of conduct and machinery of operations on the EURIBOR that promises to be a robust reference. The EURIBOR is the rate at which euro interbank term deposits will be offered by one prime bank to another at 11 a.m. in Brussels. Fears by some swap dealers that EURIBOR would be highly political and include many marginal banks in its governance proved to be unavailing. In just a few weeks there "has been tremendous progress, a real breakthrough,” said Nikolas Bomcke, secretary general of the FBE. "Now the devil is in the details. Many small things still have to be worked out.”

But the big picture is clear. Anticipating a well-defined EMU environment, many countries have declared that they'd no longer be quoting financial assets in local currencies. When old references die off, the world becomes less ambiguous for derivatives. But there are a few disturbing laggards—notably Italy (the lira RIBOR) and Portugal (the escudo LISBOR)—where it is not clear if the domestic rates will be maintained or will disappear. "Considering how little we know,” says one swaps trader, "I wouldn't do a lira or escudo swap with a maturity that crossed January 1999.”

Beneath the surface of these events, some deeper issues have lurked: to wit, the competitive standing of Europe vs. London's hegemony as a financial center when the EMU is born. A credible, market-based EURIBOR now gives European exchanges a powerful weapon against the London Interbank Offered Rate (LIBOR) More than that, EURIBOR also plans an overnight euro deposit rate, based on a weighted average of actual transactions, similar to the French franc TMP rate. This will be the basis for overnight index swaps. "We have no equivalent in that,” says a London trader. "Therefore it is quite a feather in EURIBOR's cap.”