Derivatives exchanges shift their unique—and complicated—strategies for euro-readiness into high gear.
BY ROBERT HUNTER
While the 12 countries that will make up the first wave of European economic and monetary union gambol about, intoxicated by an unprecedented spirit of cooperation and fraternité in Western Europe, the three biggest European derivatives exchanges are busy behind the scenes twisting their mustaches and fine-tuning their strategies for euro supremacy.
What has developed in the prelude to “E-Day” can be likened to a financial Tower of Babel: A slew of new convertible basket products have been announced, no less than four euro conversion methods have been identified, a simple issue like rounding has produced five different standards, and a conflagration over the euro interest rate of choice—Euribor vs. Euro-Libor—has already begun. The euro was designed to streamline the European financial system; the Deutsche Terminborse, the London International Financial Futures and Options Exchange and the French Matif are taking aggressive—and sometimes maddening—steps to make sure they're not swept up along the way.
The DTB has perhaps the most to gain from EMU. It has already wrested from the Liffe the benchmark German Bund contract, now trading more than 90 percent of total worldwide volume, and it views EMU as an opportunity to use its electronic trading system to vault to the head of the European class. “We are sticking to our remote membership strategy, to connect members to our electronic system with the goal of increasing liquidity,” says the DTB's Walter Allwicher. “At the same time, we are aiming to build up strategic alliances so that our members can trade as many products as possible with the easiest possible access.”
Eurex—the all-electronic derivatives exchange jointly operated by the DTB, the Swiss Exchange and, perhaps someday, the Matif—has already begun listing futures and options on the Dow Jones Stoxx and Euro Stoxx indices, making the euro equity markets playable in one instrument. “With Eurex, we have made an important step toward what the EMU will bring—a concentration process in the derivatives industry,” says Allwicher. “This might lead to two things. First, there might be exchanges that simply disappear. The other thing might be—and this has already started to happen—that exchanges will go into strategic alliances to offer market participants easy, cost-efficient access to as many products as possible, with the highest liquidity.”
In the meantime, however, the DTB has unveiled the most complicated euro conversion plans in the exchange world (see box). The most intriguing of these is its decision to parallel-list money-market products—offering Euribor- and Euro-Libor-based contracts—in the hope of bringing some of Liffe's business to the DTB. “We have to face the fact that, right now, the money-market products are traded at Liffe,” says Allwicher. “However, we believe that we're in a great position because we're offering both Euribor and Euro-Libor products, giving the market the flexibility to trade the product the market needs. In the end, we believe the Euribor will be the most important benchmark, but until then the members will have the choice.”
Fighting for its Liffe
If the DTB has the most to gain from EMU, the Liffe has the most to lose. After watching its benchmark product, the Bund contract, move to the cheaper, all-electronic DTB, the Liffe has embraced technology as never before, electing to offer intraday electronic trading by the end of 1999. While it laments the loss of its beloved Bund, it views EMU as a chance to gain market share in other products. The exchange came out swinging a long time ago: In March 1997, it listed the first euro product—the three-month euro money-market contract.
Nevertheless, the Liffe's euro conversion strategy manifests its ambivalent feelings about EMU: Like the British government, it remains something of a euro-skeptic. The exchange plans to parallel-list its contracts in ecus (European currency units, which represent a basket of EMU in-country currencies and will convert to euros on E-Day) and national currencies until 2002, when the in-country currencies are scheduled to disappear forever. “We've developed a flexible strategy toward the euro, by allowing members to chose between contracts denominated in national currency units or in euro-denominated units,” says a Liffe spokesman. “So if you believe, for instance, that EMU will break up—which might still be possible—you might rather trade the Deutsche mark version of the euro than the euro version of the three-month euro.”
But the Liffe is approaching EMU pragmatically, and since parallel listing can skim liquidity all around, building liquidity in euro-denominated products is a priority. It has announced three methods to convert NCU-denominated contracts into euro-denominated contracts: the voluntary position conversion system (VPC), the pit-based spread trading facility (STF) and the central processor system. The VPC is a book-conversion procedure that occurs at the end of the trading day, allowing member firms to guarantee their clients' conversion positions by taking equal and opposite positions. For instance, if a client is long 10 Deutsche mark contracts, the member would take the opposite position by going short 10 Deutsche mark contracts, and would then make the client long 10 euro contracts. The STF is a pit-based system that allows members to trade the spreads between two contracts, such as the three-month euromark and the three-month euro. The central processor system is a nonguaranteed conversion facility where one member's position is offset against another member's account.
The Liffe has taken a decidedly non-continental tack to EMU. Perhaps most notably, it unequivocally supports the British Banker's Association's Euro-Libor rate over the Banking Federation of the European Union-calculated Euribor. “All our contracts are going to settle against Euro-Libor,” says the Liffe spokesman, “because the BBA's rates are currently the benchmark for the settling of interest rate instruments—accounting for 80 percent to 90 percent of swap fixings as well. So we're confident that Euro-Libor will become the benchmark for European interest rate instruments as well.” In addition, Liffe has listed euro-denominated FTSE Euritop 100 index contracts to compete with continental Dow Jones products. The FTSE 100 index comprises the 100 largest-capitalized companies in Europe, whereas the Euro Stoxx indices include only companies within the euro zone. “It is going to take a while for investors and fund managers to start focusing on the euro zone as a single entity,” says Liffe. “And if you use an index that doesn't include the biggest (London) and fourth-biggest (Switzerland) stock markets, you're missing quite a big chunk of liquidity.”
The DTB has visions of euro-dominance. But going from a dozen national currencies to the euro is the tricky part, and the DTB isn't making things easy for member firms. Here's a partial guide to the madness of the DTB's euro conversion methodology.
For equity and currency products, the DTB will use what it calls the “version number” method. On January 4, 1999, strike prices of non-euro-denominated contracts will be converted to euros using a standard factor, which will result in odd strike prices that must be rounded to a certain number of decimal places, depending on the product (one or two decimal places for equity products, two decimal places for currency products). The contract sizes will not be changed, and there will be no cash settlement for rounding differences.
Index products, meanwhile, will be converted via the “splitting” method. Contract values will be computed using the euro conversion factor, and the odd-lot values that are produced will be split off from the even-lot values and traded as separate contracts. Preconversion positions, therefore, will remain identical after conversion.
But doesn't contract splitting threaten to sap liquidity from even-lot contracts? The DTB has put three measures in place to make sure that doesn't happen. First, no new strike prices or expiry months will be introduced for odd-lot contracts. Second, it will close any expiry months or strike prices in odd-lot contracts that have an open interest of zero at the end of a trading day. Finally, it plans to offer fee incentives to close out odd-lot contracts.
To complicate matters, interest rate products will be converted via parallel listing, in which contracts are traded in denominations of ecus and Deutsche marks. Contracts denominated in ecus will be converted on a 1:1 basis to euros on January 1, 1999. Existing Deutsche-mark-denominated products will continue to be traded as foreign currency products until the March 1999 maturity date. An interproduct spread facility will calculate the variation margin between contracts in Deutsche marks, and that figure will be converted to euros using the standard conversion factor. This will happen every day until the Deutsche-mark-denominated contract is delisted.
Matif: bullish on the euro
No exchange has embraced EMU as fully as the French Matif. “We were the first exchange to announce that all our marketplace—equity markets, derivatives markets, over-the-counter markets—will change to the euro on the first day of the new currency,” says Pascal Samaran, chief executive officer of the Matif. “We will all be in euro in Paris on January 4, 1999.”
The Matif is so high on the euro, in fact, that it is parallel-trading ecu-denominated and franc-denominated three-month, five-year and 10-year bond (notional) contracts only until December 14, 1998. After that, all franc contracts will close. And as of January 1, 1999, all Matif products will be denominated in euros, with 1:1 convertibility from ecu contracts. “Our strategy for the euro,” says Thierry Morello, senior vice president for product development, “is to cover the French yield curve—three-month, five-year, 10-year—and to attract liquidity on these contracts and convert them as easily as possible to euros.”
Perhaps most telling, the Matif has announced total commitment to Euribor. It plans to launch on September 15 ecu-denominated futures and options based on Euribor, with 1:1 convertibility to euros on January 1, 1999. Moreover, it will convert all existing Pibor contracts to Euribor on January 1, and will stop listing Pibor contracts at the end of this year. To stop liquidity drainage resulting from parallel listing, and to channel all liquidity to the Euribor contract, the Matif is offering a voluntary euro conversion facility. Customers wishing to convert Pibor contracts to Euribor contracts can do so via the Matif clearinghouse, which will use a fixed franc-euro conversion rate and will become a counterparty to the conversion deal. The customer will be able close the position in Pibor, and the clearinghouse will open a position for the customer in Euribor at the same price. To sweeten the deal, the Matif will do this at no charge.
The Matif has been aggressive on other euro-fronts as well. Most notably, it has listed futures and options on the Dow Jones Stoxx indices, in direct competition with the DTB/Eurex. While the Matif had initially signed on to become a partner in Eurex, it has cooled of late. “Eurex is a great marketing concept, but I think [the DTB and Swiss Exchange] had some difficulties in translating it into an operating concept,” says Samaran. “So we have delayed what we agreed to deliver to the market—cross-trading, cross-clearing and single listing. But we're working on it. My goal will be to make some progress on cross-membership. Once we clear some regulatory and technological hurdles, we'll be able to propose to the marketplace the cross-trading benefits that are at the heart of the cooperation.”
The Matif also plans to launch a multi-issuer fixed-income contract called the E-bond, initially at a 30-year maturity. And it has already listed the Euro All Sovereign, a 10-year debt contract based on sovereign debt of the euro in-countries. “We think EMU will call for new products in equity index derivatives and fixed-income derivatives,” says Samaran. “We think EMU will go ahead faster than the market seems to think, and we're preparing for it.”
And in Chicago…
The Chicago Mercantile Exchange, the biggest currency derivative exchange in the world, would seem at first glance to be a candidate for euro-induced suffering. But a closer look shows that only one contract, its French franc future, is in jeopardy, and it's far from the exchange's most liquid product. “Our main EMU strategy,” says David Goone, senior vice president of product development at the Merc, “has been to diversify into the emerging market currencies, which we've done over the last four years, starting with the Mexican peso and, most recently, the Russian ruble.”
That said, the exchange launched in May a series of ecu products that will convert 1:1 with the euro on E-Day. “The ecu hasn't traded much so far,” says Goone, “and we didn't expect it to, because the first contract that's listed is in March 1999. Assuming all goes well in January, our December roll in Deutsche marks most likely will start having significant volume into ecus, which will become euros in January.” Overall, the Merc is optimistic. “We see only upside,” says Goone. “EMU simply presents us with opportunities to capitalize on.”
The Chicago Board of Trade, meanwhile, has hitched its cart to what could be the winning horse in the euro derby—Eurex. The two exchanges expect to finalize an agreement in September that will provide each with cross-membership and cross-trading of all products. “As this European union comes into existence and convergence occurs later on this year, and you have 11 countries in the first tranche,” says CBOT chairman Pat Arbor, “the German Bund will be the de facto, quasi interest rate product for the euro. The CBOT is delighted to be able to offer that product to its members.”
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