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The Fight For Europe

LIFFE, DTB and MATIF all want to dominate the trading in euro interest-rate contracts. Only one can win.

By Nilly Ostro

The close-knit world of derivatives exchanges is abuzz with two unanswered questions: Will EMU radically alter the playing field for European derivatives exchanges? Or will it merely consolidate the advantages held by the biggest players? At stake is the number-one spot for trading European yield products. The winner will be largely determined by whether or not the Euro will unleash another big bang of sorts.

By next year, one of Europe's three leading futures exchanges (LIFFE, DTB and MATIF) will have clinched the top prize-the number-one spot for trading euro-denominated yield-curve futures and options. While the three contenders disagree on a lot-in particular on which one of them will likely capture the lion's share of trading-there are two key points they readily accept: If and when EMU occurs, the playing field in futures trading will be altered forever. And when the dust settles, only one will emerge as the exchange of choice for trading benchmark interest rate products. Other players-and there are more than 20 financial exchanges in Europe-will be relegated to managing niche markets in equities, non-EMU currencies and long-term government bond futures.

Which exchange will win is anyone's guess. The market bets are on LIFFE and DTB as the front-runners. MATIF is the long shot, and its success will depend on the chances that the euro will so dramatically alter the trading landscape that all current bets will be off. "It's important to understand that the euro and the third stage of EMU will be like a big bang for European capital markets," says Patricia Rouast, a MATIF spokeswoman. "Just because an exchange is number one today may not mean it will remain so in the new environment."

Most market observers, however, are deeply skeptical of such "total reshuffling" theory. "The French position is understandable, since nothing short of massive transformation is likely to give MATIF a chance at the helm," says one trader. "Frankly," says Chris Plona, author of a recently published book, The European Bond Basis, " I don't think EMU will make that much of a difference."

Anthony Belchambres, chief executive of the Futures and Options Association (FOA), an industry group based in London, recalls the original Big Bang. "This," he says, " is no Big Bang for Europe." In fact, Europe has been too eager to assign Big Bang status to its initiatives. "Take the banking directive," he says. "Yes, it caused a certain amount of restructuring, but other than that, it was a bit of a dud."

Little bang?

Market experts disagree on EMU's importance, but do not disagree that its threat is imminent, and that one exchange will likely emerge as the key player. "There's really no room for more than one dominant exchange in the same time zone," says Chris Taylor, partner at Price Waterhouse in London and author of a recent PW/FOA survey titled Futures and Options: A Forward Look (see sidebar). The DTB, LIFFE and MATIF have broadly similar yield-based contracts, and with an overall decline in volume only one will be able to sustain enough trading. "History tells us people go where the liquidity is."

History also tells us Europe's ambitious attempt at converging monetary policy across national borders has less than a sure chance at success. "Although there's clearly political pressure for EMU to happen, economic cracks are now beginning to appear that may threaten the timetable," notes the FOA's Belchambres. A study by the Union Bank of Switzerland recently found that while the market assigns a 65-percent chance that EMU will happen on time, the bank sees a 25-percent probability that EMU will have to be delayed by more than a year, and a 5-percent chance it won't happen at all. "The one thing that surprised me the most about EMU sessions at the recent Futures Industry Association conference in Chicago," says Galen Burghardt, senior vice president with Dean Witter's futures group, "is the willingness of people to suspend disbelief about the potential pitfalls and roadblocks."

The reality, however, is that one's degree of EMU-skepticism is largely irrelevant in this case. Whereas the euro-skeptics may be right, the heads of Europe's futures exchanges cannot afford to be wrong. "The impact of EMU will be very broad," predicts Jane Carlin, principal at Morgan Stanley and member of a broad financial market liaison committee organized to study the legal consequences of the conversion to the euro. "EMU impacts any financial transaction with any sort of local currency component," says Carlin. Indeed, the PW/FOA survey reveals that Europe's futures exchanges are the most EMU-prepared members of its financial industry. Banks and pension funds rank far below futures exchanges in their degree of readiness.

The exchanges are anxiously preparing for a new wave of products and trading volume that may result in a violent industry shake-up. The optimists are looking forward to a welcome boost in futures trading volumes, after a two-year-long global recession. "EMU will have a big and positive impact on derivatives," predicts Joseph S. Rizzello, executive vice president of the Philadelphia Stock Exchange (PHLX). The PHLX recently published a white paper on EMU outlining its plans for converting European currency options and futures into euro-settled products. According to Rizzello, currencies such as the guilder and krona, which right now offer too thin of an underlying market to support listed options and futures, will become part of the larger post-EMU trading market. "It could have a tremendous impact on trading activity," he says.

The pessimists fear that the evaporation of cross-currency pairs in Europe may further depress FX trading. After all, the convergence of European interest rates will undoubtedly reduce the need for multiple and duplicate interest rate products. "Interest rate products are the European exchanges' bread and butter," concedes Rizzello, who points out that they account for more than 58 percent of European business, compared with 48 percent in the United States.

The European exchanges are painfully aware of the consequences. "I am certain there will be a huge reshuffling of the landscape of derivatives exchanges in Europe," says Gerard Pfauwadel, chairman of MATIF. "The fact that we will all have one yield curve will dramatically reduce the opportunity for having domestic niches, built on the domestic currency yield curve."

Exchanges are not the only ones likely to feel the weight of consolidation and streamlining. The broker/ dealer community is equally exposed. Dean Witter's Burghardt grimly admits that "the more efficient things become, the fewer of us the world needs."

Battle lines

All three exchanges are now preparing to do battle over the entire euro yield curve. "There will be a larger market that will focus on two interest rate benchmarks," predicts Daniel Hodson, chief executive of LIFFE-a short-term, three-month euro contract (a successor of the euromark, most likely) and a 10-year Bund future equivalent.

The short end of the yield curve is the first battle zone, since the money markets will be the first to converge. The current scorecard puts LIFFE in the lead with more than 70 percent of the market in trading of three-month euromarks. MATIF is far behind in second place with its Pibor contract. The DTB did not even have a three-month euromark product until mid-January. On the even shorter end of the curve, the picture is a bit different. In November, the DTB launched a one-month euromark product that now has about 50 percent of the trading volume in its maturity range (the other half held by LIFFE). Although both MATIF and DTB see the short end as their long shot, neither is ready to give up the fight. "Even if for this part of the yield curve we are the underdog," says MATIF's Pfauwadel, "with London's volume at three times Paris' volume, we can still win."

Jorg Franke, general manager of DTB, assumes a more realistic, less heroic tone. "I think this is the weakest point for us," he admits. "The London money markets are more liquid, to a large extent because of minimum reserve requirements by the Bundesbank." However, Franke points to the success of the DTB's newly launched one-month contract. Frankfurt, he says, remains committed to a full range of products, up and down the yield curve. "If the underlying market for a 30-year bond was liquid enough, we would do that as well," says Franke.

The impact of EMU on the short end of the yield curve will be instantaneous. It's effect on medium- and long-term maturities will take more time to discern, giving the exchanges more time for competitive maneuverings.

No matter what happens, a post-EMU national market in some government bonds may continue in some fashion. Some European countries, like Sweden and Italy, may not be part of the core EMU currencies. "As far as the government bond markets are concerned, there will be a tendency-but no more than a tendency-toward a single market," predicts the DTB's Franke. "At least during the initial stages of EMU, there will continue to be segregated markets for government debt."

European governments that do converge will see their debt trade at different levels for some time. "There will be different credit risk premiums associated with different countries," says DW's Burghardt. "The world is not quite ready to lend money to Italy and Germany at the same rate," he says.

And it may never be. In the United States, the debt of different states and municipalities trades at different credit spreads as well. In fact, if Europe engages in economic fudging to create a larger core group of EMU nations, the performance of government bonds may be so divergent that a single benchmark may not evolve for years.

Ultimately, if and when convergence occurs, most market participants expect the euro bond future to be fashioned after the German Bund futures. "That's what the market seems to be saying, and not just in Germany, but internationally," says the DTB's Franke. "Early signs of this trend can be noticed in the increasing tendency of large-portfolio managers to hike their Bund holdings on a weighted basis."

MATIF argues that the jury is still out on which 10-year bond will provide the template for the euro bond futures. The Notionnel market of French government debt is of comparable size with the Bund market. "The quality of the French treasury debt is considered one of the best in the world," says MATIF's Pfauwadel. Finally, and not surprisingly, MATIF dominates trading in the Notionnel. It also has had some experience-though not very successful-in trading 10-year ECU-denominated futures.

MATIF also points to the French resolve to convert to euro en masse come January 1999. The planned wholesale changeover is of a magnitude and scope unparalleled by any other EMU member. "There's a lot of machinery-back office and access to delivery, settlement and intraday-that is extremely important to the daily process of our business," says Pfauwadel.

Still, if the market's current inclination to pick the Deutsche mark as its baseline for the euro persists, LIFFE holds the current lead in futures trading. It now controls around 65 percent of the Bund futures business, with the reminder trading on the DTB. LIFFE's lead on the long end of the curve is less clear-cut, however. The DTB's share of the market has been steadily rising, and reached 40 percent during some hectic trading days late in 1996. One possible scenario puts short-term liquidity with LIFFE and long-term liquidity with DTB, the two eventually sharing the throne.

Screen or scream?

The battle between DTB and LIFFE, however, is not merely about dominance of the euro yield curve. At war are two competing trading philosophies: floor and screen. "It may all come down to the efficiency of the trading system," predicts a top executive at a U.S. exchange. "From any perspective, market liquidity and good clearing systems are the key to the success of a particular exchange or market," says PW's Taylor (see graph on page 48).

CBOT, CME, LIFFE, MATIF, SIMEX and the Sydney Exchange still rely on open outcry for liquidity and the trading of about 90 percent of the world's futures. "The important aspect of open outcry is transparency," says Hodson at LIFFE. "You can see the entire market, see people's actions and listen to their conversations." Hodson points to the disappearing screen-based liquidity on the middle and long end of the curve during currency crisis and LIFFE's 65 percent dominance of Bund futures business. "It indicates the market is not prepared to an overwhelming degree to trade electronically," he says.

That, however, may be just a matter of time. "Last year, we overcame MATIF with trading volume and are now number two behind LIFFE," points out the DTB's Franke. And while futures trading has been down overall, the DTB's screen system has suffered the least defections. In 1995, by far the worst year, DTB recorded a 2-percent drop, compared with a 30-percent decline at MATIF and 14 percent at LIFFE. Last year (through November), DTB volume was up 33 percent compared with 25 percent at LIFFE and a further 3.9-percent drop at MATIF. DTB also had the biggest increase in market participants worldwide-35 new members in 1996, raising the total to 160. Each new generation of traders is increasingly more comfortable with computers versus the pits.

"Ultimately, the market will decide where liquidity will go," says MATIF's Pfauwadel. For the time being, 90 percent of the world's futures trading takes place in the pits. "When you are an exchange like MATIF, you don't leave the mainstream," he says. Both LIFFE and MATIF have been busy forging cross-Atlantic ties with U.S. exchanges to expand the floor-trading hours of their product. Of course, some electronics must be used because traders cannot stay in the pits around the clock. "The euro, like the dollar, is going to be a global product," says Pfauwadel. "You therefore have to provide service on a 24-hour basis."

The allegiance to open-outcry or screen runs so deep that it has put the death nail into a proposed merger between DTB and MATIF that would have given them both reasonable chance at toppling LIFFE from its leadership position. In January, when MATIF decided to pull out of GLOBEX, outcry proponents pointed to the event as final proof that electronic trading would ultimately fail. In reality, MATIF's decision to drop GLOBEX was nothing of the sort-it simply replaced GLOBEX with NSC, a local system that it hoped would work better. Sources at the Merc and CBOT say the two are already talking to NSC's Paris-based trading system operator in hopes of linking up with NSC as well.

Chicago hope

The U.S. exchanges are decidedly mum about their bets. "Everyone is keeping all options open," admits one exchange executive, referring to the crisscross of electronic and open-outcry linkages that connects U.S. exchanges with their European counterparts. "In this game, we are bit players. We really have nothing to gain from expressing a preference for one winner or the other."

Within a span of a few months, for instance, the Chicago Mercantile Exchange announced alliances with all three European exchanges. It will allow the DTB to place its screens on its floor for trading DAX products. With MATIF, the Merc has agreed to extended floor trading hours of medium- and long-term Notionnel futures-although who will be trading 10-year French futures on the Merc remains a big mystery. The CME/ LIFFE link expands trading hours for LIFFE's hallmark three-month euromark contracts.

Rizzello at the PHLX is less concerned about hedging his bets, primarily because PHLX eats and breathes currency products, not interest rate futures. "In Europe, LIFFE seems well-positioned," he agrees. "It is the most diverse in terms of product lines outside its domestic market and the European exchange most experienced in fighting-and beating-nondomestic competition. In the United States, competition across markets and products is common. The transition to the euro for European exchanges should be interesting to watch."

A Snapshot of the Future

A joint study of the industry by Price Waterhouse and the Futures and Options Association provides a glimpse into the future of the futures business:

  • Growth in activity will move alongside the increasing convergence between derivatives and their underlying cash markets.
  • There will be a preference for more customized products, hence exchanges will have to work on shortening their product development cycle and offer more customized contracts.
  • There's untapped opportunity in the small and mid-size companies markets. Some 90 percent of corporate end-users say they would like to see exchanges becoming more accessible to them.
  • Hedgers will overtake speculators, with more than 60 percent of traders seeing more hedging activity using listed products.
  • Trading in interest-rate and equity products is likely to grow.

Bracing for the Price War

It happened in the computer industry. It happened in consumer goods. It happened in the auto markets. Why not a price war in the listed futures business? No reason, say the heads of the three European exchanges that are fiercely competing for the number-one spot in post-EMU Europe. In fact, it's already begun.

London, home of LIFFE, the largest and currently dominant player, is rife with rumor that the two "underdogs" are concocting elaborate incentive schemes to lure away business. For example, "they (DTB and MATIF) may offer a 'trade two short-term contracts and get a long-term contract free' package," suggests one cynical trader.

DTB and MATIF won't rule anything out. "My conviction is that you have to get the liquidity first," says Gerard Pfauwadel, chairman of MATIF. "You also have to be price competitive." Not surprisingly, MATIF has already announced a 30-percent discount on all MATIF-traded euro products.

"We all did the same thing," says Jorg Franke, member of the DTB's executive board. The DTB has been less vociferous than its French counterpart, but no less aggressive. It now offers Dm400,000 to market-makers, and DM200,000 to designated brokers as an up-front cash payment to defray start-up costs in trading new products. However, price wars tend to lead to some natural price balance. "You cannot reduce the price every year," says Franke.

Ultimately, the exchange-related fees are a tiny portion of the overall transaction cost. Far more important are the bid/ask spread and personnel cost. In that regard, Franke foresees the DTB's screen trading system becoming an increasingly cheaper alternative to having staff on the floor. "That, in itself, is a price incentive," he says.

Incentive packages aside, the market is also checking the radar screens for any sign of governmental subsidies. "If you look at the airline industry," suggests Chris Taylor, a partner at Price Waterhouse in London, "you will see that various countries, notwithstanding EU rules, have subsidized their national carriers." There is nothing stopping the British, German or French governments from doing the same with their exchanges. While on the face of things the French are the likeliest to intervene, that is by no means a foregone conclusion. "It's easy to sit here when London is on the up and up and say the U.K. government does not subsidize. What if British Airways was not doing so well on its own? Would the position be the same? I am not that certain."