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
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
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
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."
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
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
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
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
"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,"
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."