As the derivatives market is so diverse this article focuses
on the potential effects that such concentration will have on European
Futures and Options exchanges, particularly from the Product Development
and Strategic Business Development perspectives. The current product range
on the Futures and Options exchanges within Europe tends to focus liquidity
into three major areas; Money Market, Fixed Income and Equity products.
Of these, the changes that seem likely to the short term Money Market area
appear to be the most straightforward.
The ECB will have sole responsibility for setting monetary policy, therefore one short term EURO reference rate should prevail across all participating countries. Currently market participants seem to be favouring the potential for a wider set of EMU qualifying countries and therefore certain countries will need to see a further convergence of short term interest rates prior to 1999. However, assuming that this is the case, the aggregate size of the EURO money market will be more comparable to the current Eurodollar market in size and larger than the Euroyen market. As such there should be greater concentration and liquidity in the EURO related FRA and swaps markets which in turn will lead to a larger related Short Term Interest Rate EURO futures contract. Some market participants believe that the significance of this new market, coupled with the fact that the swap curve will represent the only truly homogeneous yield curve in a EURO environment, may result in the EURO money market curve becoming the benchmark yield curve for the derivatives market post 1999.
Currently the Euromark futures contracts, representing the short end of the DM yield curve, are seen as the likely contracts to benefit from such a benchmark status and also gain the vast majority of the increased liquidity in an EMU world. However, the potential effects of the TARGET payment system and the imposition of a Minimum Reserve Requirement by the ECB may change the landscape in two different ways. As there will be certain EU states which will not be part of the first stage of EMU in 1999 it has been suggested that they should not participate fully in the European System of Central Banks (ESCB) intra-day liquidity and therefore would not have full access to TARGET. This may lead to greater acceptance of a EURIBOR rate, to reflect such differences, by the participating countries.
Given that the current Euromark contracts have been amended to settle to a EURO LIBOR rate, based on the current benchmark BBA London fixings, but the potential importance of a EURIBOR rate may lead market participants to fix their new OTC instruments to this rate, there could be a resultant shift in the futures liquidity to a contract based on EURIBOR. Certainly it has been noticeable that MATIF’s PIBOR contract maintained its position as a major volume, short term interest rate contract without having a LIBOR fixing as the market was deemed to be based in Paris rather than London.
Alternatively, if there is any significance attached to
a EURIBOR rate, the imposition of a Minimum Reserve Requirement on EMU
- In banks, by the ECB, could diminish any credibility that it could hold
in the European money markets. This has been seen in Frankfurt, where the
Minimum Reserve Requirement imposed by the Bundesbank effectively killed
the FIBOR fixing as an international reference rate, encouraging the flow
of business to London, perceived as an ‘off-shore’ centre without monetary
restrictions. Market participants are already referring to the possibility
of a Euro-EURO market based in London, centred around an alternative Pan-European
payment system to TARGET, if such events were to take place.
The aggregate size of the EURO denominated Government debt market will be more comparable to the US Treasury market and much larger than the Yen debt market. While the market will initially be more heterogeneous, due to the large number of different issuers and different market conventions, the consolidation of the securities markets will increase the available liquidity, increase the competition and therefore reduce the costs for investment capital. Investors will also benefit as capital allocation becomes more efficient due to lower costs for cross-border transactions.
A major convergence in yield levels has already been witnessed at the longer end of the European yield curve, with market participants particularly focusing on the yield differentials between those markets where the uncertainties regarding the timing and participation in EMU is highest. The major question outstanding is, even if there is a wider set of EMU qualifying countries, will there be any further convergence of long term yields prior to 1999 or will differences exist due to the credit perception of the outstanding debt of individual countries? In addition, what will be the liquidity impact on certain contracts given that the current volumes based on exploiting such differentials may be largely eliminated?
While most market participants see the DM yield curve maintaining its current benchmark status, assuming that all DM debt is immediately redenominated into EURO, and therefore the current DM Fixed Income futures contracts are seen as the benchmark contracts to win liquidity post 1999, the market has yet to decide whether such credit differentials are sufficient that individual EURO denominated country contracts will still exist. It would appear that this could be less certain for some than others. For example, the Benelux markets appear to use the DM futures market as a proxy hedge for their underlying debt already, hence the relatively low liquidity in these countries futures markets. However, in a EURO denominated world, with common monetary policy, some market participants argue that the French government bond market may also be hedged with a EURO denominated BUND contract.
This raises further questions as to whether the current tight yield differentials between such markets will be maintained, whether there will be a harmonisation in market conventions for each market and also if there will be any liquidity concerns given the size and turnover of certain issues. If the concerns attached to these issues are resolved the market suggests that there may be demand for multiple issuer bond futures contracts along the EURO yield curve. This would entail that each contract would have a range of bonds from different sovereigns within the deliverable basket, which would increase the deliverable supply for what would be an expanded European bond futures contract.
The crucial question however is whether there may be shocks
to the financial markets post 1999 which would entail that certain bonds
would immediately attain Cheapest to Deliver (CTD) status within the contract,
increasing the liquidity for certain sovereign issues at the expense of
others. This potential scenario may entail that the market maintains demand
for individual country bond contracts, redenominated into EURO, for the
larger German, French, Italian and Spanish markets rather than a basket
approach. Of course the answer is also dependent on which countries will
actually form the first stage of EMU!
It has been apparent that the vast majority of discussions on the consequences of EMU for the derivatives market have focused on the interest rate side of the market. However, some market participants feel that this has been at the expense of the potentially more interesting developments in the new Pan-European equity market that will exist once the currency risk between different member states disappears. The redenomination and quotation of outstanding underlying stock in EURO will create a huge Pan-European market of blue chip stocks which may bring about changes in investment strategy from private investors to major fund managers. This will be driven by the creation of European wide industries and financial companies with requirements for capital on a European scale.
Insurance companies and pension funds may no longer be required to invest in home country currency related assets to match their liabilities, increasing the propensity of such institutions to spread their portfolios into other markets. This has already led some of the major fund management companies to change their investment style away from the traditional country focused stock selection to more of a sector bias.
In order to meet the requirements of such changes exchanges have already begun to investigate the type of Pan European and Sub Indices that market users will demand to use as both a benchmark and to cover risk in the larger market. The fact that the UK will remain outside the EMU, at least for the first stage, causes more of a problem here than for the interest rate market given that the UK represents a significant part of the European equity capitalisation. Nevertheless the Amsterdam Exchanges (AEX) have already entered an agreement with FTSE International to revamp their Eurotop indices and Deutsche Börse, the Swiss Exchange (SWX) and the Paris Bourse (SBF) have entered an agreement to provide new European indices that can be used as true representations of the new equity market.
In response the exchanges will need to consider introducing
new futures and options contracts on such indices which may gradually replace
country focused futures and options contracts as the benchmarks. If this
is so there could be a significant impact on the turnover on both the derivative
and stock exchanges in smaller markets. To combat this, the number of mergers
between the cash and derivatives exchanges in such countries has been noticeable.
However, as the equity markets tend to have more peculiarities within their
domestic structure than the interest rate markets the effects of EMU could
be slower to appear.
The potential implications of the product development scenarios has led more exchanges to enter into co-operation talks rather than continue with competition. This is not only true for the domestic alliances mentioned but also cross-border co-operations are beginning to appear. The most prominent examples of this are the Pan-Scandinavian links between the Swedish, Finnish and Norwegian derivatives markets and the formation of the Eurex exchange, initially arranged between the German (DTB) and Swiss (SOFFEX) derivatives markets, which is also open to other European exchanges which wish to join.
The current structure of European exchanges has been shaped by history and does not suit an EMU world. There are over 20 derivatives exchanges within the European Union. The market is characterised by a variety of market models and trading systems. Market participants are demanding more uniformity and standardisation in trading, clearing and settlement in order to act more quickly and cheaply in the market. As market access costs are reduced, due to the concentration of exchanges, competitive pressure for customers will increase. Market participants are arguing that in order to contain costs more trading and processing should be done electronically.
It appears, from recent attempts, that agreements to link open outcry exchanges together, so that they can increase their access to users in other markets, has proved to be unsuccessful (with the noticeable exception of the CME/SIMEX link). Therefore, participants are clearly viewing the potential for linkages between automated exchanges, whereby traders on different exchanges are allowed automatic access to the plethora of contracts, with more enthusiasm. Such alliances can help members to meet the demands of their clients for investment or risk management strategies by providing quick and easy access to all markets via one interface.
In some ways this concentration of exchange’s business is perhaps mirroring the concentration of business which is evident among its major members. The introduction of EMU will only accelerate this trend amongst exchanges just as the consolidation of the banking industry will further concentrate exchange member business. This may in turn lead to agreements to share the major EURO products. A recent example of such an approach is the futures/options contracts arising from the AEX/FTSE agreement to develop the Eurotop 100 and 300 indices, whereby the AEX has determined that they will trade the option and allow another exchange to trade the future. Also, there is the recent agreement between Deutsche Börse and Eurex with the SBF amalgamation of MATIF and Monep where the exchanges have agreed to pool resources, and eventual benefits, to jointly develop the new EURO product range.
The next logical extension of this may be to bow to pressure
generated from common members to develop clearing linkages between the
exchanges so that cross margin offsets can be implemented across the respective
product ranges, thereby potentially reducing the amount and the number
of capital calls required. The efficiency that this could provide to member’s
settlement and clearing operations could be substantial. A further step
from this premise will no doubt be further efforts to incorporate cash
and OTC market trades within a common clearing structure as collateral
and margin calls are becoming more common outside of the traditional exchange
structure. The clearing houses will then be able to ask members for collateral
requirements which more closely resemble there own internal risk assessments.
THE WAY FORWARD
If the derivatives markets do consolidate, or co-operate, whichever term eventually seems more appropriate, and the number of potential products diminishes, the European market may begin to resemble the US model more closely. However, the competition and politics which perhaps has influenced the development of the US market may not be as evident in Europe given the ‘clean sweep’ that EMU will provide. In addition, it seems likely that European exchanges, once the dust has settled, should be in a position to initiate common marketing efforts for EURO products, with the possibility that such a concerted approach may allow them to overtake the dominant position that the US derivatives markets have held since their introduction.
The scene is certainly set for huge change in the European derivatives markets. The landscape will no doubt look completely different by the end of 1999 in comparison to today. For both market participants and the exchanges it could be the case that only the strongest survive or agree to co-operate. In such an environment it would seem that those aligned to the automated markets will be in the strongest position to provide a truly cross-border solution. Therefore, whether these are the consequences of EMU, or whether it has accelerated the already established trend, market participants are driving the derivatives market towards globalisation and further technological development in order to decrease costs and increase the quality and variety of services that they provide.
* Chief Executive Officer - Eurex, Zurich. Member of the Executive Board Deutsche Börse, Borsen platz 4 - 60313 Frankfurt