"The euro will change the entire landscape of Europe's capital markets!" This statement - generally accepted and frequently repeated - appears to be finally believed by most protagonists and observers of the financial markets, at least in Europe. But is it really true? EMU will definitely have a major impact on European capital markets. But what will it change? Will it lead to a sea- change for Europe's capital markets as a whole? And what will this mean for stock exchanges and Deutsche Börse in particular?
The impact of the euro on financial centers and stock exchanges will
be manifold. Bonds will be redenominated, stocks will be quoted in euro
instead of national currencies, technical systems will be adjusted, laws
amended, contracts adapted, and so forth. The key question for Deutsche
Börse is: what is the impact of the euro on competition between European
stock exchanges? To assess this impact one first has to analyze in which
markets competition exists and if the euro is responsible for this competition.
In a next step the consequences for Deutsche Börse are to be examined.
This article focuses on the cash market and leaves aside the derivatives markets, where European exchanges already compete heavily. As for the interest rate markets, EMU will certainly have a major impact. These markets are centered on fixed income securities issued by governments, because they are the benchmark and determine the role national fixed income markets will be able to play in a euro environment. The Maastricht Treaty compels the governments of the member states to meet convergence criteria, in particular to reduce their budget deficit. Lower deficits lead to a higher credit rating, which in turn results in lower interest rates. Since all member states have to fulfil the same criteria, interest rates spreads are narrowing. Even though liquidity and creditworthiness as the major factors for pricing will continue to differ and therefore the European interest rate market will not be as homogeneous as the U.S. or Japanese ones, yields of EMU-bonds grow closer together and by doing so cause harmonization of the European fixed income markets. Harmonization is also supported by the decision of Germany and France to redenominate their actively traded outstanding government debts as of January 1, 1999. EMU's impact on the money market is even more dramatic. Due to the European Central Bank's exclusive responsibility for setting monetary policy only one short-term euro reference rate will prevail across all participating countries.
However, the impact on the equity markets will be different. The Maastricht Treaty is addressed to member states, i. e. the issuers of government bonds, not to private enterprises. There are no convergence criteria to be met by corporate stock companies as issuers of shares. Contrary to the fixed income markets, EMU can therefore only have an indirect impact on the equity markets. Two major factors which might change the equity markets will derive from EMU: First, currency risk between participating member states will disappear. Second, stock exchanges of participating countries will quote shares in euro rather than in their national currency; in some non-joining countries stock exchanges will have to handle both euro-quotation for a number of blue chips, and quotation in national currency. It is hard to predict, how strong the impact of these factors on equity markets will finally be. Some argue that greater comparability of shares will lead to changes of investment strategies; industry-allocation will replace the prevailing country-allocation; all this will result in a common European blue chip market.
One should not forget, however, that pricing of stocks is following different rules than pricing of interest rate instruments. While the price of a bond can be evaluated on the basis of a few, quite reliable factors, pricing of stocks is based on less transparent information and therefore more complex. What information does a government bond trader really require? Basically, he first needs to know the conditions of the instrument: issuer, interest rate, maturity etc. - information that is clearly defined. He then needs economic data giving him a clue about the probable future developments of interest rates, exchange rates and the issuer's creditworthiness. These data provided by central banks and government institutions are usually subject to immediate or even pre-announced publication. This equal access leads to transparency and a level playing field for all participants. Last but not least, benchmark interest rates derivatives, such as the Bund- or the T-Bond-future may serve as indicators for the prices of the underlying bonds.
The data necessary for equity pricing, however, is not as readily available. Information about an enterprise's profits or losses, new products, new strategies etc. is less accessible. This is why insider trading is a problem in equity markets but not in bond markets. And, more important in this context, this is the reason why stocks are mainly exchange-traded, whereas government securities are mainly traded over the counter. Since information about a company's potential future is less transparent, the price of a stock depends much more upon the investors' valuation. The stock exchange represents the most pertinent place for price determination because here various appraisals get together.
The euro will not change this. Certainly, stock prices will become more comparable: In many European countries they will be quoted in euro; moreover, a few participating member states including Germany are expected to introduce nominals of 1 euro. But there are countries, which will (Germany) or already do (Belgium, Luxembourg) allow no par value shares. In the case of no par value shares the transition to the euro is not affecting the value of a stock, it is just expressed and quoted in euro instead of national currency. Since this is happening on the basis of the nominal a share was bearing before becoming a no par value share and since nominals are different all over Europe (because of legal definitions and different currencies) this will not lead to greater comparability.
Even more important, the information that is relevant for the pricing
of shares will not become any more comparable. European companies operate
in different legal environments. In particular, accounting standards and
tax regimes significantly diverge and we are still far from EU harmonization.
What does this mean with regard to competition between stock exchanges? It means that in fixed-income markets where the euro will have the strongest impact, there is not much competition and, in equities where is some competition, there will not be much impact of the euro, at least in the near future.
The euro will have the biggest impact on the fixed income markets. However, exchanges only play a minor role in bond trading and no role in the trading of money market instruments. Many European exchanges do not trade bonds at all. The euro therefore will not affect competition between stock exchanges. Exchanges' real competitor is the OTC market. But this has been true for a long time and is not triggered by the euro. Coming back to the beginning, we can state that from the perspective of a stock exchange (but not from that of a derivatives exchange) the euro will not change the landscape in the European bond markets.
As for the equity side of the market, there is some competition between stock exchanges. They are competing for orders rather than for issuers. Many issuers are multi-listed, but usually their "home exchange" gets the lion's share in trading volume. For instance, even in the best days of London's SAEQ International, the London Stock Exchange was far from reaching the liquidity that the Frankfurt Stock Exchange could offer in German shares.
Will the euro change this situation and increase competition? Will it eventually break down the "home exchange scenario"? As described above, the European equity markets will be harmonized somewhat but not to the same extent as the interest rates markets. Even though stock prices will become more comparable, accounting standards and tax regimes on which company data (and thus stock prizes) are founded will not be harmonized in the course of EMU. Hence, even for blue chips the national perspective will continue to be important.
And what about the disappearance of currency risk? This will certainly result in industry-allocation becoming more important than country-allocation. However, currencies of European member states have been quite stable and inflation has been relatively low for many years. Also, institutional investors will continue to hedge their assets via derivatives against the US$-EUR exchange rate. Hence, what will continue to be the crucial factor for their investments is liquidity. Since the intermediation costs do not diverge much between the main European financial centers, institutional investors will continue to route their orders to the most liquid market. Private investors, on the other hand, might try to behave like institutionals and wish to get their order executed at the most liquid market. However, if this is a stock exchange abroad, their banks or brokers are usually charging significantly higher fees than for transactions in the domestic market. Thus, the euro will not increase stock exchange competition in the European equity markets either.
So, does all this mean that competition between stock exchanges will not increase? Clearly no, it just means that the euro is only playing a minor role. Rather than being the cause of potential changes the euro is accelerating existing trends. One exception may be indices. However, the success of a European Top 50 or Top 100 benchmark index will not decide upon where the shares represented in the index will be traded. Competition between stock exchanges is increasing. However, this is not due to EMU but to longer-term developments.
The key factor are intermediaries. Thanks to the advances of information technology, today's financial markets are characterized by globalization. The increasing competition between intermediaries is forcing them to save costs. One consequence is the concentration process among intermediaries, another the streamlining of their business, which is often centralized in one or a few offices. EMU might intensify this development, because intermediaries could change their strategies according to the changing (euro-) environment they are operating in.
Costs that trigger competition between intermediaries also trigger competition
between stock exchanges. Stock exchanges are a cost factor for intermediaries
who have to pay membership, transaction, clearing and settlement fees,
etc. These costs intensify competition between stock exchanges. At present
there are 32 stock exchanges in Europe. Why would big players be willing
to pay 32 times membership fee, why would they be willing to maintain staff
at different locations, if they could electronically access one platform
for all products? There is some evidence that they are not. Stock exchanges
have to compete with proprietary trading systems (PTS), some predict they
will have to compete with the internet. Deutsche Börse's fully electronic
futures and option exchange DTB may serve as an example: In August 1997,
out of its 171 members 58 were remote, i. e. directly trading from abroad.
This being cheaper than maintaining employees and offices in another city
was helping DTB to increase its market share in the Bund-future to well
above 40 %. Not long ago LIFFE used to catch about 70 to 75%.
Deutsche Börse's Answer
Thus, the changing environment in which intermediaries operate is changing the world of the stock exchanges. Exchanges therefore have to follow or, preferably, anticipate the changing demands of market participants. Since stock exchanges are service providers and since it is just services that market participants require, they have to improve the quality of their services. This is why Deutsche Börse integrated the cash market, the derivatives market, clearing and settlement and systems development in one holding. Deutsche Börse AG is running both the Frankfurt Stock Exchange and DTB and owns Deutsche Börse Clearing and Deutsche Börse Systems. Thanks to this structure that has been implemented in 1993 and copied by other exchanges since, Deutsche Börse is able to offer services from the routing of an order right through to the settlement, i. e. one-stop shopping.
The more internationalization and globalization change the intermediaries' business and strategies, the more the intermediaries' requirements for exchange services change. Exchanges have to follow their clients, not the other way round. Electronic trading systems which provide remote access take the exchange to the customer, the customer does not need to go to the exchange. As described above, this flexibility is one major reason for DTB's success. Only those stock exchanges will keep or improve their present competitive position that will offer rapid, secure, easy and above all cheap access to their market. If they fail to do so, they might eventually lose their blue chips.
This year Deutsche Börse is launching Xetra®, its new electronic
trading system for the cash market which will replace the existing IBIS
system. Deutsche Börse is introducing this system not only to improve
market quality in equities, fixed income securities and exchange-traded
warrants. Since the Xetra® market model was developed with the market
participants, it also meets the key requirements for optimum market organization.
Its open order book guarantees transparency and creates a level playing
field for all market participants. Regardless of their geographical location,
it gives all participants equal, low-cost access to the trading platform.
All these benefits will contribute to further increase Frankfurt's outstanding
market share in German stocks. But will they break down the "home exchange
scenario"? The core question is how to transfer liquidity from a liquid
to an illiquid market. Chances are good that supported by the euro and
EMU's impact on the strategies of market participants, Deutsche Börse
could succeed. In 1990, DTB started at zero, it now has well above 40 %
market share in the Bund future.
Last but not least, it has to be mentioned that Frankfurt (and its exchanges) which is at present the second financial center in Europe is far from having reached the frontiers of its growth. Again this has not much to do with the euro, but with structural trends. By the end of November 1996 Germany's market capitalization was 27% of its GNP (France: 38%, UK:152%, USA:122%). Only some 15% of the German population is owning equities. Private households hold only about 15% of the capital invested in equity. In spite of these poor figures which let Germany appear as an emerging equity market, the Frankfurt Stock Exchange is in second place in Europe and number four in the world.
Chances are that the structural framework of the German equity market
will be improved. A major reform of Germany's pension system is not just
a matter of urgency, it is almost inevitable. The existing pay-as-you-go-system
will be replaced by private contributions to a funded system requiring
investments in the capital market. One important means will be investments
in the capital markets. Equally, the necessary reform of the taxation system
will increase the attractiveness of Germany as a financial center. Much
has been done already to promote the German capital market. In view of
the increasing competition, the government and the Bundesbank have been
deregulating the German financial market and because of that improving
The euro will not change competition between European stock exchanges. It will lead to some harmonization and have impact on the strategies of the stock exchanges' clients. EMU will only accelerate and intensify existing trends, such as globalization and automation.
Deutsche Börse's answer to globalization and internationalization
of the financial markets is remote access to its trading platform regardless
of the participant's geographical location and internationalization of
its membership. Sooner or later, political and structural changes of the
pension system and taxation will tap the huge potential of the German capital
market. This will significantly increase the size of the German financial
market and add to the attractiveness of its exchanges.
* Deutsche Börse, Market Policy and External Relations. Borsen Platz 4 - 60313 Frankfurt