Battle for euro control begins

News Analysis: London may be losing out already in the fight for dominance among European exchanges

THE FIRST few days of the euro's life have set competing financial centres scrambling to become the dominant market-place for new euro-denominated financial instruments.

Many traders believe that the market-places which prove most popular in the euro's early days will maintain this position as the months and years roll on.

Hence the distress shown by French financial institutions at the failure of French government bonds to attract as much investor attention as their German equivalents. Last week, the French exchanges were shaken by news that turnover in German bonds had been 10 times that of French bonds.

And hence the eagerness of the competing pan-European indices - the FTSE Eurotop and the Dow Jones Stoxx - to establish themselves as the equity index benchmark in the minds of potential investors.

The last few days have seen reports that Clearset, the French clearing house, is trying to muscle in on the London Clearing House's dominant position in the European government bond markets.

Most attention has been focused on the battle between London and Brussels to set the key benchmark reference rates for European money markets. To date, London has been trounced by Brussels, and some fear this could spell the beginning of the end of the City's dominance of the European financial markets.

For the last decade, the reference rate set by the British Bankers' Association here in London - now known as Euro Libor - has been the benchmark for trade in major European derivative contracts. However, since the euro's launch, continental banks have been shunning Euro Libor and turning to Euribor, a new reference rate for money market deals set by the Brussels- based European Banking Federation.

Although senior figures in the City maintain it would be premature to admit defeat, most traders believe Brussels' Euribor has already won the battle.

Trading volumes to date show that Euribor - essentially an average of borrowing rates of a group of European banks - is proving immensely popular. It is estimated that, since the beginning of the year, between 60 and 80 per cent of interest rate swaps have been based on Euribor rather than London's Euro Libor.

As Ed Condon, head of derivatives at the investment bank Credit Suisse First Boston (CSFB), put it, "The market will determine the benchmark rate, and right now it seems that it is telling us that it is Euribor."

Less clear-cut, however, is whether the markets' passion for Euribor is sustainable. "There's clearly been a preference so far for Euribor," admitted one City figure, "but this initial burst of enthusiasm, for the Euribor could simply be pent-up demand."

Simon Hills, a director of the British Bankers' Association remarked: "So far, there has been pressure on mainland European banks to use Euribor. We're going to have to wait for the brouhaha to die down before we can really tell what's going on."

Although the official City line may be that it is far too soon to sound the death knell for Euro Libor, it is difficult to find anyone on the trading floor who agrees. Traders who deal with the competing reference rates on a daily basis are convinced that Euribor has already won.

According to one trader at a leading investment bank: "All the market is looking for is to establish a single credible benchmark. To say there is pent-up demand is wrong. There has been political pressure for the European banks to use Euribor and this pressure will continue."

Even Liffe, London's financial futures exchange and traditionally a supporter of all things British, seems to be distancing itself from the London- based Euro Libor. At the end of last year, Liffe announced that it would be referencing its heavily traded Euromark and Eurolira contracts to Euro Libor. Now the exchange admits that "market conditions" could force it to switch to Euribor instead.

Traders argue that market participants value liquidity above all else. Competing benchmarks are bad for liquidity because trading volumes are split between different markets.

This means, traders say, that whichever reference rate proves most popular in the initial weeks of trade will become the benchmark for the industry. Hence the attention paid by the City to the relative performance of the two rates - as well as to other competing euro benchmarks such as the French and the German government bonds and the Eurotop and the Stoxx equity indices - since the euro's launch.

Not surprisingly, therefore, many of the key benchmarks for the new euro financial instruments have already been set. Euribor seems to have effectively established itself as the benchmark European money market rate. German government bonds, not French bonds, will be the benchmark in the new euro- zone.

For Stoxx versus FTSE Eurotop, the picture is less clear-cut, but most traders believe that the FTSE indices have the upper hand.

This does not all necessarily spell disaster for national exchanges - it simply means that they have to move quickly to adapt to changing investor demands.

If the French exchanges, for example, fail to realise that French bonds and French bond-based contracts are less appealing to investors than German bonds, then they are bound to lose out.

The same goes for Liffe - which arguably has the most to lose from the switch from Euro Libor to Euribor. A failure to offer sufficient Euribor- referenced contracts could see trade migrate to Liffe's arch-rival, the Eurex exchange, formerly known as the Deutsche Terminborse.

Indeed, the speed with which trade in the German government bond future (the Bund) migrated from Liffe to Eurex shows how quickly markets can move if investors believe there is a better deal to be had elsewhere.

As Mr Hills at the BBA put it: "Although personally I would like to see the Euro Libor become the benchmark, I don't think it would be disastrous for London if it doesn't. It would only be a disaster if our financial creativity did not allow us to create new contracts."

Put simply, the market has already chosen many of the benchmark products it wants to see traded after the birth of the euro. The challenge for the national exchanges is to respond to market demand.