There will be Liffe after monetary union

Date: 10/04/1997

By Tim Jones

WHETHER a single currency appears 21 months from now or not, the supreme position of London in the European money markets is unassailable, claims the chief executive of Europe's largest financial derivatives market.

The revolution which has taken place in information technology means that it is now almost a matter of indifference where an institution is located if it wants to trade.

“The money markets are hugely powerful,” says Daniel Hodson of the London International Financial Futures Exchange (LIFFE). “The flows are enormous and it is possible with modern electronics to be 'virtually' in Frankfurt or Paris by virtue of your ability to press a button and move money around instantaneously.”

Two years from now, this could well mean that the main venue for trading instruments based on the euro will be outside the single currency bloc.

LIFFE is currently the world's second largest market for trading futures and options contracts - tools which allow investors and trading companies to cover themselves against heavy losses in currency, stock, bond or commodity markets and let speculators bet on future events.

Even though the UK is unlikely to join the first wave of countries going into a monetary union in January 1999 - whoever wins the coming general election on 1 May - Hodson is quietly confident that London has nothing to fear from Paris and Frankfurt.

“London is basically EMU-neutral,” he says. “In fact, there are advantages to being offshore, in the same time-zone and an international money centre, in that the sort of distortions that you can get in domestic money markets will not affect the London market. I suspect this is the reason why London has risen into the ascendancy it has.”

In Germany, for example, banks are forced to make huge reserve payments to the central bank at zero interest as a way of controlling the quantity of loans they make.

Such reserve requirements, when forced upon US banks in the Sixties, were widely blamed for the creation of the so-called Eurodollar market - whereby deposits were made in dollars at American banks but held outside US jurisdiction.

When these dollars were lent onwards, they created a huge and volatile market in which London specialised.

Hodson believes the same could happen again for London and the euro.

This would come as a blow to the Paris-based MATIF - le marché à terme international de France - which has invested massively in its attempt to become the biggest player in contracts for three-month euro interest rates and ten-year bonds.

“The battle for the euro (on the assumption that the euro comes) is really going to be concentrated on these two contracts,” admits Hodson. “LIFFE already has by far the largest share of the competing contracts: about 80&percent; at the moment, and close to 90&percent; of the volume taking place on those contracts after the putative beginning of monetary union.”

Investors at LIFFE and MATIF can already buy and sell contracts which expire after 1 January 1999 for French, German, Italian and British government bonds and short-term interest rates. Those who believe the euro is coming are tending to buy and sell the contracts for deutschemark interest rates, known as the Euromark.

“We have the Euromark and the deutschemark looks like being the bench-mark currency; it is the one that most people are interested in,” says Hodson. “The market is saying that it wishes to use that currently as its principal proxy for the euro and, so far as open interest and trading after 1 January 1999 is concerned, it wants to trade in London. Eighty-seven percent of the volume and around the same percentage of open interest is currently held in London.”

Hodson argues that it is London's pre-eminence as a money market, where 80&percent; of all transactions are carried out in foreign currency, which means that investors trust interest rates quoted there more than anywhere else in Europe.

This trust in the integrity of interest rates is vital for the futures market. When each short-term interest rate contract expires, it has to be settled in cash between parties based on the actual interest rate operating in the market at the time.

“That means the final settlement of interest rates is extremely important,” says Hodson. “What the market says is that it really wants these interest rates to be settled in London base rates rather than in Paris or Frankfurt, or a confection of rates across Europe.”