Euronext.liffe, the London-based derivatives exchange, launched a new set of pan-European bond futures contracts on 24 January this year. These contracts are designed to fill a gap in the current line-up of exchange-traded contracts for the European government bond markets. The initial suite consists of four contracts with a diversified pan-European as well as individual German, French and Italian seven-10 year futures contracts. If the concept proves successful, Euronext.liffe has indicated that they will introduce further contracts at shorter and longer maturities.
Government debt in Europe now ranks alongside US government bonds as a key international "safe haven" for investment and a source of liquidity for global investors. However, there are significant and rising fiscal disparities between major countries within the Euro-zone that have not been eliminated by the introduction of a common currency. The downgrading of Italy last year by S&P's and Fitch Ratings dramatically illustrated that the universe of European government bonds cannot be viewed as a single market analogous to the US treasury market, but has very significant and increasing credit divergences within it.
In terms of exchange traded derivatives, despite the plethora of instruments available, the only longer maturity products that can be said to be pan-European are the various Swapnote® contracts traded on Euronext.liffe. These are essentially bond futures contracts based on notional European swap yields and therefore can be regarded as futures on European corporate bonds. In the absence of a genuine pan-European government bond futures contract, that role has been taken on so far by the Bund futures, traded on Eurex. While the German economy is not necessarily the best replica of Europe as a whole, the current dominance of the Bund futures is not perhaps surprising, given the Bundesbank's historical focus on inflation and the resulting credit strength of the obligations of the German Government. This does however, lead to the situation that a specific German bond, the cheapest to deliver bond in the basket of bonds available for delivery in the Bund futures contract, is used as a proxy to represent a much wider pan-European universe of bonds.
Such a situation clearly has significant drawbacks. Key issues that market participants are concerned about include the following: Bund futures are not representative of the market as a whole and credit divergences are seen as very significant; investment strategies involving taking positions on the relative credit strengths of individual members of the Euro-zone will need a geographic spread of contracts if they are to be undertaken through derivative markets; and the use of a basket of stocks with delivery of a single cheapest to deliver stock is not only complex and confusing for many market participants, but can also lead to market distortions through ‘squeezes' in the supply of the deliverable bond.
The EuroMTS Government Bond Index Futures are designed to specifically address the market shortcomings in the existing derivatives line-up. The suite of futures introduced by Euronext.liffe represent a radical new alternative that conceptually does offer substantial attractions. The futures are all based on the EuroMTS total return bond indices that are produced on a real-time basis, using bond prices obtained from the highly liquid MTS platform. Bond indices have similar uses to those of equity indices such as giving the ability to trade the whole market simply in a single transaction, supporting and simplifying portfolio management.
Through efficient management of inflows and outflows, acting as a benchmark to assess the performance of funds, and enabling efficient asset allocation through the use of tracker funds and derivatives based on the indices giving market exposures at low cost. The EuroMTS indices themselves are highly correlated to other indices enabling hedging of portfolios benchmarked to other preferred indices to be undertaken efficiently with the futures contracts.
The range of individual country futures will also enable efficient allocation of exposures by country within the Euro-zone debt markets, and allow relative value spread trading as well as the ability to adjust exposures to individual credits and the management of corporate bond portfolios through facilitating the hedging of underlying market exposures.
For potential users of the contract, the key determinant of liquidity should be the market impact of any trading activity that they undertake. The contracts are designed to allow an easy arbitrage to take place with the underlying bonds traded on the EuroMTS platform. This should enable the futures contracts to stay close to fair value even for large trades, through harnessing the immense liquidity of the underlying cash markets on MTS.
Are the new contracts likely to be seen as competitive to existing derivative and structured product contracts or complementary? The answer is probably both. The existing liquidity of the Bund futures in terms of its highly visible daily trading volumes will certainly be an attraction for gaining immediate exposures to European government debt. However, in the case of the Euronext.liffe Government Bond Index futures, the simplicity of cash settlement, the accuracy of gaining specific country exposure through individual country contracts, and the ability to gain a more diversified pan-European exposure are all factors that will have direct appeal to specific classes of market participants.
While overall volume of trades will be a major measure of liquidity by fund managers and other market participants, this will undoubtedly grow as they become more familiar with the product range and the trading opportunities they present.
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