Frankfurt's battle to become Europe's financial centre is gaining added urgency in the run-up to the single currency. The Bund market is undergoing a series of reforms to establish its credentials as the benchmark in the new euro market. The derivatives and stockmarkets are pitching themselves as liquid and cost-effective trading centres; and the banking system claims to be better prepared for monetary union than any of its European rivals.But still the perception lingers that the German financial markets are antiquated and inefficient -- and that Frankfurt lacks the deal-making culture to be the finance centre of the new euroland. Is this misplaced?
IT IS PRETTY clear what John Redwood, the investment banker turned MP who is one of Britain's most vocal critics of European Monetary Union, thinks about the competitiveness of Frankfurt as a financial centre.
"One London-based banker working for a German business," he writes in his fierce criticism of Emu* published earlier this year, "told me that when they had been taken over by a German bank they had looked to see if there was anything that they currently did in London which they could transfer to Frankfurt as a token of goodwill.
"They soon discovered that under German rules staff were not allowed into the office building between 5pm on Friday and 8am the following Monday; in London people were used to working on deals or investment transactions across the weekend if necessary.
"The bank immediately decided it would not jeopardise its business by moving to a city where working hours were so restricted. It was a symbol of the difference between the Anglo-Saxon deal-related culture and the more regulated social culture of the continent."
Surprisingly, German bankers in Frankfurt concede that there is an element of truth in arguments such as this, and that whenever investment bankers are called upon to work over a weekend they are well advised not to advertise the fact over-extensively.
As one frankly says, there is no problem with front office professionals who are delighted to be winning mandates which call for extra hours over the weekend, although this can occasionally cause difficulties with back office staff.
On balance, however, Frankfurt-based banks bristle with indignation at the suggestion that Germany's prime financial centre remains underdeveloped relative to its competitors in London and Paris.
Perhaps Redwood should have been invited to the Glaziers Hall in London on September 17 and to a presentation entitled "Finanzplatz Deutschland -- Today!".
From London, the Finanzplatz roadshow moved on to spread the word about Frankfurt's credentials in New York (on October 14) and in Tokyo (October 24).
In particular, Redwood may have raised his eyebrows at an address by Ernst Weltecke, president of Hessische Landesbank, who noted that "polls show no other European banking system is better prepared for Emu than the German [one]".
It is easy to see why Germany is so preoccupied about its Finanzplatz, which has been a topic of heated debate and considerable rhetoric for well over a decade.
The inaugural newsletter distributed by Germany's new Aktionskreis, a promotional body set up towards the end of 1996, points out that "with around 3% of the working population, [the financial services industry] produces more than 6% of the gross national product. And its per capita value creation of about DM200,000 per employee is double the German average."
In spite of its importance to the economy as a whole, Finanzplatz Deutschland has repeatedly been the subject in recent years of international criticism -- with bankers inside Germany and overseas arguing that it suffers from an underdeveloped and poorly regulated stock exchange, a product range across the entire capital market which lacks the depth and breadth of the range available in markets such as the UK and the US, and an antiquated and inefficient fixed income market.
"It's not antiquated and it's not inefficient," is the immediate reaction of Klaus Rupprath, head of fixed income trading and sales at West LB's Düsseldorf headquarters, to the suggestion that the structure of the German federal bond market leaves a lot to be desired relative to some of its European competitors.
Others, however, do acknowledge that weaknesses in the structure of the German market may have been responsible for giving centres such as Paris a helping hand in the race to become continental Europe's premier financial centre.
"Historically," says Gina Leu of the fixed income department at DG Bank's Frankfurt headquarters, "people considered the German Bund market to be the European benchmark. Recently, the French have become aggressive in their strategy of developing something more efficient and sophisticated in preparation for the single European currency."
She adds: "Now the general sentiment is that the Bund market is regaining its competitive edge as the benchmark in Europe, although certainly a year or six months ago people were becoming convinced that the French OAT market had overtaken the German Bund market."
Other bankers argue that the relationship between the French and the German government bond markets is artificially distorted by regulations dictating where French investors can and cannot put their money.
"The French government bond market is now relatively expensive compared to Germany," says one Frankfurt-based banker. "But that is purely because of the regulatory situation which limits some French institutions to certain investment vehicles denominated in French francs. That's why OATs are expensive. It has nothing to do with France being a 10bp credit better than Germany."
Clearly one of the most influential factors determining the improved competitiveness of the federal German bond market was the long-awaited elimination in 1996 by the Bundesbank of the minimum reserve requirements for short term repo transactions, for which local bankers had been clamouring for years.
As the September edition of Germany's Finanzplatz News reports with a hint of triumphalism, "since then, the German repo market has grown dramatically: German institutions had DM7.9bn invested in repurchase agreements in March 1996 and by December 1996 this figure grew to DM15.5bn.
"Following the elimination of the minimum reserve requirement, the volume reached DM44.5bn. The total volume of the repo market in Deutschmark bonds was an estimated DM180bn at the end of 1995 and by mid-1997 had nearly doubled to DM300bn-DM350bn. Compared to 1996 the volume of transactions has grown by 70%."
THE key side-effect of this, as the report added, has been the return of German banks' repo books from London to Frankfurt, which is viewed as a vital barometer of the German centre's credibility.
Other critical recent initiatives aimed at restoring Frankfurt's competitiveness have included the launch last year of short term government paper in the form of six month Treasury Bills (Bu-bills) and two year Treasury paper (Bundesschatchzanweisungen) for the first time in a move which was widely regarded as a dramatic U-turn. Authorities traditionally notoriously twitchy about anything with inflationary connotations had previously resisted calls for the launch of a short term government benchmark security.
They argued that it was the Bundesbank's job to fight the good fight against inflation, rather than to pander to the demands of those who insisted that Frankfurt was in danger of losing out to its competitors in the absence of a more complete government yield curve.
A report on the German bond market published earlier this year by Deutsche Morgan Grenfell hints at the potential conflicts of interest felt by the Bundesbank over the introduction of short term government securities.
"The approach to Emu has obviously changed the Bundesbank's view and triggered them to look for possible compromises between the markets' needs and the Bundesbank's worries on the short end of the market," the report notes.
"The Bundesbank felt the pressure to support the German federal government in its efforts to become the benchmark issuer in the coming currency union. As France and most other issuers already possess a lively market for short term paper, Germany had to follow to make its markets more attractive."
Clearly, foreign investors welcomed the initiative. According to Bundesbank statistics, Bu-bills issued in 1996 were sold largely to non-residents (accounting for DM13.5bn), while foreigners also bought just over half (DM10.5bn) of the newly issued two year federal Treasury notes.
The other piece of the maturity jigsaw traditionally conspicuous by its absence from the German government bond market has been the 30 year bond, first unveiled by the authorities in 1994 with spectacularly unfortunate timing -- coming as it did just before the global hikes in interest rates.
With that disastrous experience now apparently forgotten, the government seems happy to reintroduce the longer dated Bund. As the Bundesbank notes: "The federal government's announcement that, provided the capital market situation allowed it, in future it would support the 30 year maturity segment once a year through a new issue or the reopening of an issue has also to be seen in connection with the rounding-off of its maturity range."
The latest initiative aimed at bolstering the competitiveness of the German federal bond market was the introduction at the start of July of bond stripping. This allowed for the stripping of four bonds -- two 10 year issues and two with a 30 year maturity -- with a combined value of DM77bn.
Bond stripping was introduced, according to the Bundesbank's latest annual report, "with due regard to the competitiveness of the German financial market", although it is probably too early to say whether or not this has been successful.
In its August bond market update, West LB described the strips market as having got off to a "sticky start", noting that "the market for strips is still lacking the necessary liquidity. In particular, maturities in which only interest rate strips can be traded suffer."
It added: "Nevertheless, the example of France shows that a good strip market needs some time to grow. Following the 1991 launch the volume was initially very modest but has grown steadily over the past few years. Today, around 10% of the outstanding national French debt is held in stripped form."
At Deutsche Morgan Grenfell in Frankfurt, however, fixed income research director Helmut Kaiser insists that there have already been clear signals of the success of the strips market.
"We've seen very good volumes so far especially in the 30 year end of the market," he says, "because the strips are offering highly attractive yields of more than 6.5%. The introduction of the strips market is one reason why we have seen a tightening in the spread between the 10 and the 30 year maturity from over 90bp to below 70bp."
Looking to the much longer term, German analysts are convinced that strips will be of growing importance given the eventual launch of pension funds with longer term investment parameters.
In concluding a bulletin published in March on the demand for Bund strips in Germany, Deutsche Morgan Grenfell noted that "overall, we expect a gradual increase in demand for strips in the near future as the restructuring of the German pension system proceeds".
It explained: "Here the principal strips
(P-strips), which offer greater size as well as the longest duration, should be particularly interesting for institutional investors with long term liabilities. Meanwhile, coupon strips (C-strips) should be appealing to individual investors: given the steep yield curve, they will offer higher yields than equivalent-maturity whole bonds without the reinvestment risk to which buy-and-hold investors financing their pensions are subject."
It is also probably too early to judge whether or not all these initiatives have been sufficient to ensure that Germany has established -- or will establish -- a clear lead over France in the run up to Emu.
As West LB frankly remarks, "The question of who is going to be the benchmark issuer hasn't been answered yet. With the announcement that the German federal government's old issues are to be converted into euros as early as January 1, 1999, Germany has strengthened its case to be euroland's finance centre. This is a good prerequisite for the preservation of the benchmark function of German government securities in the future euro currency zone."
Aside from the structural reforms to the federal bond market, German bankers are adamant that several other key recent developments attest to the enhanced competitiveness of Frankfurt as a financial centre relative to its European competitors. Several point as an example to the success and commitment of the Deutsche Terminbörse (DTB), the German futures and options exchange.
As Helaba's Welteke proudly announced at the Finanzplatz's recent London presentation: "launched only in 1990, the DTB has emerged as the second largest futures and options exchange in Europe".
He added: "Until recently, no one had ever expected that one day the DTB would be able to challenge Liffe's dominance in Europe's derivatives markets. It even now appears likely that it can draw home the majority of trading in the 10 year Bund futures contract. In August it captured 44% of that market, its biggest share to date. This is positive news, since it also proves the competitiveness of its electronic system vis-à-vis the open outcry system in London."
In October, the DTB's share of trading in German 10 year Bund future outstripped Liffe for the first time, hitting 52% on October 23. DTB officials expressed confidence that the exchange would retain a 50% share for the rest of the year.
According to figures presented at the same roadshow, on the basis of volumes recorded in the first half of 1997 the DTB will have seen an increase in trading volumes between 1993 and 1997 of 104%, compared with rises of 95% at Liffe and of just 4% at Matif in Paris.
DTB's competitive position is also being strengthened, say local bankers, through the extension of trading hours to coincide with those of Liffe, as well as through the introduction of a handful of new products including a series of equity option and stock index products and a futures contract based on the new 30 year German government bond.
In addition, the announcement in September of an alliance between DTB, Matif and the Swiss Soffex exchange to offer all their products via a single electronic trading platform will increase the competitive threat to Liffe's open outcry system.
Liffe still has a sizeable lead over its European rivals in short term interest rate contracts. But dominance of Bund futures, Europe's most liquid long term derivative instrument, is seen as a key factor in the run-up to Emu.
Although DTB has so far been Frankfurt's star turn, German financiers are also promoting the competitive advantages of the country's other securities markets. At the same London presentation, Uwe Flach, a board member at DG Bank, added that the German Stock Exchange -- under its Deutsche Börse guise -- has also become highly competitive relative to its main European counterparts.
"In a world of electronic cross-border market access," he said, "transaction costs play a central role. For the same transaction, a market participant must pay DM46 at the French Stock Exchange, DM34 at the Swiss exchange and DM20 in London. However, using the German Stock Exchange's electronic trading system -- IBIS -- it costs only DM16.60. The new trading system XETRA, which will be introduced in November this year, will allow the stock exchange to lower its transaction costs even further." EW
* Our Currency, Our Country -- The Dangers of Monetary Union, p130.