Frankfurt: Quiet capital of Europe’s derivative market

Frankfurt: Quiet capital of Europe’s derivative market

 Germany’s capital markets hub has often yearned to steal London’s crown as Europe’s financial capital. For all the marketing efforts of Finanzplatz Deutschland, and the advent of the euro, Frankfurt has never seemed to get much closer to its goal.

Listed derivatives is the one market where it has succeeded – at least on paper. In 1999 Eurex sc reamed past Liffe on the outside lane to become Europe’s biggest futures and options market by contracts traded. Its notional volume is now more than twice as big, although translating that into real cash terms is tricky.

Yet Frankfurt still doesn’t feel like the centre of gravity of European derivatives. Perhaps partly because of Eurex’s success in electronic systems, many firms that trade its contracts are based elsewhere. Participants in Frankfurt still look to London as a bigger beast.

Perhaps it doesn’t matter. If numbers are what counts, Frankfurt has the larger market. If it’s the people and culture of a place, then Frankfurt has something valuable too – a different model, something unique to offer.

Industrial roots

Frankfurt’s history as a financial centre is longer than Germany’s as a nation state. The first exchange was founded there in 1585 and it became the base for the banks that service the industries of what was until 2009 the world’s largest exporter.

“If you define a financial centre by the size of its stockmarket, then no one ’s going to take that away from Frankfurt,” says Chris Charlton (pictured), a former FX market player and now owner of Centa Asset Management, a Frankfurt-based firm that specialises in currency investing. “Historically, it was always Germany’s financial centre, even before the war.”  

But things are changing. Last year’s final, inevitable, transfer of the title of world’s largest manufacturer to China underlined the impact of the financial crisis on the Bundesrepublik, whose economy shrank by more than 5% in 2009. 

But is that merely a temporary knockback caused by the crisis, or part of a slower-burning process of decline? And what opportunities and challenges does it pose for the country’s derivatives markets?

“We continue to have this gradual shift from a manufacturing society to a services society,” says Lutz Raettig, chairman of Morgan Stanley Bank AG’s supervisory board and a veteran of both the German and North American banking scenes. “It’s keeping us alive, at least... Companies are opening up from the traditional model of family ownership.”

“It’s an exciting time for investors, compared to 20 or 30 years ago, when everything was bank-financed,” agrees his colleague Oliver Wagner, an executive director in global capital markets. “Companies are now more focused on the capital markets for funding – guys who have never issued bonds before.”

Jon Walton, a managing director in the same group at Morgan Stanley in Frankfurt, suggests the crisis may provoke German companies to make more use of derivatives for risk management, now that bank funding is less reliable. “A lot of it depends on their risk management ,” he says. “People may choose to manage risk in that way.”

Bankers and brokers

The corporate approach to risk management is changing, agrees one broker. “Where once you had that relationship with a bank, now you have to find a broker. It’s alright, once they get used to the idea!” he laughs.

You can sense a mild resentment in his voice – a common thread among many of Frankfurt’s derivatives specialists, on both the buy and sell sides.

The regional CEO of one brokerage has a theory. “The broker business in Paris is much bigger than here,” he says. “It’s a cultural thing. It’s not considered a smart thing to be a broker . Makler is a versatile term here; usually, the Germans use it to mean ‘someone who I have to pay to do something’.”

The executive goes on to point out that, in contrast with Paris, where maths and economics bulk large in higher education, the most prestigious academic backgrounds in Frankfurt are law and theology. “The most famous universities are from this tradition,” he points out. “The most noble professions, in spite of Germany’s manufacturing background, are law and theology.”

Still, the country’s strong academic drive has created a pool of business talent for the rest of the economy, argues Wagner – even if it isn’t particularly geared towards the needs of brokerages. “It is huge,” he says. “But of course, it’s the depth of the economy. We are one of the few financial centres that are fully entwined with the domestic economy. We have a very good infrastructure.”   

Eurex feels the pain – and takes the medicine

Eurex’s woes have been plain for all to see over the past 12 months. Still absorbing the cost of its $2.8bn acquisition of International Securities Exchange in 2007, the bourse suffered a loss of €367.7m last year, before interest and tax, largely owing to a writedown of €415.6m on its investment in the US options exchange.

Parent company Deutsche Börse has instigated a widespread programme of cuts, hoping ultimately to save some €200m a year.

Morgan Stanley’s Lutz Raettig, who is also head of the exchange council at Deutsche Börse’s subsidiary, FWB Frankfurter Wertpapierbörse (the Frankfurt Stock Exchange), says Eurex remains well positioned for the long term.

“I think they are competitive. And I think they will continue to be,” he declares. “Most of their major payers will stay on board. There’s always a threat ”, he adds warily, “but I don’t think I’m suddenly going to find myself sitting here without a shirt on.”

“They’re in a good position, no immediate danger,” agrees another broker. “I don’t think there’s any hope for the MTFs in derivatives – not in the near future.”

Others see the restructuring as a blessing in disguise. “In Germany, you have always the factor of staff costs,” says one senior market player. “This is why outsourcing is so attractive to companies like Eurex. But Eurex is still performing very well,” he concludes.

And perhaps even the bourse’s restructuring plans will not prove too much of a roadblock to expansion in the long term. “I’m pretty sure Deutsche Börse is looking at other markets,” says one senior market player. “For sure, they will go for a stake in the Warsaw Stock Exchange.”

“Eurex is not a pure domestic market,” agrees another. “Their expansion is not focussed on Germany. They don’t focus on the local market; they focus on the products they can sell.”

“Academia is very geared towards business here,” chimes in Raettig, a strong supporter of the German MBA system. “We have more universities than any financial centre.”

A quick drive through Frankfurt’s outskirts confirms this. Imposing post-war, new-build institutions of learning bear down on the visitor from all sides, blending seamlessly with their industrial surroundings, and churning out business minds with something like the same vigour.

Domestic tinge

Raettig’s words, however, highlight another issue that has had a bearing on Frankfurt’s position amid other global financial centres.

There is not merely a cultural split in Germany’s business population – an uneasy divide between the financial markets and industrial companies – but this elite is also spread thinly across 16 states. Even Germany’s stock exchanges are scattered over eight regions (though for how much longer, post-crisis, remains to be seen).

As Matthias Löffler, a managing director in the Frankfurt office of systems group SunGard, puts it: “Frankfurt is not the country’s only financial centre – the buy side and sell side are spread over the country. I have much higher travel expenses here, because I have to visit Munich, Berlin, Stuttgart, Düsseldorf and Hamburg.”

Charlton is blunter. “Frankfurt is regional. It’s got clout, but if you’re talking about asset management, you could even say Switzerland . Take Deutsche ’s head office for instance: is it here, is it in London? In the ’80s, Frankfurt had a serious go at replacing London as Europe’s leading financial centre, but the Big Bang in London blew Frankfurt away.”  

“Frankfurt is very specialised, and a domestic market still,” agrees Wolfgang Fabisch, CEO of b-next, which specialises in regulatory compliance software. “People don’t like to acknowledge that, but it is... I think the banks are still gearing towards New York and Shanghai... our own companies are doing more and more business with London and New York.”

This appears to be borne out by sheer numbers. “We have 350 people here; in London, we have 4,500,” says Raettig. “We’ve got a pretty big stable here the main office is in London.”

Still, Frankfurt has quite some clout. “If you divide the international recognition by the number of people who live here, it’s quite incredible,” says Walton at Morgan Stanley.

Greater Frankfurt’s population stands at 2.3m according to Demographia, which estimates London’s at 8.6m.

“It’s a small city, and extremely convenient,” says Justin Wilson (pictured), who spent several years helping develop Goldman Sachs’s technology in its German subsidiary during the mid-1990s, and now runs Alpheus Solutions, an independent consultancy. “At FOW’s Frankfurt conferences, you’d bump into the same people you saw 10 years ago. That would never happen in London.”

Yet demographically, Walton suggests, Frankfurt has more in common with London than with other, larger German cities. “If you look at Frankfurt’s population, about 30% is foreign-born and raised abroad. Also a huge number of Germans here have lived abroad – far more than in Munich, for instance.”

Is prudence a virtue?

But what you can do in London, it would seem, you can’t do in Frankfurt. “I still think in Germany, we don’t have the derivatives trading culture like in London,” says Löffler at SunGard. “The two big centres for derivatives in Europe, I would say, are London and Amsterdam. Our order flows are mostly generated in Great Britain or routed from Frankfurt to London.”

There is a huge equity bias, he says. “Sixty to seventy percent of the trading here is in equity.”

“The UK is much more of a gambling culture,” says Charlton. “Take horse racing. You have four meetings a day; here, it’s more like one a month.”

Charlton ought to know, as Centa’s offices back onto the city’s Renn-Verein Frankfurt am Main racetrack and neighbouring golf course – another firm favourite among the city’s expats.

He would not be the first to imply that you need to be a bit of a punter to like derivatives.

“The investment mentality isn’t the same here as it is in London, Italy or even Poland,” Löffler believes. “There is perhaps a conservatism... People aren’t quite sure what to do with their money — that is why gold is going up and up. That uncertainty only fuels consternation.” German retail investors do not, in general, hold derivatives products in their investment portfolios, Löffler says. “ in Germany, we have a very strong market for warrants – that’s not to be underestimated. This is the strongest retail asset class for derivatives.”   

If the retail market is small now, it is an awful lot bigger than it was even a decade ago, argues Thomas Pirzer (pictured), a former UBS derivatives trader and now Wilson’s colleague at Alpheus. “There was a very aggressive move to incorporate derivatives trading strategies 15 years ago – a real targeting of high net worth individuals,” he says.  

These trends are intimately linked, Charlton suggests, to a vastly different attitude to ownership and credit in Germany. “The housing market here hasn’t moved for 20 years. That’s one reason the crisis didn’t hit so hard here in France and Germany. The housing bubble never burst because it never went up in the first place. It’s a completely different style of living; here it’s save and export, in the UK it’s borrow and spend,” – right down to government, Charlton contends. “People wait until they’re in their eighties to buy a house. Even credit cards only became widespread five years ago. The whole idea of property is different.”

His view is shared drily by the city’s property-owning classes. “My house, after 20 years of ownership and huge renovation in that time, is still worth less than it was when I bought it!” laughs Pirzer with hardened humour.

Crisis shakes things up

But if the crisis has meant little to the country’s housing market, it has rocked the banking community – including the derivative markets.

“There has been less proprietary trading activity in general,” says one senior industry figure. “Not much has been said officially on this, but we know two or three banks have closed their prop trading divisions. Prop shops are under creation, but is still small. We don’t have that remote trading culture here, not like Italy or other countries.”

But one favourable aspect of the crisis is a broadening of the investment horizon, counters one senior market commentator. “I see trends changing. It’s quite likely we’ll have a sideways movement . The majority of our clients now are looking at derivatives. There’s a real push for single stocks.”    

“Someone’s got to pay”

“You’d have thought the Germans would have been crowing over the failure of the Anglo-Saxon model, but that’s not the way here,” says Justin Wilson, CEO of London- and Frankfurt-based consultancy Alpheus Solutions.

Although, as Wilson points out, some German institutions were as overexposed during the crisis as their UK counterparts – in spite of a national attitude of prudence.

“Sal. Oppenheim really tarnished the reputation of private banking here,” says Wilson. “If it weren’t for them, Germany would be able to say: ‘look how prudent we are.’”

The 200 year old private bank, a prominent derivatives market maker, had to sell itself to Deutsche Bank after being crippled by losses in 2008. Former managers are now being investigated.

Has the financial crisis tarnished Frankfurt’s reputation to the same extent as London’s?

“There’s been a whiplash effect here – against Landesbanks in particular,” says Chris Charlton, head of Centa Asset Management.

The highest profile crisis victims in Germany have been partly state-owned banks – first IKB Deutsche Industriebank, but then the country’s Landesbanken, a network of regional wholesale banks, designed to finance the economy of each Land.

Many got into trouble with triple-A rated structured credit investments that turned sour, and were bailed out by a specially created government fund.

“The Landesbanks are undergoing serious restructuring,” says Lutz Raettig, chairman of Morgan Stanley’s German supervisory board. “Will they in one bit, in two or three – who knows? have farmed out their bad bank, but this will have consequences, of course.”

Matthias Löffler, managing director at SunGard in Frankfurt, is also concerned. "The impact of the crisis on Germany was underestimated. We're all watching the actions of the state very closely; at some stage, I think we will see further consolidation for example the Landesbanks either coming together or being bought out."

The current state elections are not a shoo-in for the ruling Christian Democrat Union, Charlton says. “Greece has been a political issue; Merkel can’t be seen to be bailing them out. But there’s no question that they’ll do it... just not publicly.”

Wilson agrees: “I think Merkel’s playing a very clever game. It’s in her interests for the euro to be lower. Just look at exports to China and India in the past quarter.”

The local taxi drivers are more than happy to offer their opinion on the subject, too – often without prompting. Asking one what he makes of the CDU earns a noncommittal shrug. “They’re OK,” he says. “But in Germany, we just say the trough remains the same – only the animals change.”

Eurex (see box) certainly appears keen to capitalise on this apparent demand. Since the beginning of 2009, it has launched trading in more than 100 new futures on individual stocks from several countries. April 2010 was a record month for single stock futures at the exchange, with 51.6m contracts traded.

Loeffler believes the buy side is becoming professionalised since the crisis, partly because many firms suffered from the downturn.

The turmoil has also shaken up the scene, causing people to move around. “Many former bankers are joining us now,” says an insider at one of the country’s biggest brokers.

“I think those guys who have been fired by the banks are young guys, smart guys,” adds another market player. “Smaller companies will now have opportunities in the proprietary trading space.”

“Frankfurt is still very active, especially in the exchange-traded ,” insists Fabisch at b-next. “Deutsche Bank, Commerzbank and Dresdner are very active... the derivative market is still growing here. We have many new product requests from customers, even now.”

Growth on every front

“For the time being, the growth areas look to be commodities and fixed income,” says one broker. “Fifty percent of the warrants issued last month were in commodities. The end market is huge. The car industry is immense, so naturally base metals are huge... agribusiness is smaller 50% of this country is fields of wheat, lest we forget.”

Charlton insists derivatives still have an important role to play in resolving the crisis, even if innovation sometimes seems a dirty word in Frankfurt financial circles. “CDS have been abused, but they do work. They at least put pressure on the governments to do something ,” he says.

Risk appetite, Charlton says with some surprise, is resurgent too. “It’s coming back! People want more risk. Well,” he qualifies, “they want more return. People have short memories.”

Equally, the expansion of the EU can be an important driver of growth for Germany, Löffler insists, rather than simply a cheap source of labour for its multinationals. “We’re already getting order routing requests from Hungary and Romania,” one market participant agreed.

Wilson agrees, saying London’s position in EU financial circles relative to Paris and Frankfurt is hampered by the UK’s persistent Euroscepticism.

“Germany has a real opportunity now ,” Wilson says, but “the biggest barrier remains this natural pessimism. For example, in the UK we always revise up our growth figures; here, they revise them down.”

Wilson mentions the Z/Yen Group’s annual Global Financial Centres report, which assesses economic competitiveness between the world’s capital market hubs. London maintains its number one spot this year – albeit now shared with New York – while Frankfurt lies 13th. But the gap between London and Frankfurt has closed by some 43 points in just six months – the fastest move since the survey began.  

“Frankfurt is not going to be number one or two in the world, or even number five,” Wilson concludes, “but slow and steady has done well for them in the past.”

As the present crisis of government credit risk in the euro zone has shown, it is fortunate for European stability that Germany has ploughed its own, sometimes lonely course. Frankfurt’s financial style is every bit as important to the derivatives market. Long may it continue.