a matter of weeks ago, trying to get institutions to talk about back tested strategies for Eurozone breakup was like trying to get blood out of a stone. But now we have started to see this change. First came a report from Nomura, looking at the practical fall out of a collapse of the Eurozone as a single currency area. Released publicly, it was perhaps the first release from a major financial institution that showed it was taking seriously the prospect of one or more nations leaving the Eurozone in the not too distant future.
This was swiftly followed by a report from Dow Jones that the forex settlement platform CLS Bank International was running stress tests to prepare itself for the possible breakup of the euro. CLS is used by 63 member banks to settle more than 70 per cent of FX trades in 17 currencies. The fact that such a heavyweight in the FX market is carrying out back testing of its systems in preparation for a major credit event is indicative of current market sentiment.
The report from Japanese bank Nomura covered not only the financial but also the legal fallout of a redenomination of Eurozone liabilities. The report treats the risk of some form of break-up of the Eurozone structure as a formality but advises investors to plan for “redenomination risk” – which euro-denominated debts would remain so, and which would be redenominated in the new local currencies. But the risk would not just lie in sovereign debt – a breakup would create a legal quagmire and a squabble over the jurisdiction of the settlement of the debt. The arrangement would hinge around lex monetae or the “state theory of money” which should also hold for the continuation of existing contractual liabilities in third party jurisdictions. When a country left the Eurozone, it would immediately pass a law reassigning that nation’s legal tender. This lex monetae would determine how in case of a currency alteration, sums expressed in the former currency are to be converted into the new one. Resting on the mechanism put in place for the transition from the old European currencies to the euro: “References in contracts set up in the currency of a participating member state will be interpreted with reference to European law, which is directly applicable in each of the participating member states.” The EC regulation on the introduction of the euro stipulated that: “The euro shall be substituted for the currency of each participating member state at the conversion rate.”
But how would this play out in practice? Should a country be booted out of the Eurozone, it is much less likely to be willing to play by the rules than if it exited as part of a clean, orderly mechanism. A disorderly exit would carry with it the risk of Eurozone exiles attempting to pass new laws trying to alter the terms of their debts, not to mention the short term difficulty of debt risk pricing. It is likely that the country would immediately default on its sovereign debts, but private and corporate debt issuance would remain.
As such, and as the note from Nomura points out, there are three main parameters in play when evaluating redenomination risk: “The first parameter is the legal jurisdiction under which a given obligation belongs. The second is the likelihood that a break-up can happen in a multilaterally agreed fashion. The third parameter is the type of Eurozone break-up which is being considered, including whether the euro would cease to exist in a given break-up scenario.”
In anticipation of this potential for jurisdictional horseplay, we have already seen a shift in preference from English law settled bonds to local bonds. When a Greek default seemed imminent, Finland demanded a restructuring of the legal principles in application on collateral for a Greek bailout. Now that this issue of redenomination risk has reared its head into the limelight, we can expect a further shift in this direction.
The bulk of the legal concerns revolve around the settlement of euro-denominated debt. But how concerned should FX investors and traders be? “In terms of foreign exchange forward and option contracts, any break up process would be a sufficiently drawn out process that the vast majority of existing deals would have matured by the time it was completed,” says Alex Lawson, financial risk manager for Moneycorp. He adds that any new contracts taken out after the process had begun would include an agreed, built-in mechanism to effect the changeover. “As a result, in the unlikely scenario of a complete Eurozone breakup, holders of foreign exchange contracts should have nothing to fear.”
However, in the current markets, nothing is certain. On average, FX trades are settled in less than two hours. A significantly widening spread, as we saw in late-2008, signals a perceived risk that one of the counterparties will cease to exist in that time. If that happens, things are about to get very scary.