What Happens If the Euro Fails? Potential Issues for the Investment Management Community

If a country were to leave the euro, then the biggest issue would be how to allow for a member country’s currency to exit in as dignified a way as possible whilst at the same time avoiding a run on the country’s financial institutions. The consequences, if badly managed, could be a total collapse of a country’s financial system. And the knock-ons of this for all euro-zone countries would likely be worse than the situation the country would be trying to resolve by exiting the euro in the first place!

So should investment management firms be planning in any case? Well, despite all the issues, the rumors that at least one country will exit the euro this year will not go away.

Unless or until central banks and other institutions issue rules and guidelines for a currency’s withdrawal, very detailed planning cannot commence - but that should not stop initial planning to ascertain the likely impact on a firm’s business. Gathering country and currency exposures and reviewing all systems likely to be affected, ensuring a good early understanding of any central bank announcements and even outlining some ideas on high level cross period reporting requirements can be undertaken sooner rather than later.

Citisoft believes it would be prudent to commence a project to review the likely impact as the consequences of any one or more currency leaving the euro would have a major operational and system impact for any investment management firm.  Some of the potential issues are outlined below:

Legal - There would be a plethora of legal issues to resolve not least dealing with the ramifications which would result from having to amend the Maastricht Treaty. Continuity of contracts and re-papering of contracts especially for long term OTC instruments could be complex and client mandates may need to be re-drawn.

Politically - Countries re-establishing their own currencies would have to have agreement from other euro nations regarding a tactical withdrawal. They would need cross border currency controls established and the best way may be to adopt a brand new euro for the remaining participants and a new national currency for the withdrawing currency – this is a cleaner solution but would mean in effect a whole new round of redenomination from euro 1 to euro 2 and from euro 1 to exit currency.

Operationally - There are a multitude of issues which in effect are not dissimilar from those that had to be resolved when the euro was first formed in 1999. The issues include:

How to ensure accurate currency conversions - Conversion rules would need to be re-defined under changes to the relevant articles of the Maastricht Treaty. This would affect any firm trading in currencies or securities denominated in currencies that the euro would replace. Items such as how to follow the correct conversion methodology, how to link old and new securities (the most obvious way is to create corporate action type events) and how to report over the period in a consistent manner would all need to be addressed.

Any firm that trades in securities denominated in currencies that are leaving the euro would be affected. In 1999, this took three forms: Redenomination – changing the currency unit of the nominal value of a security, Renominalisation – changing the minimum amount in which the security is held and traded (rounding) and Reconventioning – changing the terms of the security issue to reflect different conventions prevailing in the market for securities in the new denomination (i.e. interest method changes). Cash positions as well as physical holdings would also be affected.

For firms who have a specific system base currency that may be leaving the euro, the issue would be far wider than for firms which have a base currency of euro, US dollars or Pounds Sterling.

There would be at least three slightly different scenarios for conversion out of euro:

1. Firms with a system base currency of euro but in a currency remaining in euro –the issues would likely be around conversion methods and triangulation rules. Although many software vendors changed their code to cater for the conversion into euro – did they all include scenarios for conversions out?
2. Firms with a system base currency of euro but in a currency exiting the euro – the issue is likely to be more complex as changing a base currency is likely to present issues around accurate historical reporting in many systems.
3. Firms with a system base currency in a non euro currency e.g. British Pounds or US Dollars – in practice, this scenario should not be that different to 1) above but again conversion and triangulation rules would need consideration.

Note: These scenarios all assume that the euro will not cease in its entirety. This scenario is possible but is considered unlikely at least in the near term. Should the euro completely fall apart then 2) and 3) above will still apply.

Performance Measurement – The key would be how to achieve consistency from the period when a currency was in the euro to the post euro period once performance is recalculated. Methods of linking securities and ensuring transparent reporting of events posted to move from one security to another would be key to running smooth and accurate performance calculations cross period. Geographic classification for performance and attribution would also be impacted.

Preservation of all historic data – How to report on assets in terms of the euro, both historically and moving forward and how to ensure historic cost and book price consistency pre and post any exit from the euro would need consideration. In-flight data too such as FX contracts and derivatives contracts would all be affected by such an event and their transition from euro would all need to be smoothly managed.

Accurate P & L reporting- How to acknowledge currency gains or losses would be an obvious first item for review. The recognition of currency gains or losses on conversion out of euro would generally be created via corporate actions in order to crystalise the currency gain or loss as of the date of the conversion.  This should allow users to report on the value of the gain or loss going forward. Also how to cater for security classification changes and geographic exposure could be quite complex.

Compliance – In an environment where major regulatory changes are already in flight, the impact of regulation during the transitional period of a currency migrating out of the euro will also likely need extensive review.