Commentary on the eurozone crisis has become a daily staple for anybody regularly following the media. But despite the widespread attention, the crisis is not going away and there is a danger that we are seeing a slow slide towards a eurozone break-up.
To be clear, the risk of a eurozone break-up is still considered to be an unlikely scenario. But with some commentators currently assessing the probability of a break-up at between 5% and 35% 1, the risk is now too large to be ignored. Several major businesses including asset managers have publically stated that they have developed contingency plans.
Several scenarios have been put forward for 2012. Currently, most observers believe that a ‘muddle-through’ approach will continue, hopefully ending with a coordinated political action that will largely solve the crisis, but not before causing even more market instability in the mid-term. But with talk of a break-up no longer taboo, what are the implications for the asset management industry, should this come to pass?
Evidently, portfolio management implications are paramount. No one should underestimate the turmoil that a partial break-up of the eurozone would trigger. While this is just one of several possible scenarios, a Franco–German agreement that the existing eurozone is unsustainable would lead the way to a new, smaller and more tightly regulated currency bloc 2. Economies that were excluded would suffer a sharp currency depreciation and severe economic contraction. Banking sector problems would probably follow, along with significant dislocations in capital markets.
Such an extreme outcome would have implications, even beyond the investment portfolio. Asset managers, therefore, should look into how to manage their clients’ expectations, as well as how they would cope with legal, compliance and operational difficulties.
Managing clients’ expectations
With respect to client relationships, we believe the main areas that need to be addressed encompass confidence building and management of expectations.
Asset managers need to move now to address client fears regarding eurozone risks. Outlining a conceptual plan internally and initiating an open dialogue with clients would be a positive start, but certain clients will, if they have not already, soon expect a substantive contingency plan, which would require investment on your part. You should also manage client expectations about what would be possible if a break-up led to an economic depression. Offering expansive promises to clients will only cause difficulties in the future, whether or not the eurozone survives in its present form.
You might think it unusual to discuss opportunities about a situation which, if it happened, would be an economic catastrophe. But remember that a eurozone break-up remains unlikely. The reason for doing this is to show clients your firm’s professionalism and responsiveness in the face of impending challenges. By developing a robust contingency plan in a market beset by fragile confidence, you enhance your brand, potentially at your competitor’s cost.
In developing a framework for discussion with clients, the following areas need to be taken into account: portfolio management, legal and compliance, and operational readiness. Below, we give a broad overview of some of the issues that are likely to weigh heavily on any contingency planning.
Legal and compliance issues
While the legal and compliance implications of a eurozone break-up depend heavily on your exposure to the exiting country, the risks would be extremely high. To begin with, the exiting country would probably close its banks, impose capital controls and issue a new currency 3. Regarding assets and contracts, the clear risk is whether obligations would be paid in euros, another national currency, or the resurrected currency of the exiting country (what Nomura has designated as ‘redenomination risk’ 4). The law under which the contract was written would be key, as would the contract’s ‘geographical centre of gravity' in terms of assets, underlying securities and counterparties 5.
Regarding jurisdiction, in one example Nomura has pointed out that Greek government bonds issued under Greek law could be redenominated in drachma. But Greek eurobonds issued under English law in euros, and US dollar-denominated bonds issued under New York law, would not be easily redenominated.
Beyond redenomination, there is the question of enforcement. Even if a favourable judgement were granted in one country, getting it enforced in the country that had exited might prove difficult, particularly as the rapid deterioration of that country’s finances would probably lead to social and political upheaval, potentially of a violent nature.
In addition to asset loss, devaluation and exchange-rate risk, you need to examine corporate structures to ensure that governance, tax and legal structures would not be compromised. You also need to look into whether you would be able to answer regulatory queries on a timely basis. Responding on a timely basis to a slew of queries in relation to FX transactions, market and counterparty risks in a crashing market might prove to be impossible – particularly in an increasingly complex regulatory environment.
Finally, a euro break-up would spark a mass of litigation. Should a eurozone break-up happen in a negotiated and orderly fashion (what Nomura has described as a ‘lawful and consensual’ withdrawal), the time schedule would allow industry to disengage with far less complication, even taking into account the market turbulence guaranteed to follow such an announcement. A unilateral withdrawal, on the other hand, would be disastrous.
A number of operational issues must be considered in the event of the break-up of the existing eurozone.
The ability of IT platforms to handle a massive increase in transactional volumes, as well as the potential requirement to handle one or more new currencies, is the more obvious risk. Recently, ICAP, the world’s largest foreign-exchange platform, ran tests on its electronic trading platform to ensure that all 17 legacy currencies could be traded against the dollar within a matter of days 6. The company stated that the move followed concerns from investment bank and hedge fund clients.
Key IT issues to assess include: the investment to amend existing applications, ascertaining whether there are contractual or physical limitations in the reconfiguration of legacy systems, and preparing for increased capacity in certain functions as institutions switch business to non- or lesser-impacted countries. IT research firm Gartner 7 recently questioned the ability of risk models to cope with redenomination, because this would remove the historical data necessary for regression testing and yield curve analysis, both for hedges and for stressing asset and liability portfolios.
With asset managers’ workforces at low levels, another issue is whether you could cope with the surge in work associated with a break-up. A market panic with heavy trading volumes, sharp asset devaluations, a run on banks and high fund redemptions would require a massive surge in output across the asset management industry. Also, even if trained staff were available, would there be sufficient access to terminals and passwords for systems accesses?
What’s more, there is the risk that critical service providers might not cope. Identifying suppliers’ business continuity plans is just as important as identifying your own. Given the specialisation within the financial services industry, plus the complexity of moving service providers, identifying a single, robust service provider is your best option. But any complex migration requires a significant investment and takes many months at the minimum.
Unlike the collapse of Lehman in 2008, which was a sudden and largely unanticipated event, the eurozone crisis has been developing for almost two years. While break-up looks unlikely, the risk has grown sufficiently to warrant a proper risk assessment. More than any other sector, the asset management industry is well placed to assess and plan for this risk. Just as Europe’s leaders can stop this latest crisis from deepening, so our industry can prepare for the worst and ensure their clients are similarly prepared.