How to Prepare Your Firm and Protect Your Clients in the Event of a Eurozone Exit
Many Eurozone countries are experiencing severe debt problems and there is much speculation on the future of the Euro. There is growing concern that the Eurozone crisis could worsen and may lead to one or more Eurozone countries exiting the Euro and reintroducing national currencies.
Firms should prepare for the consequences of several potential scenarios.
The first step firms need to take to prepare for these eventualities is to undertake thorough research to understand exactly what part of their investments and operations would be impacted.
Exposures can be at a firm, fund, asset, and investor level. All need to be examined with a view towards understanding the impact on legal structures, investor documents, mandates, adjudication locations, and investment operations.
Firms can begin by crafting an overview of their asset exposures, bucketing exposures not only by issue country but by risk country—i.e. in the example of a firm that derives a strong component of its income from a specific country or region. Such analysis and review should cover both listed and non-listed investments with a view to understanding the financing terms as well as the impact of any underlyers. Underlying fund of fund products should disclose the same—and firms should begin contacting these providers to understand the level of risk inherent in their products.
Contracts. They should also begin to review legal contracts with clients and service providers, as well as asset contracts, including ISDAs/swaps, where assets and/or counterparties are based in one of the countries concerned. The jurisdiction applicable in case of an exit should be determined and any necessary changes made in the contracts themselves. One key area to investigate is the potential impact of a Eurozone exit on assets’ adjudication rules: if for example a firm has a contract on a swap on a Greek asset, it will be governed by EU laws. However, if Greece exits the Euro, will it also exit the EU? Will this contract then come under Greek law, or will it still be governed by EU law? Will the contract’s terms and conditions change, and if so how?
Counterparties. Firms also need to assess how their counterparties would be impacted by the exit of one or more countries from the Euro, and how this might increase their counterparty risk. They need to measure their exposure to each counterparty and review relationships to minimize that risk, identifying risks early on through a formal screening process, and differentiating between low, medium and high risk counterparties, taking appropriate steps to mitigate each level of risk .
Fund Structures. From a fund legal entity standpoint, firms will need to understand the impact of the exit on a fund with legal entities in an affected currency and the likely need to issue new classes and/or create a new feeder entity with a different denomination. This will involve planning for the transfer of assets, hedging strategies, and any need for specific currency cash accounts at counterparties. With this research, firms can work to minimize the potential impacts by redomiciling relevant entities and/or updating registrations where necessary.
Corporate Actions. At the asset class level firms should begin to keep themselves informed as to whether any exit will be orderly or disorderly Redenomination of equities is relatively simple using various corporate actions types, but the nature of cost basis will likely require a hard look, as will the performance reporting on those assets. Performance statements may need to include disclosures on any movements. Fixed income assets are by nature contractual agreements and may remain unaffected (i.e. a country returns to its originating currency but continues to leave bonds denominated in Euros). Or they could renominalize and/or redenominate, implicating a two-part corporate action, not to mention the possibility of failed settlements that could occur due to the upheaval of a Euro exit, and their consequences on valuation. Until further information is available, there is little firms can do but keep informed as to the general directions.
OTC investments present unique challenges as they are also contractual agreements but may provide underlyer exposure—and currency swaps meant to hedge currency fluctuations may no longer adequately protect the portfolio if a new currency is suddenly introduced. Underlyers may also provide exposure again to a risk or issue country.
Financing and Collateral. Investment managers using leverage need to review their current financing and collateral, to measure their exposure on the leveraged assets (Will I be able to pay back? What is the risk that the value of these assets will go down? What are my counterparty rules around collateral and currency?) and on the assets used as collateral for the firm’s financing (if these devaluate, firms may find themselves incapable of meeting the terms and conditions agreed with the lender). They should also be prepared to adapt to changes brought about in margin and financing rules from a jurisdictional perspective.
Accounting Systems. In terms of the overall accounting, a firm’s books are likely to be in one single currency, which may or may not be the Euro. They need to have a plan in place to make all the necessary base currency changes across their books for all the possible scenarios. Firms will need to assess the impact of introducing a “new” currency and converting relevant assets to that currency, as well as researching possible conversion rates and possible value adjustments. This may also have a knock-on effect on the accounting systems, so firms need to ensure their technology can support the different scenarios. In particular, they should make sure that audit trails are maintained, so they can retroactively trace and explain the origin of the new valuations, and report this to investors and regulators if need be.
Rules and Reporting. Finally, investor rules and reporting should be reviewed. Firms should look to draft the necessary alterations or amendments an exit would imply for investor rules. For example, they need to decide whether some investors based in one of the exiting countries would require redefined terms and conditions. In the same way, they should consider preparing draft statements of exposure, returns, etc. for their clients. Finally, for high net worth investors, tax consequences should also be reviewed and explained to the clients. This will demonstrate good due diligence, and help both firms and their clients understand exactly what would change.
Advent is monitoring the situation with the Euro and has begun working on solutions that may be needed to help clients in the event of such an exit scenarios coming to pass. Similar to previous currency conversions, Advent would provide tools to help users create new currencies and new investments in that new currency, redenominate and renominalize assets, and convert base currencies.
For legal structures, Advent will also provide tools to help facilitate the process of converting fund structures and investors to a new currency and enable the conversion to new share combinations in the new currency.
Advent teams are working with clients to address their specific concerns and are keeping a close eye on regulatory actions so they are able develop solutions as needed by users to ensure they are fully supported.