Banks need to be more transparent on eurozone crisis
Banks need to be more forthright with buy-side clients about the operational implications of a eurozone country (or countries) exiting the single currency or common market.
“A lot of banks hold seminars and webcasts hosted by market analysts talking about the macro implications of eurozone countries exiting but they have been quiet about the legal and operational implications. Banks need to be more open about the operational challenges they and managers will face were one or more countries to leave the eurozone,” said one hedge fund COO in London, speaking anonymously.
Investment banks, with the notable exception of Credit Suisse, have been exceptionally quiet about the operational risks of a worsening eurozone crisis. This silence has been marginally offset by law firms such as Dechert and technology vendors including Advent Software publishing white papers on the topic.
“Banks cannot be seen to be taking a negative view on the eurozone by discussing operational issues – publicly at least. Not only would such a view damage market confidence at a fragile juncture but it could lead to a regulatory backlash,” said Charles Proctor, partner at Edwards Wildman Palmer in London. “Furthermore, many of the operational issues are subordinate to the macro and broader financial risks making it even harder for banks to be transparent,” he added.
Nonetheless, more debate on the issue needs to be forthcoming, said Richard Frase, partner at Dechert. “Institutions are cautious about admitting they are planning for a country’s exit because of political pressure and concerns that this would itself undermine the market. However, more does need to be done to raise awareness about the operational issues facing banks and fund managers,” he said.
The hedge fund COO acknowledged banks are better prepared to handle the eurozone crisis now than four years ago. The Bank of England, for example, has demanded banks raise more capital from stock and bond markets, and have in place contingency plans to handle a country or countries exiting the eurozone. “In terms of IT systems, banks will be able to cope, particularly with currency redenomination, for example. The real problems for the banks lie with all the legal uncertainty,” said the COO.
Hedge funds, on the other hand, particularly smaller ones, appear to have given the ongoing eurozone travails little thought. One manager said he tried not to think about it, for example. The COO acknowledged such opinion tended to be industry consensus. “Buy-side firms and hedge funds tend to employ around 200 or so people maximum although there are larger houses. It is practically impossible to have 50 employees working full time on preparing for a eurozone exit. Banks like RBS and Citi can dedicate hundreds of staff to it but we, as an industry, do not have the resources,” said the COO.
There is debate as to whether legal contracts will be interpreted in EU law or national law following an exit. Advent Software recently issued a paper urging managers to review legal contracts with clients and service providers, as well as asset contracts such as ISDAs. It questioned whether firms with contracts on a swap with a Greek asset would be subject to EU or Greek law, and advised managers to check whether the contract’s terms and conditions would materially alter.
Aside from this and the obvious counterparty risk, the two biggest operational challenges facing managers are sub-custody risk and settlement risk. While very few hedge funds use local custodian banks, some do utilise the local branches or indeed sub-custodian networks of bulge bracket organisations. An exiting country, be it Portugal, Spain, Italy or Greece, is likely to impose exchange controls and implement an instant redenomination of currency. The terms and conditions imposed on foreign creditors are unlikely to be favourable.
“Sub-custody risk is probably the biggest concern for larger managers – many of whom have began to manage their exposure to the affected countries, and risk assess their custody networks,” commented Frase. It is also not unreasonable to suggest that sub-custodians or local banks, struggling to meet margin calls, might use client assets to meet collateral requirements in the ensuing panic. “This is something that could potentially occur,” said Proctor.
Another danger is that cash payments into and out of any withdrawing country will be subject to instantaneous redenomination, but very little has been said about cash payments which are in flight from an in-country to an out-country before the countervailing securities are received. If capital controls are imposed, this cash transfer might not be recovered.
“Cash payments are not instantaneous. If a manager transfers euros out of Greece to Germany and Greece issues a redenomination before a German branch of the bank can confirm the transaction is completed, it would not be unreasonable to suggest that the manager would find himself stuck with Drachma,” added Proctor.
Such a scenario might be wishful thinking at best. A long legal battle is likely to ensue not too dissimilar to what Lehman creditors are going through albeit worse. “If assets were mid-flight during redenomination, they could be trapped in the settlement system. I would not be surprised if there was a protracted legal debate, which would among other things need to establish a cut-off point at which assets are classified as either euro or Drachma. This could be very time consuming and complicated,” commented Frase.