Editor’s note: This is part two of a three-part series on a hypothetical breakup of the Eurozone, and the corresponding currency and derivative contract issues that could follow. If you missed part one, Eurozone Dissolution (“Episode I: The Sovereign Menace”), you can find it here: Episode 1: The Sovereign Menace

A long time ago, in a monetary union far, far away…

The single currency benefitted many and joined them in common interest. The elimination of exchange rates among the 17 member states alone increased efficiencies and competitiveness, resulting in greater economic output. Collectively, the member states in the monetary union rivaled the largest economies on the planet, and the people experienced a financial freedom of movement like never before. But the economic crisis would take its toll and expose weaknesses in the union. Prosperity and growth were not as widespread and distributed as imagined. The central bank’s tools of monetary policy were now but blunt instruments, incapable of quenching an overheating economy in one member state while simultaneously addressing anemic growth in another, given the ECB’s single mandate of price stability. The sovereign states took stock of their individual circumstances and could see only one solution…

Fed up with austerity, and unequivocally reasserting its right to self-determination, Greece could wake up one day and unilaterally withdraw from the euro. When other ailing nations see that there is life after the euro, they too could follow suit. Or, perhaps the fiscally strongest member states, fed up with bailing out their neighbors, could preemptively withdraw and form new currencies or currency unions. Dissolution could take many forms, as previously discussed. Once the euphoria of departure subsides, though, the reality of new currency regimes will set in. The new Drachma, or Deutsche Mark, or even a new monetary union currency would be just the beginning. And whether and how you are impacted personally would depend on a number of factors and, critically, your agreements. But first, how do we get there from here?

A Transitional Currency. There is currently no mechanism to depart the euro, but one possible orderly solution is to apply the “European Exchange Rate Mechanism” (ERM), but in reverse. The ERM was used to stabilize the currencies of countries joining the euro and reduce exchange rate variability, bringing balance to the Force. Before the euro was introduced, the “European Currency Unit” (ECU) was determined based on the weighted average of participating member states, and exchange rates were determined against this ECU with member states permitted to float within a tight band in a semi-pegged system. In the case of dissolution, a departing member’s currency could initially be set at a fixed exchange rate to the remaining euro currency, and then permitted to float in a band under a semi-peg, and finally permitted to float freely. This would take enormous cooperation between the ECB and the departing member’s newly empowered central bank. But just like in Star Wars , nothing would create a greater disturbance in the Force than a poorly executed dissolution plan, with bank runs and arbitrage sure to follow without tight controls. Clearly, for every simple solution put forward, there are very real pitfalls on the departing member’s road back to full fiscal and monetary control.

Redenomination Risk. By now you’ve realized that this wouldn’t just play out in some movie theatre, but rather directly in your business, in your supply chain, or with your global customers or partners. Before the dissolution, you had currency risk, which you hedged by purchasing or selling euros forward, or with outright FX options. But with dissolution comes redenomination risk, which is the risk that either your hedge or underlying hedged item could be settled in different currencies than expected, even though both contracts clearly stated they involved “euros” when entered. Worse still, you might not just get a new currency, but possibly a significantly devalued currency, as sovereign states newly assert their rights to manage their own money supply and market driven exchange rates set in. Your redenomination risk will be dependent on your hedge and hedged item agreements, and your connection to the departing member state(s) or new currency(s).

What’s in Your Agreements? A simple example serves to highlight some of the contract issues. Let’s say that you have sold some equipment to a company in Greece, and will be paid in euros one year from today upon completion of the order. Since your production and financing costs are in dollars (labor, materials, loan payments, etc.), and the future exchange rate is uncertain, you elected to hedge your euro payment receipt by selling euros/purchasing dollars forward to coincide with your completion and payment. But before you could complete the order and receive payment, dissolution occurs, and Greece departs the euro. What now?

Let’s examine your contracts. It’s important to highlight differences between your contracts, as you are at greater risk of redenomination when the hedge and hedged item contracts do not agree. Does either contract specifically address redenomination? While this sounds unlikely, your contract may, in fact, advise an alternate payment currency, which could significantly influence your redenomination risk. Another provision to consider is the place of payment. Cash flows that originate from or are paid to a location in a departing member state could make it more likely that you will face redenomination.

Next, what is the governing law on each contract? Transactions governed by the local law of the departing state, for example, would be more likely to be redenominated. Even if the governing law is not the local law of the departing state, different governing law on the hedge and underlying hedged item could result in different redenomination outcomes. Finally, you will need to examine each contract’s country of dispute resolution. If your forum selection also happens to be the departing member state on either contract, that contract could be more likely to be redenominated. Regardless of the governing law or dispute provisions, many courts will want to take a “wait and see” approach to allow the remaining Eurozone nations to develop a protocol or directive for dissolution.

Tune in next week for Part 3 in this series, Termination Risk (“Episode 3: The Contract Strikes Back”). Start at the beginning: Episode 1: The Sovereign Menace