Termination Risk


Editor’s note: Editor’s note: This is the final episode of a three-part series on a hypothetical breakup of the Eurozone, and the corresponding currency and derivative contract issues that could follow. You can read the past episodes here:
Episode 1: The Sovereign Menace

Episode 2: Return of the Drachma

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

World economies braced for the inevitable breakup. Despite Eurozone members having many more ties than just a single currency, in the end austerity, capital flight, and contagion proved to be too much to overcome. The departing state’s interconnectedness would put many banks and businesses, even other nations, at grave risk of default. The monetary union thus shifted its focus towards shoring up the defenses of other at-risk states, and preparing the way for the first unilateral withdrawal from the common currency. With no precedent, Eurozone ministers had to make quick decisions to cut through the chaos and affect an orderly dissolution and redenomination. Ironically, new cooperation was required to legitimize the departure, create an exchange rate mechanism, and breathe new life into the departing state’s dormant central bank. The grand Eurozone experiment was far from over, but weaknesses in the unity model – exposed by unprecedented economic woes – could no longer be ignored. And, a sovereign state was reborn, in full control of its destiny, but with a long road ahead to recovery. The world would never be the same…

And so, what was unthinkable has come to pass. Greece has departed the Eurozone. A new Drachma is established, and with a carefully constructed plan, the currency goes from pegged to semi-pegged to floating freely on the market once again. Long ago you dusted off your contracts and asked the most absurd “what if?” questions imaginable, and the events actually happened. However, the landscape is still changing rapidly and courts around the globe are just beginning to rule on the matter. Your job is not done. You must re-assess your hedge and underlying hedged item contracts to see whether and how they can withstand these unprecedented changes. Dissolution risk and redenomination risk now give way to the possibility of termination of your agreements.

What is your desired outcome? Before you can ask whether your contracts will hold up, it’s best to know your preferences based on this new reality. The last time you checked your agreements, you assessed the likelihood that the hedge and underlying hedged item would be redenominated. If both contracts still agree, with both still having either euro risk or both now having new drachma risk, then it is probable that your hedge will perform correctly, even if based on the new currency. If the hedge and underlying hedged item contracts no longer agree, then you will need to determine whether termination is your desired outcome. It’s a funny thought to assess your desired outcome on each contract. After all, you entered each agreement in good faith and expected that you and your counterparty would perform. But the chaos of dissolution and redenomination will inevitably mean disarray in the courts, as well, so identifying what you wish to accept versus what you intend to challenge, and where to do so, will be critically important in the aftermath of this unprecedented event. Your assessment of your desired outcome could lead you to seek a voluntary termination of either contract, for example, if it appears that paying any associated termination penalty is more desirable than a yet-to-be-finalized court remedy.

Termination Risk. Short of voluntarily unwinding your agreements, though, you could still face termination risk. This is the risk that the hedge or underlying hedged item contracts can be terminated directly because of the dissolution or redenomination. While it is unusual to see an additional termination event (ATE) address these issues head-on, termination risk could arise because of how legislatures and courts craft legal remedies to deal with the situation. For example, depending on how broadly the clause is drafted, the dissolution could trigger an illegality, material adverse change, or force majeure clause. None of these deals specifically with dissolution or redenomination, but could be the path through which your trades are terminated. Courts could also take the opposite approach and specifically bar declaring a contractual default as a result of a dissolution or redenomination. This is much like the case when the euro was introduced, when the ISDA EMU Protocol addressed the new euro currency and prevented termination or event of default solely on the basis of its introduction./p>

Indirect Termination Risk Finally, even if you have assessed your desired outcome, and you have reason to believe that you face minimal or no direct or “first order” termination risk, a dissolution and redenomination could still negatively impact your counterparty. Bank failures, business failures, and credit rating downgrades could aggravate the situation to a point where your own counterparty breaches your agreement or fails outright. This is a much more difficult risk assessment, as you have an imperfect picture of your counterparty’s interconnectedness and ability to withstand these sweeping and unprecedented changes. Counterparty risk is nothing new in derivative contracts, but market participants have moved in the direction of fully secured or collateralized transactions to address the uncertainty, especially after the financial market disruptions, bankruptcies, and bailouts of 2008-09. The departure from the euro of one or more member states will fully expose inherent risks in the system, but should ultimately lead to stronger and smarter protections.

Start at the beginning:
Episode 1: The Sovereign Menace
Episode 2: Return of the Drachma