nomura eur breakout plan

7/31/2019 Nomura EUR Breakout Plan

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30 January 2012

Planning for an orderly break-upof the European Monetary Union

Jens Nordvig (Lead Author)

Head of Fixed Income Research Americas

& Global Head of G10 FX Strategy

Nomura Securities

Dr Nick Firoozye

Head, European Rates Strategy

Nomura Securities

Submission to Wolfson Economics Prize 2012:

The opinions expressed in this paper

reflect the personal viewpoints of the authors,

not an official view of their employer.


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Table of Contents

Summary .............................................................................................................. 4Section 1: Possible break-up scenarios ........................................................... 6

We see a real risk of break-up .......................................................................... 6A very limited eurozone break-up: possible ...................................................... 7A big-bang eurozone break-up: possible .......................................................... 7A sequential onion peeling break-up process: unlikely ................................... 8

Section 2: Legal aspects of redenomination ................................................. 10Redenomination risk: Which Euros will stay Euros? ....................................... 10The importance of legal jurisdiction ................................................................ 10The need for an ECU-2 and EU directives in a break-up ............................... 12Risk premia and legal jurisdiction.................................................................... 14More detail on legal jurisdiction ....................................................................... 14The judicial process ........................................................................................ 16Enforcement .................................................................................................... 17Legal aspects of redenomination and contingency planning .......................... 17

Section 3: Size of Euro assets by legal jurisdiction ..................................... 18Euro denominated bond markets by legal jurisdiction .................................... 18Euro denominated derivatives by legal jurisdiction ......................................... 20Euro denominated loans assets by legal jur isdiction ...................................... 21Information gaps and redenomination complexity .......................................... 21

Section 4: Cost-benefit aspects of planning ahead ...................................... 23Uncertainty about the eurozone is affecting investor behavior ....................... 23The private sector is making contingency plans in any case .......................... 23Uncertainty makes risk-management difficult ................................................. 25

Section 5: Key steps in planning for a break-up ........................................... 26Aiming to avoid unnecessary disruption ......................................................... 26Four steps in an plan for and orderly break-up ............................................... 27

Section 6: Guiding principles for redenomination ........................................ 28Guiding principles for redenomination of local law assets .............................. 28Guiding principles for redenomination of foreign law assets .......................... 28

Section 7: The new European Currency Unit (ECU-2) .................................. 30The advantage of the basket currency redenomination .................................. 30Potential weights of the new ECU ................................................................... 31

A brief history of the original ECU ................................................................... 33A few technical considerations around the ECU-2.......................................... 34

Section 8: A hedging market for intra-EMU FX risk ...................................... 35The need for a hedging market for intra-EMU exposure ................................ 35 Creating instruments for hedging intra-EMU currency risk ............................. 36Creating instruments for hedging ECU-2 exposure ........................................ 36Ensuring efficiency of intra-eurozone NDF markets ....................................... 36

Section 9: New regulatory frameworks .......................................................... 38The need for quantification of intra-eurozone currency risk ............................ 38Risk limits for systemically important institutions ............................................ 39


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Section 10: Concluding remarks ..................................................................... 40Appendix I: Illustrative bank loss calculations in debt restructuring scenarios 41Appendix II: BIS data on international bond issues by Eurozone issuers ...... 44Appendix III: Valuing new national currencies ................................................ 45Currency risk in a eurozone break-up ............................................................. 45

A framework for valuing new national eurozone currencies ........................... 46Quantifying current real exchange rate misalignment .................................... 46Quantifying future inflation differentials ........................................................... 48Valuation of new national currencies: A two-factor approach ......................... 50The countries not in our story ...................................................................... 51How to interpret the results ............................................................................. 52

Appendix IV: Eurozone assets by legal jurisdiction further detail ................ 54Appendix V: How to value the new ECU ......................................................... 55References ...................................................................................................... 57


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Summary

Two types of break-up scenarios for the Eurozone are possible, from a practical

perspective: A very limited break-up scenario, involving the exit of one or a few smaller

countries, and big bang break-up scenario, which would see the Euro cease to exist. A

sequential onion peeling type of break-up process, which would see only stronger core

countries remain in the eurozone, is highly unlikely to be possible as the process would

become uncontrollable around the exit of a larger Eurozone country. Policy makers

should therefore plan primarily for the very limited break-up as well as the full-blownbreak-up scenario. The latter could be highly disruptive from a macroeconomic stand-

point in the absence of any detailed and thoughtful advance planning.

Eurozone break-up risk has clearly risen notably during the second half of 2011 as

European policy makers have failed to put in place a convincing and credible backstop for

the larger eurozone sovereign bond markets. Given this increased risk, investors and

policy makers should think carefully about dynamics associated with redenomination of

Euro denominated assets and obligations in a break-up scenario. There are important

legal dimensions to this analysis, including the legal jurisdiction of the Euro denominated

assets and obligation in question. In order to determine which contingency plans would be

helpful to facilitate and orderly break-up process, it is important to understand certain

legal aspects of a redenomination process, including the differences between domesticand foreign law instruments.

In making contingency plans for a Eurozone break-up, it is important to think about the

size of exposures involved, including new currency risks which would ensure from a

redenomination process. Since Euro adoption was supposed to be irrevocable, very little

attention has been paid to legal jurisdiction of assets and obligations up to this point, and

the related differences in redenomination risk. But our preliminary analysis highlights the

very large contingent open currency exposure. In particular, the importance of the size of

Euro obligations under English and New York law, in the form of FX swap and forward

contracts, as well as interest rate derivatives, should not be underestimated. The huge

size of these markets illustrates that complications related to the redenomination process

around such assets and obligations have potential to cause very significant disruptions,

with dramatic macro economic implications.

There is a general perception that any attempt to make contingency plans for a euro-zone

break-up would lead to increased investor anxiety. But investor concerns about the risk of

a eurozone break-up are already present. Moreover, the new uncertainties around break-

up risk and related legal and political uncertainties around a possible redenomination

process makes it hard for investors to manage risk related to their eurozone exposures.

At this point in the crisis, communicating contingency plans for a break-up would reduce

uncertainty, rather than add to it, and potentially even improve the current capital flow

situation.

In preparing for an orderly Eurozone break-up, we propose four key step in a contingency

plan for orderly currency redenomination. European policy makers should: 1) Offer

forward-looking guidance on the redenomination process for local and foreign law assets;

2) Specify the role of a new European Currency Unit (ECU-2) in the redenomination of

foreign law assets and obligations in a full-blown break-up scenario; 3) Create a hedging

market for intra-EMU currency risk, allowing risk reduction ahead of a break-up event;

and 4) Adopt regulation which over time is aimed at reducing intra-EMU currency risk for

systemically important institutions.

Communicating guiding principles for redenomination of Euro denominated assets and

obligations under local and foreign law ahead of a break-up would be a crucial first stepin

an orderly redenomination process. Communication ahead of the event would allow

market participants to prepare efficiently, helping to avoid triggering bankruptcies and

other disruptions as a function of losses on new currency exposures. Clear

communication on guiding principles for the redenomination process ahead of time wouldhelp resolve uncertainty in the planning process, and reduce delays associated with legal

disputes following an actual break-up.


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A new European Currency Unit (ECU-2) could play an important role in facilitating an

orderly redenomination process for the myriad contracts and obligations under foreign law

without a clear country specific nexus. Specifying the role of a new European Currency

Unit in the redenomination process would be an important second stepin planning an

orderly redenomination process. The ECU-2 would be a basket currency, and would be

mechanically linked to the performance of new national currencies of current eurozone

member countries in accordance with a pre-determined weighting scheme. The ECU-2

would play a crucially important role in facilitating efficient redenomination of foreign law

contracts, which would otherwise be hard to settle in a fair and efficient manner. The

ECU-2 would thereby serve to minimize unnecessary insolvencies due to protracted legal

battles about redenomination issues and due to losses on new currency exposure

associated with a redenomination scenario.

To facilitate an orderly break-up process, market participants would need instruments to

reduce intra-EMU currency risk ahead of an actual break-up taking place. A third stepin

the planning process would involve the creation of non-deliverable currency forward

markets for potential new national currencies of eurozone member countries. This step

would be an important component in facilitating risk reduction in relation to contingent

intra-EMU currency exposures. The availability of an efficient hedging market for intra-

EMU currency risk ahead of a bread-up would serve to minimize redenomination related

disruptions in an actual break-up.

The fourth and final stepin preparation for an orderly eurozone break-up would be to

implement new regulatory frameworks. The purpose of such a framework would be to

monitor and over time reduce intra-Eurozone currency exposure for systemically

important institutions, including by taking advantage of newly created hedging instrument

for this purpose. Given the prevalence of Euro denominated assets and obligations under

foreign jurisdiction, such a process should have a global component in order to shield the

global banking system from shocks emanating from a eurozone break-up.

The four-step plan outlined here offers a framework for orderly currency redenomination

in a break-up scenario, including a full-blown break-up scenario where the Euro ceases to

exist. To be clear, this would be just one aspect of an overall plan for an orderly break-up

of the European Monetary Union. But this specific aspect is likely to be a crucial one

given the very large contingent open intra-EMU currency exposures which have beenaccumulated since 1999. Any plan for a break-up, which does not include a framework to

ensure an orderly currency redenomination process, is an incomplete one, and one which

significantly underestimates the large disruptive force associated with an uncontrolled and

unmanaged redenomination process.


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Section 1:Possible break-up scenarios

Two types of break-up scenarios for the Eurozone are possible, in our view: A very limited

break-up scenario, involving the exit of one or a few smaller countries, andbig bang

break-up scenario, which would see the Euro cease to exist. A sequential onion peeling

type of break-up process, which would see only stronger core countries remain in theeurozone, is highly unlikely in our view. Policy makers should therefore plan primarily for

the very limited break-up as well as the full-blown break-up scenario, which could be

highly disruptive in the absence of any advance planning.

We see a real risk of break-up

The treaties of the European Union, which also define the rules of the monetary union, do

not contain any specific procedure for a eurozone breakup. When the euro was created,

policymakers wanted euro adoption to be irrevocable, and they did not want to spell out a

route to exit.

But the eurozone debt crisis has changed matters. The turmoil around the suggested

Greek referendum on the bailout package in November 2011 illustrated that a break-up is

no longer inconceivable. Following then-Prime MinisterPapandreous proposal for a

referendum, key European policymakers, including French President Sarkozy and euro-

group head Juncker, talked openly about a potential Greek exit from the eurozone.

European policymakers continue to argue that they will do what is needed to save the

euro. But the genie is out of the bottle, and various break-up scenarios are now being

discussed more openly. In December 2011, new ECB President Draghi even commented

on the consequences of a break-up in a Financial Times interview.

Fig. 1: Opinion poll measuring support for the euro

Note: Grey bars represent respondents who answered Yes tothe question, Do you think the euro will remain your nationscurrency in 10 years? Red bars represent respondents whoanswered Yes to the question, Do you prefer the euro to yourpast national currency? Source: Nomura, Wall Street Journal

Fig. 2: Italian CDS and default probability

Source: Nomura, Bloomberg

In this context, a key question is what form a potential break-up the eurozone could take.

There are various theoretical possibilities: a one-off departure of a single country, such asGreece; a sequential process, where weaker peripheral countries gradually peel off, like

50%

55%

60%

65%

70%

75%

80%

85%

EUR will remain

in 10 yrs

EUR is preferred

currency

0

100

200

300

400

500

600

Jan.08 Jan.09 Jan.10 Jan.11 Jan.12

bp

Over 30% probability

of default


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A sequential onion peeling break-up process: unlikely

We think a sequential break-up where the eurozone over time is reduced to a core of

strong eurozone countries is highly unlikely to be feasible in practice. This is at least the

conclusion if the time frame is just a few years. Such an onion peeling process, during

which weaker eurozone countries gradually exit, is likely to come to a halt when the

process reaches one of the larger eurozone countries, such as Italy or Spain. At this point,

we think the process would l ikely become uncontrollable and lead to a big bang collapse,

including the core countries.

There are three main reasons why we think an Italian exit and default scenario is unlikely

to be manageable and would translate into a big bang collapse of the eurozone:

First, Italy is a part of Europes core: Italy was one of only six founding members of the

EU more than 50 years ago. In fact, the founding treaty of the EU was signed in Rome in

1957. It is no coincidence that the ECB president is an Italian and that the previous ECB

presidents were also from original founding member countries (Duisenberg from the

Netherlands, Trichet from France). There may have been some doubt about Italys

position and role under Prime Minister Berlusconi. But after his resignation, Germany and

France have strongly endorsed Mario Montis technocratic government and Italy is clearly

back in the core.

Second, an Italian default and exit would likely bring down large parts of the

eurozone banking system: An exit by Greece or Portugal may be manageable given

that those countries are small, and given that preparations for potential debt restructuring

have already been under way for some time. But an Italian default and eurozone exit is a

completely different matter.

The size of Italys debt burden has precluded an explicit sufficient official sector backstop

up to this point, and an Italian debt restructuring may indeed be too much for the French

banking system to handle. Figure 3 shows the exposures of French banks to Italian

assets based on BIS statistics, and Appendix 1 contains some illustrative calculations of

potential losses for French banks. The losses for French banks in a situation of Italian

exit/restructuring could generate losses in excess of 20% of French GDP.

Given that the French debt to GDP ratio is already set to reach around 90% during 2012,this additional contingent liability and a related drop in the level of French GDP could see

the debt to GDP ratio jump to levels in the region 120%, similar to the level in Italy

currently.

Hence, an Italian default and exit scenario would likely make core eurozone banking

systems so unstable that capital controls would be a distinct possibility, at which point the

euro project would be obsolete.

Fig. 3: French exposure to eurozone periphery countries

Note: See Appendix I, Fig. 1 for further detail on exposure to eurozone periphery.

Source: Nomura, BIS

Third, European policymakers have already articulated that an Italian default wouldspell the end of the European Monetary Union: When Chancellor Merkel and

President Sarkozy meet with Mario Monti at the end of November 2011, Mr Montis office

Type of Exposure Greece Ireland Portugal Spain Italy Total

Public sector 10.7 2.9 6.2 30.5 106.8 157.0

Banks 1.6 9.8 6.2 38.6 44.7 100.9

Non-bank private 43.5 19.3 13.3 81.8 265.0 422.8

Total 55.7 32.0 25.7 150.9 416.4 680.7

French exposure to eurozone periphery ($ bn)


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of Italy would inevitably be the end of the euro. As such, policymakers already recognize

that failure to limit contagion to Italy would likely lead to a breakdown of the monetary

union altogether.

We therefore believe that even if a break-up begins to unfold in an onion peeling fashion,

it will eventually spin out of control and turn into a big bang break-up of the eurozone.

The conclusion is that policy makers should focus on contingency plans, which would

minimize the disruptions associated with a very limited break-up and a full-blown break-

up, in which the Euro ceases to exist. Those are the two main adverse scenarios to plan

for.


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Section 2:Legal aspects of redenomination

Eurozone break-up risk has risen notably during the second half of 2011 as European

policy makers have failed to put in place a convincing and credible backstop for the larger

eurozone sovereign bond markets. Given this increased risk, investors and policy makers

should think carefully about dynamics associated with redenomination of Eurodenominated assets and obligations in a break-up scenario . There are important legal

dimensions to this, including the legal jurisdiction of the assets and obligation in question.

In order to determine which contingency plans would be helpful to facilitate and orderly

break-up process, it is important to understand certain legal aspects of a redenomination

process.

Redenomination risk: Which Euros will stay Euros?

Countries do change their currency from time to time. Argentina moved away from an

effectively dollar-based economy in 2002, towards a flexible peso based currency system.

Similarly, currency unions have seen break-downs in the past. The break-up of theCzechoslovakian currency union in 1993 and the break-up of the Rouble currency area

between 1992 and 1995 are key examples from the relatively recent history.

In the context of the eurozone, the issue of redenomination is complex because there is

no well-defined legal path towards eurozone and EU exit. In addition, there is some

debate about the specifics of Article 50 of the Treaty on the Functioning of the European

Union (TFEU) and the immediacy of its applicability1. However, the recent political reality

has demonstrated that the lack of legal framework for an exit/break-up is unlikely to

preclude the possibility. Moreover, during its recent national congress the German CDU

party approved a resolution that would allow euro states to quit the monetary union

without having to also exit the EU. We note that this decision would need to be approved

by the national parliament before having any legal power. Nevertheless, it shows the

direction in which politics are moving.

Since the risk of some form of break-up is now material, investors and policy makers

should be thinking about redenomination risk2: Which Euro denominated assets (and

liabilities) will stay in Euro, and which will potentially be redenominated into new local

currencies in a break-up scenario?

The importance of legal jurisdiction

There are a number of important parameters, which from a legal perspective should

determine the risk of redenomination of financial instruments (bonds, loans, etc).

The first parameter to consider is the legal jurisdiction of an obligation.

If the obligation is governed by the local law of the country which is exiting the

eurozone, then that sovereign state is likely to be able to convert the currency of

the obligation from EUR to the new local currency (through some form of

currency law).

If the obligation is governed by foreign law, then the country which is exiting the

eurozone cannot by its domestic statute change a foreign law. If the currency is

not explicit to the foreign contract, then it may be up to the courts to determine

the implicit nexus of contract.

1 See P Athanasiou, Withdrawal and expulsion from the EU and EMU: Some reflections, ECB Legal Working paperseries no 10, Dec 2009, (seelink), although we note that the Commission has specifically said exit was not possible.2

See, e.g., Eric Dor, Leaving the Euro zone: a user's guide, IESEG School of Management working paper series,
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Full blown eurozone break-up: In a scenario where the eurozone breaks up inits entirety and the EUR ceases to exist, contracts cannot for practical purposes

continue to be settled in Euros. In this case, there are three basic solutions. (1)

obligations are redenominated into new national currencies by application of the

Lex Monetaeprinciple or there is significant rationale of the legal basis for the

argument ofImpracticabilityorCommercial Impossibility3. (2) where there is no

specific nexus established to a country which previously used the EUR, (and

thus the LexMonetae principle cannot be used), an EU directive could be

implemented ensuring that existing EUR obligations are converted into a new

European Currency Unit (ECU-2), reversing the process observed for ECU

denominated obligations when the Euro came into existence in January 1999.

(3) Euro denominated obligations could in theory be settled in an international

foreign currency, such as GBP or USD, as per terms implicit in English and NY

Law contracts, with exchange rates as determined by directive, legislation, or by

Courts

Fig. 4: Redenomination risk on eurozone assets

Source: Nomura

The need for an ECU-2 and EU directives in a break-up

There are a number of practical difficulties associated with creating a new European

Currency Unit (ECU-2) to provide a means of payment on EUR denominated contracts

and obligations. We will address those issues in detail in Section 7 ( Do you remember

the ECU?). For now, we simply want to highlight the introduction of the ECU-2 as a

attractive option for settling payment on EUR obligations and contracts in the full-blown

break-up scenario.

Without some overriding statutory prescription, the Courts are left having to decide the

currency of each contract. While this has certain advantages given the overall flexibility of

the Lex Monetae principle (see Box 3: Lex Monetae) for attempting inference as to the

originally intended (and likely more equitable) currency of the contract, in the event of

complete split-up, it is likely that a great many ambiguous cases result in arbitrary awards.

For example, if English courts decided on redenomination into British pounds, as case

Full-blown Break-up Scenario:

Euro ceases to exist

Unilateral withdrawal Multi laterally agreed exit

Securities/Loans etc

governed by

international law

No redenomination: EUR remains

the currency of payment (except

in cases of insolvency where local

coart may decide awards)

No general redenomination: EUR

remains currency of payment,

although certain EUR

contracts/obligations could be

redenominated using lex

monetae principle (if there are

special attributes of contracts)

and/or an EU directive setting

criteria for redenomination

Redenomination happens either

to new local currencies by

applying lex monetae principle or

by converting

contacts/obligations to ECU-2

Securities/Loans etc

governed by local law

Redenomination to new local currency (through change in local currency law, unless not in the interest

of the specific sovereign)

EUR remains the currency of core Eurozone countries

Small Break-Up scenario:


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law gives precedence to (as highlighted by Charles Proctor), clearly the redenomination

process would involve currency risk that would seem rather arbitrary, and would depend

crucially on conversion rates decided upon by courts, (i.e., most likely some last official

EUR-GBP exchange rate before trading halted). As we will discuss in more detail later,

the lack of an economically fair unit for settling purposes would likely lead to a large

number of redenomination related bankruptcies. This is the key attraction of a new

European Currency Unit.

While courts themselves will be unable to apply a conversion to a new ECU-2 without

some overriding legislation, it would be necessary for the EU Council to adopt a directive,essentially to the effect of:

Where the EUR was previously the currency of denomination of any contractthat is not so determined to have a nexus to any one particular country whichhad previously used the EUR, it will henceforth be redenominated into the ECU.

As Governing Law is one of several determinants of the nexus of a givencontract, it is altogether likely that national courts would only apply this directivein the case where the governing law is that of an EU country, not in theEurozone, i.e., England, Scotland, Northern Ireland, Wales, Sweden, Denmarkand the CEE. Furthermore this directive could only apply where there was nomeans for the courts to infer a nexus of the contract under the other typically

usual terms of Lex Monetae as highlighted in the grey box below.

Box 1: Lex Monetae

Lex Monetaeor the law of money is a well determined principle with a great deal of

case law. It is generally established that sovereign nations have the internationally

recognised right to determine their legal currency. Reliance on this principal was actually

key to the establishment of the EUR itself (see W Duisenberg, The Past and Future of

European Integration: A Central Banker s Perspective, IMF 1999 Per Jacobsson Lecture,

seelink).

For a brief overview of the principle, see C Proctor, The Euro-fragmentation and thefinancial markets, Cap Markets Law J (2011) 6(1) (seelink) or The Greek Crisis and the

Euro A Tipping Point, June 2011 (seelink) and for a more in-depth exposition as well as

the history of case law, C Proctor, Mann on the Legal Aspect of Money, 6th Ed, Oxford

UP, 2005 (seelink).

When thinking about the likely redenomination process, the following parameters are

likely to be crucial in order to establish the legal territorial nexus of contract/obligation:

1. Explicit Nexus of contract can be established via a (re)denomination clause: The

EUR or in any event the legal currency of from time to time.

2. Implicit Nexus of contract if

a. Contract is governed by the Laws of

b. Location of Obligor (debtor) is

c. Location which action must be undertaken (e.g., place of payment) is

d. Place of payment is

If no denomination clause exists, it is up to the courts to determine the Implicit Nexus of

the contract. Was EUR meant to be EUR or the currency of the ? If all

of the factors mentioned tie the contract to the , there is a rebuttable

presumption that the parties to the contract had intended to contract on the currency of

the . If one or more of the implicit tests fails, it is highly likely that there

is insufficient evidence to determine the link to the and the contract orobligation is likely to kept in EUR. We expect that under this principle, the vast majority of

English Law contracts originally denominated in EUR will remain in EUR (if it exists)
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Risk premia and legal jurisdiction

The overall conclusion from our perspective is that the risk of redenomination of EUR

obligations into new local currency is higher for local law obligations than for obligations

issued under foreign law, and this type of differentiation based on redenomination risk is

already starting to impact investor behavior.

This distinction is especially relevant in scenarios where the break-up is limited, and

where the EUR remains a functioning currency. In the alternative scenario of a full-blown

break-up, redenomination into new local currency or ECU-2 is possible even for foreign

law bonds, and there is a less clear-cut case for differing risk premia based on different

jurisdictions.

In any case, the immediate conclusion from an investor perspective should be that assets

issued under local law should trade at a discount to foreign law obligations, given the

greater redenomination risk for local law instruments. This conclusion is based on the

implicit assumption that a new national currency would trade at a discount to the Euro.

Obviously the validity of this assumption will depend on the specific country in question,

but most would agree that this assumption is l ikely to be correct for countries such as

Greece, Portugal, Ireland, Spain and Italy, and our analysis in Appendix III substantiates

this. The caveat to this argument is that insolvency may alter the conclusion. In the case

of insolvency, foreign law obligations may remain denominated in Euro (in a limited break-

up scenario). But there could still be a material hair-cut on foreign law obligations. Hence,in an insolvency, whether local law obligations should trade at a discount to similar foreign

law obligations will then depend on an evaluation of the higher redenomination risk

relative to the size of likely haircuts on local law vs foreign bonds. If hair-cuts on foreign

law bonds are higher than local law bonds, that could negate the redenomination effect,

and foreign law bonds should no longer trade at a premium in this scenario.

More detail on legal jurisdiction

In making contingency plans for various break-up scenarios, policy makers would need to

understand issues around the redenomination process in detail. This is an extremely

complex issue to think about in totality, and it would require significant leg work by keyEuropean institutions to aggregate issued at the micro level to a full macro perspective.

The table below highlights the legal jurisdiction of a number of key eurozone assets.

While we cannot claim completeness, we have attempted to highlight the appropriate

governing principals, whether Local, English or NY and the body of law (e.g. Banking Law

for deposits, Covered Bond law for Pfandbriefe, Company Law for Equities) which

governs each security, contract or interest. In the case of English or NY law, the only

relevant body of law likely will be contract law, as foreign law is only used as a means of

contracting outside of a local jurisdiction, and no specific foreign statute could have an

impact.

We give examples of the various financial instruments which trade. For instance, while

BTPs and GGBs are governed by local statute and local contract law and for the mostpart international bonds (Rep of Greece Eurobonds, and Rep of Italy Eurobonds) are

governed by English law or NY law, there are some countries which have issued

international bonds (i.e., for international investors) under local law, making the outcome

of a redenomination far less certain given the ambiguity of the nexus of the governing law.

What is obvious as well about this table is the vast number of master agreements which

underpin most financial transactions. These include the various swap agreements from

ISDA (under NY or English law) to those under French, German or Spanish law, as well

as the various Repo and Securities Lending master agreements and MTN platforms for

issuing bonds. Each master agreement involves far more paperwork than a single

standalone swap contract or bond. But the setup costs ensure that once the master

agreement is finished, individual swap and bond transactions can be documented quickly

and efficiently. Moreover some master agreements such as MTNs may be flexible enough

as to allow the issuance of bonds to be under various different governing laws.


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30 January 2012

Fig. 5: Governing law and standard financial securities and contracts

Source: Nomura

Governing Law Security Type Body of Law Examples

Local Law Sovereign Bonds, Bills Local Statute/Contract GGBs, Bunds, OATs

International Bonds Local Contract Rep of Italy, Kingdom of Spain, etc

Corporate Bonds Contract

Covered Bonds (Pfandbriefe, OF,Cedulas, etc)

Covered Bond Law(Pfandbriefe)

Pfandbriefe, Obligacions Foncieres,Cedulas, Irish CBs

Schuldscheine (marketable loans) Contract Banking schuldscheine

Loans Contract

Equities Company Any EU Equity

Commercial Contracts Contract

Deposits Banking Law CDs

English Law Sovereign Bonds Contract Greek Euro-bonds, Rep Italy

Eurobonds, Kingdom of Belgium USD-

denominated bonds

Corporate Bonds (Euro-bonds) Contract

Loans (Euro-Loans) Contract Euro-Loans


NY / Other Law Sovereign Bonds Contract Yankees, Samurai, Kangaroos, Maple,

Bulldogs, Dim Sum, Kauri, Sukuk, etc

Corporate Bonds Contract

Loans Contract


Master Agreements International Swap Dealers

Association (ISDA)

English or NY Contract IR Swap/Fwd, FX Swap/Fwd, CDS,

Bond options

Commodity Master Agreements Various for each commodity Gold Swaps/Forwards, Electricity

Swaps/Fwds, etc

Rahmenvertrag fr

Finanztermingeschfte (DRV)

German Contract Swaps and Repos with German

counterparties

Fdration Bancaire Franaise

(AFB/FBF)

French Contract Swaps with French counterparties and

all local authoritiesContrato Marco de Operaciones

Financieras (CMOF)

Spanish Contract Swaps with Spanish counterparties

ICMA Global Master Repurchas e

Agrement (GMRA)

English Contract Repo Agreements

Master Repurchase Agreement

(MRA)

NY Contract Standard NY Law Repo Agreements

European Master Agreement (EMA) English Contract Repo wi th Euro-systems NCB/ECB

General Master Securities Loan

Agreement (GMSLA)

English Contract Sec lending

Master Securities Loan Agreement

(MSLA)

NY Contract Sec lending

(Euro) Medium Term Note

Programme (MTN/EMTN)

English or NY Contract WB, Rep Italy, EIB MTN Programmes

Other Bond Futures (Eurex) German Contract Bund, Bobl, Schatz, BTP Futures on

Exchange

IR Futures (Liffe) English Contract Euribor Contracts on Exchange

Equity Futures Local Law/English Law SX5E, DAX, CAC40, MIB, IDX, IBEX,

BEL20, PSI-20,WBA ATX

OTC Futures English or NY Contract Client back-to-back futures with

member firm

Clearing Houses (LCH, ICE, etc) Engl ish Contract, etc Repo, CDS etc via clearing houses

Cash Sales Sales or Transaction All cash sales prior to settlement (i.e.,

before T+3)


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30 January 2012

The judicial process

In terms of the judgment, there will likely be some variance as to courts decisions based

on both the method for introduction of the new currency and any legislation directly

binding on the courts. The general criteria for decision is as follows:

Local Courts

Specific Legislation (a currency law) for Redenomination of Local Contractsinto new currency can bind courts and overrule any contractual terms. It is

particularly likely that contractual terms will be changed to re-denominate alllocal law contracts.

English Courts:

Lawful and Consensual Process implies application of Lex Monetaeprinciple: if legal nexus is to the exiting country then redenomination can

happen in some cases. Otherwise, the Euro will remain the currency of

payments.

Unlawful and Unilateral Withdrawal - No redenomination -- As UK issignatory to the Treaties, unlawful withdrawal is manifestly contrary to UK public

policy and no redenomination will likely allowed.

EU Directive/UK Statute to redenominate and ensure continuity of contract :English Court must uphold UK statute and/or interpret UK Statute so as to be in

agreement with EU directive and re-denominate.

NY/Other Courts:

Lex Monetae principle: If legal nexus is to the exiting country thenredenominate. Otherwise, leave in euro.

NY (or other) Statute to redenominate and ensure continuity of contract.NY Courts must uphold NY State Legislation and redenominate contracts if so

directed.

We note that the difference between lawful and unlawful exit/breakup is crucial for UK

courts. This is, in particular, because the UK was signatory to the treaties, and unlessotherwise directed, a Legal tender law from an exiting country in flagrant violation of the

treaties will be considered to be manifestly contrary to UK public policy and the Lex

Monetae of the Exiting Country will likely not be upheld in UK Courts. The legality of exit

is of little consequence to NY and other non-EU courts and probably will not prejudice

their judgments.

We thus expect that foreign law will insulate contracts from redenomination in the vast

majority of cases, and in the UK in particular, will do so in all cases when the method of

exit is unilateral and illegal. The one overriding concern would be the introduction of

legislation (NY or EU/English) which circumvents any court decision, although due to the

politics of exit, it is unlikely that any such legislation would occur unless there were

complete breakup.

In a scenario where the eurozone breaks up in its entirety and the EUR ceases to exist,

contracts cannot for practical purposes continue be settled in Euro s. In this case, there

are two basic solutions. Either obligations are redenominated into new national currencies

by application of the Lex Monetae principle or there is significant rationale of the legal

basis for the argument ofImpracticabilityorCommercial Impossibility4. Alternatively,

existing EUR obligations are converted into a new European Currency Unit (ECU-2),

reversing the process observed for ECU denominated obligations when the Euro came

into existence in January 1999.

With specific mention of sovereign bonds, it is likely that local law sovereign bonds will

immediately be redenominated, while the foreign-law bonds, with obvious international

distribution, would likely remain in EUR.


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Enforcement

The court of judgment is of some matter, but the court of enforcement is of paramount

importance in determining payoffs. In particular, if the court is:

Local Court:

Courts will enforce only in the local currency (as per the new Currency law) andconversion will take place at the time of award or at some official rate (which

may differ from the market rate (see Nomura s Global Guide to Corporate

Bankruptcy, 21 July 2010,link.)

Insolvency: If the entity is undergoing an insolvency governed by local law,conversion is generally made at time of insolvency f iling (irrespective of eventual

award).

There probably will be uncertainty over the timing of payment and the conversionrate may not be at market rates, but exchange controls may further complicate

repatriation of awards.

English NY/Other Court:

Redenomination is unlikely to change the award and enforcement will likely bemade in appropriate foreign currency.

Insolvency: If English or other court is determined to be the appropriatejurisdiction for insolvency, then delivery in appropriate foreign currency (see

Global Guide to Corporate Bankruptcy,link)

The combination of the award and the enforcement risk highlight a number of interesting

credit concerns. If there is an exit, local law instruments will typically be redenominated

and there will be little protection in them, but foreign law affords far greater protection. If

on the other hand the exit also involves an insolvency, foreign law instruments may

similarly afford little protection. This would be true, for instance, for Greek bonds.

Generally, investors look to Greek Eurobonds for the extra protection afforded by English

Law in an attempt to avoid some of the restructuring risk in GGBs. If, on the other hand,

we take exit into account, it would make more sense for the Greek government to

continue to service their GGBs using seignorage revenue (or perhaps with support of theCB) and default on the overly expensive Eurobonds. The current PSI discussions

underway, however, appear to give little comfort to holders of either Greek or foreign law

debt.

Legal aspects of redenomination and contingency planning

The purpose of this section has been to outline a number of important legal aspects of a

currency redenomination process in a Eurozone break-up. A detailed understanding of

these conceptual issues is a prerequisite for adequate contingency planning in an orderly

redenomination process for European policy makers.

In the next section, we will offer some preliminary estimates of the size of various Euro

exposures, broken down by legal jurisdiction. Proper planning for orderly redenomination

should be guided both by the underlying conceptual legal aspects of redenomination as

well as the economic importance of certain types of exposures currently in place across

the broadest possible spectrum of relevant markets.
http://intranet.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=382043http://intranet.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=382043http://intranet.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=382043http://intranet.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=382043http://intranet.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=382043http://intranet.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=382043http://intranet.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=382043http://intranet.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=382043


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30 January 2012

- EUR684bn of foreign law bonds in the financial issuer category.

- EUR432bn of foreign law bonds in the non-financial (corporate)

category.

We note that the available data does not have information about jurisdiction for every

single issue. For sovereign issues, this seems a smaller problem, as most issues have

this information. But for non-financial issuers (corporations) the information about legal

jurisdiction is unknown for the majority of issues. However, among the issued with known

jurisdiction we find that EUR432bn or 60% is under foreign law. If we apply this

percentage to the entire population of Euro denominated corporate debt, it suggests that

EUR1.3 trillion could be issued under foreign law. This highlights that the redenomination

process could be extremely complex for corporate debt in general.

Figure 6 below has the detailed figures broken down by the eleven Eurozone countries

which we have scanned (Noting that amounts listed under the sovereign header include

subsovereigns, i.e., regions and municipalities, and agencies):


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30 January 2012

Fig. 6: Euro-denominated bond amounts outstanding in the eurozone (EUR bn)


The table below, Figure 7, offers additional detail on the specific foreign jurisdiction which applies. As it turns

out, the most relevant foreign jurisdictions are English, German, and New York. For simplicity, the data isreported as aggregate figures, rather than broken down by individual Eurozone countries. The main message

here is that English law accounts for the majority of all foreign law issues, especially for sovereign and

financial issuers. For the non-financial (corporate) issuers, we note that a number of Eurozone issuers seem

to use German law rather than their own domestic jurisdiction. Meanwhile, New York law applies to just below

10% of financial and non-financial issuance under foreign law, and less than that for sovereign issues.

Fig. 7: International EUR-denominated bond amounts outstanding (EUR bn)


Euro denominated derivatives by legal jurisdiction

Turning to derivatives markets, the importance of foreign law jurisdiction grows further,

including for basic markets such as FX forwards, FX swaps, and interest rate swaps.

These contracts are generally written with reference to English and New York law, which

would add significant complexity to any redenomination process.

Moreover, these markets are very large in size. The outstanding notional of FX forwards

and FX swaps is potentially very large, potentially in the EUR15-25trillion range.

We are not aware of any official estimates of the notional size outstanding of FX forwards,

but one way to proxy it would be to look at daily turnover statics, estimate average

maturity of contracts, and supplement with information about the Euros share in thesetransactions

Local LawForeign

LawUnknown Local Law

Foreign

LawUnknown Local Law

Foreign

LawUnknown

Austria 176 2 1 151 58 30 11 19 9 459

Belgium 309 16 5 2 7 1 10 9 86 446

Finland 69 1 0 9 14 10 3 8 1 115

France 1421 19 12 422 139 125 139 89 100 2466

Germany 1530 1 23 2053 66 130 54 16 43 3916Greece 256 9 5 19 18 47 2 3 1 360

Italy 1517 74 14 567 141 90 17 43 210 2673

Ireland 114 0 0 51 111 49 0 15 239 579

Netherlands 282 15 0 188 81 131 23 196 448 1363

Portugal 107 13 2 39 16 22 16 2 26 244

Spain 638 74 16 490 32 33 14 32 279 1608

Total 6420 224 80 3990 684 670 288 432 1443 14230

Sovereign Financial Nonfinancial

Total

Amount

Outstanding

(EUR bn)

%

Amount

Outstanding

(EUR bn)

%

Amount

Outstanding

(EUR bn)

%

Total 258.7 100% 2304.4 100% 1931.6 100% 4494.7

Unallocated 79.6 31% 669.8 29% 1442.5 75% 2191.9

Allocated 179.0 69% 1634.7 71% 489.0 25% 2302.7

Local 121.0 68% 1060.2 65% 138.2 28% 1319.4

Foreign 58.1 32% 574.5 35% 350.8 72% 983.3

English 51.7 89% 454.4 79% 200.7 57% 706.8

New York 2.1 4% 50.2 9% 31.1 9% 83.4

German 1.9 3% 42.9 7% 115.1 33% 159.9

Other 2.3 4% 26.9 5% 3.9 1% 33.2

NonfinancialSovereign Financial

Total


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30 January 2012

- The latest Tri-annual BIS surveys states daily FX market turn-over of

$2.5trillion, when excluding spot transactions),

- The average tenor of contracts traded is estimated to be roughly around

1 month, based on input from Nomuras Foreign Exchange Franchise.

- The Euro share of FX market turn-over is 40%, again according to BIS.

Working with the assumption of 22 trading days in a month, this would give a proxy

estimate of outstanding notional of Euro denominated FX forward, swap and other

derivates of around USD22 trillion, or EUR17 trillion at the current EURUSD exchangerate. Without going into details, we simply note that the outstanding notional amounts of

Euro based interest rate swaps is also very large.

Since it is generally the case that these instruments are traded predominantly under

English or New York law agreements, it would be very complicated to redenominate such

contracts in an economically fair fashion in a break-up scenario, as they would have no

clear nexus to a given country.

Euro denominated loans assets by legal jurisdiction

As with derivatives contracts, there is a general lack of information about the legal

jurisdiction under which loans are extended. BIS data for the third quarter of 2011, which

were released in January 2012, shows that total cross-border loan exposure in Euro

reported by global banks add up to USD11 trillion.

It is our understanding that a large portion of these loans are governed by foreign laws,

particularly English law , although we are not aware of any publicly available database to

quantify the split by legal jurisdiction more specifically.

Information gaps and redenomination complexity

The bottom line from the examples presented here is that Euro denominated exposure in

foreign law contracts is very large. In addition to the relatively well-defined exposure inbond markets (in the region EUR2.5 trillion), there may be around EUR10 trillion such

exposure in the form of cross-border EUR denominated loans. In addition, FX related

derivates, may involve outstanding notional amounts in the region EUR15-25 trillion.

Even excluding the exposure through Euro denominated interest rate swaps, aggregate

exposure to foreign law Euro denominated instruments could easily add up to a figure well

in excess of EUR30 trillion.

And since the majority of these instruments are governed by foreign law, it would create

major redenomination issues in a break-up scenario. One added complexity is the fact that

many such transactions involve laws of several countries. For instance, it would be

possible to have issued an ABS securitization of Spanish assets under English law. There

are similar complexities involving so-called back-to-backs, where banks generallyintermediate trades which are meant to be economically hedged, but the underlying

contracts have several jurisdictions. A common example is members facing Eurex under

German law, but facing non-member investors in a back-to-back contract under English

law.

Regulators would need to investigate the break-down of assets by legal jurisdiction more

carefully to close the current information gap. The analysis above of bond market

information is based on a sample of more than four hundred thousand bonds. But this

sample is not covering the entire spectrum of bonds outstanding. More importantly, there

is almost no aggregate data available on the legal jurisdiction of derivatives and loan

contracts.

Regulators, in preparation for a possible break-up, should seek to quantify the exposures

at the institutional level to instruments of different jurisdiction, in order to determine implicit

open currency exposures and determine the need for planning across various


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30 January 2012

jurisdictions, including English, New York and other jurisdictions. In particular, these

derivative transactions and back-to-backs where several legs could potentially be

differently redenominated, which will be the cause for far greater scrutiny by regulators

and Courts seeking resolutions which are the least disruptive to the majority of

counterparties involved.


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30 January 2012

Section 4:Cost-benefit aspects of planning ahead

There is a general perception that any mention of contingency plans for a euro-zone

break-up would lead to increased investor anxiety. But investor concerns about the risk of

a eurozone break-up are already present. Moreover, the elevated uncertainty about key

legal and political aspects of a possible redenomination process makes it hard for

investors to manage risk related to their eurozone exposures. At this point in the crisis,communicating contingency plans for a break-up would reduce uncertainty, rather than

add to it, and potentially even improve the current capital flow situation.

Uncertainty about the eurozone is affecting investor behavior

There was no plan for a eurozone break-up when the European Monetary Union was

created. In fact, policymakers made an effort not to spell out any procedures for an exit

from the eurozone as euro adoption was supposed to be irrevocable. But the genie is

now out of the bottle.

As mentioned in Section 1, various forms of eurozone disintegration are possible, ranging

from a very limited break-up (involving one or a few small countries), to a full-blown

break-up (which would see the euro cease to exist).

The increasing risk of a break-up is already having an impact on investor behaviour.

Since the Italian bond market came under pressure in mid-2011, foreign investors have

been looking to reduce their eurozone exposure across the board, both in the periphery

and in the core.

In December 2011 and January 2012, we have also seen a shift in euro trading dynamics.

Euro weakness is now seen in the strength of currencies from both emerging markets and

other European countries relative to the Euro. This is a departure from patterns observed

up to November, when euro weakness was concentrated versus the US dollar and the

Japanese yen. The recent broadening of the euro weakness points to nascent capital

flight out of the eurozone. This would be a disturbing development, if it continues.

Since fears about a break-up are already present and affecting investors flows, the cost-

benefit analysis of announcing contingency plans for a break-up is very different to what it

would have been in 1999. At this juncture, contingency plans would help to reduce

uncertainty, rather than add to it.

The private sector is making contingency plans in any case

Foreign investors around the world, as well as institutions within the EU are already trying

to make contingency plans for a eurozone break-up. The types of market participants

making such plans includes global central banks and major banking institutions. There iseven evidence that some regulators outside the eurozone are asking banks to submit

contingency plans for various eurozone break-up scenarios.

Against this background, the cost-benefit analysis of planning ahead versus pretending

that a break-up is not possible has shifted:

Back in 1999, it would have created unnecessary uncertainty to spell out procedures for

and exit (although perhaps it could be argued that awareness of the exit possibility it

would have avoided the seemingly irrational spread compression in Eurozone bond

markets generally observed during 1999-2007).

Today, the cost-benefit analysis is clearly different. The worlds biggest investors are

already drawing up contingency plans. They have to, since objective market based

metrics are showing high default risk in the biggest eurozone bond markets, and since

policy makers are increasingly open about the possibility of various break-up scenarios,
http://www.ft.com/intl/indepth/euro-in-crisishttp://www.ft.com/intl/cms/s/3/5d05d33c-27fb-11e1-9433-00144feabdc0.html#axzz1j0yfAT35http://www.ft.com/intl/cms/s/3/5d05d33c-27fb-11e1-9433-00144feabdc0.html#axzz1j0yfAT35http://www.ft.com/intl/indepth/euro-in-crisis


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30 January 2012

There is no simple way to prove that these specific considerations are affecting investor

investor behavior and flows. But recent trends in Eurozone cross-border capital flows

point to a new form of structural weakness, suggesting that concerns of a new type is

driving investors away.

In the July to November period, foreign investors purchased eurozone fixed income

instruments to the tune of only EUR66bn, or EUR160bn annualized. This compares to an

inflow of EUR270bn in H1, or EUR540bn annualized, and is a very large swing (see

Figure 8).

Only a small part of the eurozone bond market has consistently traded as a risk-free

asset. Downgrades have hit Italian and Spanish bonds, and all major rating agencies

have recently warned that France could see its AAA rating put in question. More

generally, there is now a certain type of stigma associated with European exposures,

making it more difficult for US banks to hold such exposures, for example.

These factors point to a more structural form of weakness, which is less likely to be

impacted by short-term changes in risk sentiment. The fact that weakness in inflows into

Eurozone debt instruments has persisted over the July-November period, through ups

and down moves in risk assets, supports this notion.

Importantly, investors are no longer substituting from the periphery to the core. This was

the case in 2010, when weakness in the periphery tended to generate additional demand

for German and French bonds. But in the second half of 2011, there has been no

evidence of a substitution effect. In fact, foreign sales appear to be broad-based,

including sales of core eurozone bond holdings.

Fig. 8: Fixed income investment into eurozone (monthly by region of investors)

Note: 3 month moving average. Source: Nomura, Bloomberg, MOF, US Treasury.

For example, private investors in Japan, were large net-sellers of eurozone fixed income

assets during August November (see Figure 9), and they were selling not only the three

small peripheral countries, and Spain/Italy. They were also selling out of core exposures.

In addition, global central banks demand for Eurozone bond appear to have dropped too.

This is partly a function of slower global reserve accumulation than normal. But it could

hint at a shift in preference for eurozone bonds within the official sector too.

-40

-20

0

20

40

60

80

2007 2008 2009 2010 2011

USJapanOther areaTotal

(EUR bn)

Net selling


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30 January 2012

Fig. 9: Japanese investment in eurozone fixed income (periphery, Spain/Italy, and core)

Note: Monthly figures calculated as 3-month moving average. November figure is Nomuraestimate. Source: Nomura, MOF, Bloomberg.

Uncertainty makes risk-management difficult

Making contingency plans is currently very difficult given the huge legal uncertainty

around the break-up process. It is very difficult for investors to assess with confidence

what would happen to certain assets and obligations in a break-up scenario:

- What is the redenomination risk for local law assets?

- How would the redenomination process work for the myriad of English

and New York law assets?

Against this background, there is now an opportunity to reduce ex ante uncertainty by

offering a plan. This advantage comes in addition to the benefits such well thought out

plans would have on market functioning in an actual break-up.

As we will detail below, a suitable contingency plan will offer guidance on orderly

redenomination of euro-denominated assets and obligations in a break-up scenario. Such

guidance is crucial in connection with a full-blown break-up scenario, in which the euro

would no longer exist as a currency. This specific scenario involves a host of very

complex redenomination issues associated with the very large number of assets and

obligations which are subject to English law (not the laws of the eurozone countries). The

basic problem is that it is extremely difficult to predict with confidence how the

redenomination process would work for such instruments.

At the current time, foreign investors are leaving eurozone fixed-income markets, in part

due to the uncertainty about break-up and redenomination risk. A contingency plan for

orderly asset redenomination in a break-up scenario could help alleviate investor worries

about the tail-risk for eurozone assets, and may improve the current capital flow situation

and funding costs for sovereigns. Ironically, spelling out guidelines for a eurozone break-

up may at this stage in the crisis even help to reduce the risk of the break-up itself.

-8

-6

-4

-2

0

2

4

6

8

2007 2008 2009 2010 2011

Other countries

Spain & Italy

3 peripheral countries

Euro area total

(EUR bn)

Net selling


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30 January 2012

Section 5:Key steps in planning for a break-up

Having outlined the very complex legal aspects of redenomination of foreign law assets

and illustrated the huge size of assets and obligations issued under foreign law, we are

ready to outline key steps needed to facilitate an orderly currency redenomination

process. We propose four key elements in a contingency plan: 1) Offer guidance on the

redenomination process for local and foreign law assets; 2) Specify the role of a newEuropean Currency Unit (ECU-2) in the redenomination of foreign law assets and

obligations; 3) Create a hedging market for intra-EMU currency risk; and 4) adopt

regulation which over time is aimed at reducing intra-EMU currency risk for systemically

important institutions.

We have outlined that various forms of eurozone break-up are distinct possibilities, and

that investors are already making contingency plans for various scenarios, and that this is

already having an adverse impact on capital flows.

A break-up of the eurozone is hardly going to be a smooth process. In the best of

circumstances it is likely to be very disruptive indeed. Nevertheless, the quality of the

preparation will be crucial in determining the degree of disruption.

In a disorderly break-up scenario, with little forward looking guidance on the

redenomination process, court decisions on redenomination are l ikely to be inconsistent,

potentially arbitrary from an economic stand-point, and they are likely to be very slow.

This would be a worst case outcome.

Aiming to avoid unnecessary disruption

The fall-out from a disorderly redenomination process, for which market participants

would have had little chance to prepare, would likely be to trigger a large number of

bankruptcies among banks, corporations, and other financial market participants.Importantly, a significant portion of bankruptcies would be arbitrary, linked to specific

court decisions, and would affect viable companies and financial institutions. Overall, this

would raise the risk of more severe than necessary banking crisis, with create a negative

impact on actual and potential growth for a prolonged period of time.

We will not try to directly quantify the negative effects associated with a disorderly and

unmanaged redenomination process, although it would be an important an interesting

exercise. But our prior is that these negative effects would be very large. The huge size of

Euro denominated assets and obligations (as illustrated in Section 3) would create new

open currency exposures in a break-up scenario. Combined with the current inability to

hedge those exposures (as discussed in Section 8) suggests that a large wave of

bankruptcies would be triggered in Europe and globally as a function of losses on new

currency exposures associated with the redenomination for specific institutions.

A key goal for an orderly break-up process would be to reduce the amount of

bankruptcies triggered by redenomination itself. There would likely be insolvencies

associated with sovereign defaults, but that is a separate matter. An orderly break-up

process should facilitate redenomination in a way where the break-up is not in itself a

catalyst for unnecessary disruptions, including those triggered by losses on new currency

exposures associated with the redenomination process.


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30 January 2012

Four steps in an plan for and orderly break-up

Four specific steps would be important in a contingence plan for a break-up.These steps are aimed at avoiding unnecessary disruptions and bankruptciesassociated with currency losses on new currency exposures resulting from aredenomination. Clearly this is only one aspect of managing an orderly break-upprocess. But given the size of exposures involved, and the current inability tomanage risks around those exposures, it is probably one of the most importantaspects. And it is certainly one aspect to which sufficient attention has not yet

been given.

We propose the following four steps as part of the contingency planning:

STEP 1: Communicate guiding principles for the redenominationof Eurodenominated assets and obligations under local and foreign law in variousbreak-up scenarios.

STEP 2: Define the role of a new European Currency Unit(ECU-2) in thesettlement of EUR denominated assets and obligations under foreign lawin a full-blown break-up scenario.

STEP 3: Create a hedging market for intra-Eurozone currency exposure,including creating a non-deliverable FX forward market for potential newnational currencies of current eurozone member countries and creating ahedging market for potential ECU-2 exposures following a break-up.

STEP 4: Introduce a new regulatory framework to reduce intra-Eurozonecurrency exposurefor systemically important institutions in preparationfor a eurozone break-up, by encouraging hedging of potential new FXexposures..

This four-step plan would not address the disruptions associated with sovereigndefaults, disruptive capital flows; nor does it outline plans for how to dissolve the

ECB. Those, and other important aspects of a holistic contingency plan, wouldhave to be analyzed in detail separately. But the plan does present a frameworkfor facilitating an orderly currency redenomination process. In the absence ofsuch a framework, any break-up of the Eurozone is likely to be devastatinglydisruptive, highlighting the importance of such specific contingency plans, as apart of an overall package of contingency plans.


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Section 6:Guiding principles for redenomination

Communicating guiding principles for redenomination of Euro denominatedassets and obligations under local and foreign law ahead of a break-up would becrucial. Communication ahead of the event would allow market participants toprepare efficiently, helping to avoid triggering bankruptcies and other disruptionsas a function of losses on new currency exposures. Clear communication on

guiding principles for the redenomination process ahead of time would helpresolve uncertainty in the planning process, and reduce delays associated withlegal disputes following an actual break-up.

Step 1 of an orderly currency redenomination process would be to communicate, ahead

of time, the key guiding principles for the redenomination of both local law assets and

foreign law assets.

The so-called Lex Monetae principle could help establish an initial framework for

redenomination of some assets and obligations, and the guiding principles of the

redenomination process should specify the application of those principles in some detail,

as appropriate.

If it can be argued that the currency of a given obligation refers to the currency of a

certain country, rather than the euro (the currency of the European Union), then

redenomination from euro to the new national currency is feasible, and in some cases

probably desirable from the perspective of limiting disruptive redenomination.

Guiding principles for redenomination of local law assets

As mentioned in section 2, it would generally be relatively straight-forward to devise a

fairly efficient redenomination process for local law assets and obligations. Each

Eurozone country, following a limited for full-blown break-up, should be able to

redenominated assets and obligations in accordance with a new currency law.

Nevertheless, in planning for an orderly EMU break-up, it would be beneficial to

communicate guiding principles for this process, to clarify areas of legal uncertainty, andmake planning more efficient.

The guidance principles should correspond to established legal principles in the area,

such as those outlined in Section 2. And the guidance will be particularly important in grey

areas where exposures are large from a macroeconomic perspective.

Guiding principles for redenomination of foreign law assets

Importantly, there is an essential need to reduce the very high level of legal uncertainty

about the process around redenomination of Euro denominated assets and obligations

under foreign (non-Eurozone) law in a full-blown break-up scenario.In this scenario, some form of redenomination would be necessary, by definition. But no

single existing currency globally would provide a good and fair redenomination option, nor

would any of the potential new national currencies of Eurozone countries. As we will

detail in the following section, there is a need to specify a role for a new European

Currency Basket (ECU-2) in this scenario as a means to settle payments on Euro

denominated assets and obligations.

Fortunately, the majority of foreign law contracts (as indicated in section 3) are under the

jurisdiction of English law. Since the United Kingdom is a member of the European Union,

there is an opportunity to use EU directives to guide the redenomination process for

contracts under English law. This was the process used for ECU denominated assets

were redenominated into Euro in 1999, and it would be logical to use the same process inreverse in a eurozone break-up scenario.


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This does not directly address the redenomination of Euro denominated assets under the

jurisdiction of countries and states outside the European Union. But these assets and

obligations are smaller in size (although derivates exposure under New York law is very

significant). Importantly, if an EU directive can offer guidance for redenomination of

English Law and other non-eurozone EU area assets and obligations, there is hope that

New York courts and other courts will follow that precedent. That was the case in

connection with the redenomination of ECU denominated assets in 1999, and it could be

the case again in the future.


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Section 7:The new European Currency Unit (ECU-2)

A new European Currency Unit (ECU-2) could play an important role infacilitating an orderly redenomination process for the myriad contracts andobligations under foreign law without a clear country specific nexus. The ECU-2would be mechanically linked to the performance of new national currencies ofeurozone countries in accordance with a pre-determined weighting scheme. The

ECU-2 would play a crucially important role in facilitating efficient redenominationof foreign law contracts, and thereby serve to minimize unnecessaryinsolvencies due to protracted legal battles about redenomination issues anddue to losses on new currency exposure, some of which could be purely afunction of unpredictable court decisions

Step 2 of an orderly currency redenomination process would be to specify the role of a

new European Currency Unit (ECU-2) as a means of settling Euro denominated contracts

under foreign law in a full-blown break-up scenario.

The advantage of the basket currency redenomination

The advantage of applying an ECU-2 based redenomination is that it removes legaluncertainty around obligations that would otherwise be difficult to re-denominate into

national currencies.

There are many examples of obligations and contracts where there is no clear nexus to a

specific eurozone country. Examples where it would be very hard to link EUR-

denominated obligations to a specific country include:

A EUR-denominated loan from a UK bank to a Polish corporation.

A EUR/USD FX forward transaction between a Japanese bank and a US assetmanager.

A fixed/floating interest rate swap between a French bank and a German

insurance company.

We have argued (in Section 3) that the notional value of contracts and obligations where

a re-denomination into new national currencies would be problematic and potentially

arbitrary is very large. Without claiming any great degree of precession, we suggested

that foreign law Euro denominated instruments could easily amount to something in

excess of EUR30 trillion in terms of notional value, including foreign law bonds, cross-

border loan contracts, and FX derivatives such as currency forward contracts (but

excluding interest rate swaps).

How the redenomination process would work for assets and obligations of this nature is

crucially important since case law suggests that contracts and obligations are unlikely to

be frustrated simply due to their redenomination. Contracts and obligations would

continue to live on after the euro ceased to exist. Hence, making the redenominationprocess as smooth, fair and efficient as possible is an important goal in its own right,

including in relation to macroeconomic performance, such as growth.

From this perspective, a new European Currency Unit (ECU-2) which would be a basket

currency linked to new national currencies according to a pre-determined weighting

scheme - could play an important role in facilitating an orderly redenomination process for

the myriad contracts and obligations that do not have a clear country specific nexus.

By issuing an EU directive, English courts would be instructed to interpret EUR in any

contract to mean ECU-2 thereafter. In this context, we note that the Euro itself was

created by the process of EU directives as well as passage of legislation in NY, Tokyo

and other localities (while some were determined to need no further statutes)5. These

statutes were passed to ensure continuity of the contract and in order to do so, they

5
http://www.law.harvard.edu/programs/about/pifs/research/15scott.pdfhttp://www.law.harvard.edu/programs/about/pifs/research/15scott.pdfhttp://www.law.harvard.edu/programs/about/pifs/research/15scott.pdfhttp://www.law.harvard.edu/programs/about/pifs/research/15scott.pdf


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specifically stated that frustrations that force major clauses, redenomination clauses or

the possibility of claiming material adverse change would all be overruled. In order to

ensure a timelier and more certain outcome, an EU directive could compel UK courts to

re-denominate contracts into some official new currency such as the ECU-2, at a

specified rate.

Fig. 10: ECU basket currency weights over time

Note. Source: Nomura, ECB

As mentioned, the new European Currency Unit (ECU-2) would be a basket currency

linked to the new national currencies created after a break-up akin to the original ECU

basket (although there would be technical differences, as detailed below).

The value of the new ECU would be mechanically linked to the performance of the new

currencies of previous eurozone countries, and the redenomination process would mirror

how ECU-denominated instruments were redenominated into euro in 1999.

Potential weights of the new ECU

The specific nature of any break-up process would play a role in determining the weights

of individual national currencies in a new European Currency Unit (ECU-2).

If the break-up process happens in sequential fashion where weaker eurozone countries

exit before the later full-blown break-up, then there would be zero weight attached tocertain of the current eurozone countries in the new European Currency Unit.

However, if a break-up happens more like a big-bang, presumably all eurozone countries

(including weaker eurozone countries) would have a weight in the ECU-2, provided that

the break-up is multilaterally agreed.

Based on our analysis in Section 1, we would focus on scenarios where all major

eurozone countries will have a weight (as would be the case in a big-bang break-up). For

illustrative purposes, we also show weighting schemes where Greece, Ireland and

Portugal are excluded, based on the idea that they could exit the eurozone before a big-

bang collapse. But given their small size and small equity weights in the ECB, it does not

make a large economic difference whether they are excluded or not.

The original ECU weights, shown in Figure 10 were determined based on the size of the

economy and the magnitude of intra-EU trade, although no strict mathematical formula

Apr 1990 - Nov 1992 Nov 1992 - Mar 1995 Mar 1995 - Dec 1998

Belgium 7.8% 8.1% 8.4%

Denmark 2.5% 2.6% 2.7%

Germany 30.5% 31.7% 32.7%

Greece 0.8% 0.6% 0.5%

Spain 5.2% 4.8% 4.2%

France 19.4% 20.2% 20.8%

Ireland 1.1% 1.2% 1.1%

Italy 9.9% 9.0% 7.2%

Luxembourg 0.3% 0.3% 0.3%

Netherlands 9.5% 9.9% 10.2%

Portugal 0.8% 0.8% 0.7%

UK 12.1% 10.9% 11.2%

Austria - - -

Finland - - -

Estonia - - -

Cyprus - - -

Malta - - -

Slovenia

Slovak Republic - - -

Total 100.0% 100.0% 100.0%

Original ECU weights


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ECB equity weights (derived from the size of the national population and GDP) will be

used.

The current ECB equity weights are shown in Column A in Figure 11 below (in a raw and

not normalized fashion).

Baseline ECU-2 weights, based on normalized ECB weights, are shown in column B of

the table. Note that we have excluded the six smallest eurozone countries from this

calculation (Luxemburg, Cyprus, Malta, Slovenia, Slovakia and Estonia). This is because

their weights are likely to be very small (their combined ECB weight is 1.9%) and because

having very small and illiquid basket components in the new ECU may make it harder to

manage from an operational perspective. Specifically, considerations around liquidity may

make it preferable not to have very small currencies in the basket, and this type of

consideration could be used to exclude additional currencies, as appropriate.

Linked to this, an additional caveat in relation to the weights is that the ECU would only

work if new national currencies remain convertible and actively traded. This is similar to

the considerations behind the IMFs SDR basket, which only consists of highly liquid

convertible currencies (USD, EUR, JPY and GBP). Such considerations could become

particularly relevant in a situation where the break-up process creates a need for capital

controls in certain countries (as discussed below).

Fig. 11: Fair value estimates of a potential ECU-2

Note: ECU fair values are expressed in ECU/USD terms. Source: Nomura, ECB

Figure 11 above shows an illustration of an ECU-2 valuation exercise, based on

the fair value estimates of individual eurozone currencies shown in Appendix III.

In our baseline case where all current eurozone countries, except the smallest

ones, have a weight in the ECU basket, the estimate comes out at 1.13 versus

the USD (bottom row of table). This calculation is only shown for illustrative

purposes, as one should expect potentially significant under-shooting of

individual new national currencies and the ECU-2 basket relative to standard fair

value considerations in the immediate aftermath of a break-up, given the need

for sizeable risk premia.

ECB WeightsBaseline

ECU-2 weights

ECU-2 weights

(ex. Greece)

ECU-2 weights

(ex. Greece,

Ireland, Portugal)

Fairvalue

in breakup

( A ) ( B ) ( C ) ( D ) ( E )

Belgium 2.4% 3.5% 3.7% 3.8% 1.02

Germany 18.9% 27.7% 28.5% 29.8% 1.36

Greece 2.0% 2.9% 0.0% 0.0% 0.57

Spain 8.3% 12.1% 12.5% 13.1% 0.86France 14.2% 20.8% 21.4% 22.4% 1.21

Ireland 1.1% 1.6% 1.7% 0.0% 0.96

Italy 12.5% 18.3% 18.8% 19.7% 0.97

Netherlands 4.0% 5.8% 6.0% 6.3% 1.25

Portugal 1.8% 2.6% 2.6% 0.0% 0.71

Austria 1.9% 2.8% 2.9% 3.1% 1.25

Finland 1.3% 1.8% 1.9% 2.0% 1.25

ECU-2 calculations - Sum (B * E) Sum (C * E) Sum (D * E) -

ECU-2 valuation - 1.13 1.14 1.16 -

ECU-2 fair

nomura eur breakout plan

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