Amid one of the worst crises in the EU’s history, many financial institutions are still unsure as to the potential legal and financial implications that the exit of Greece – or indeed of any nation from the single currency – may cause.
Akber Datoo & Simon Leifer, co-partners of D2 Legal Technology, call on financial institutions to urgently review their derivatives contracts to determine the true level of risk exposure and to take remedial action as appropriate.
It seems extraordinary today in the face of Greece’s third bailout that, until recently, the possibility of a country leaving the single currency had simply not been considered. Yet the implications for derivatives contracts are potentially extremely serious. While bodies such as the International Swaps and Derivatives Association (ISDA) have been recommending that certain provisions are amended by counterparties to ensure greater certainty in the event of Grexit – or indeed the exit of any other member state from the Euro – many older derivatives documents leave organisations at risk of unintended consequences.
The most critical issue to determine is the redenomination of payment obligations which could lead parties to incur considerable losses as a result of the devaluation of the new currency. Will payment obligations become payable in the new currency adopted post Euro exit; or would the payment be due in whatever form the Euro takes without the nation in question? Either way, are such results in line with the original intentions of the contract or, if not, how much additional risk – and cost – is being created?
The introduction of capital and exchange controls may also trigger various provisions within derivatives documents, including illegality, which may allow an institution or counterparty to terminate transactions early. It is clearly important to understand whether this is an option – or whether the counterparty may opt to terminate – and account for this potential eventuality. What happens if a counterparty is particularly vulnerable to deterioration of credit worthiness post exit? Identifying such counterparties is not difficult; however it is then essential to understand the terms of every document related to that counterparty.
To analyse whether any of these issues would come into effect under certain circumstances, institutions need to review derivatives contracts, looking closely at provisions such as the governing law and jurisdiction, the definition of Euro and exchange clauses. ISDA has given excellent guidance as to the new wording recommended in documentation to avoid the risk that contracts may suffer from e.g. payment redenomination so that it is possible to amend these documents to minimise potential risk – but only once they have been identified.
The key is to take action. Every document will contain a long list of clauses or items that will need to be checked and assessed to determine the potential impact. The more time an institution has to undertake that due diligence, the less last minute fire fighting will be required. Rather than just looking at a handful of contracts post exit, an organisation will be in a position to prioritise the most significant exposures.
Indeed, while the priority today is to gain legal certainty regarding the implications of Greece’s bailout, the potential of Grexit has made it very clear that institutions need also to consider the potential implications of any country leaving the Euro. While new contracts are clearly being drafted with this eventuality in mind, it is essential for institutions to understand the risks associated with those contracts based on the previous assumption that no country would ever leave. Identifying and amending those contracts should now be a priority.
The goal is legal certainty – and the only way financial institutions can attain that objective is to rigorously review derivatives documents and take action to minimise the impact of a potential exit from the Euro.