Reverse-Engineering the Euro

By Robin Sharp
June 5, 2005

Will we start to see countries leaving the Euro - and what impact will this have on Trading Systems?

The Euro is showing signs of faltering; and the software infrastructure which we've built around it may have to be deconstructed as EU countries threaten to return to their own currencies. While the intention to create a new European currency was announced at the Hague Summit in 1969, it wasn't until 1992 that I heard the first announcement that Europe would get a new currency (the Euro). My first reaction was it would create tensions between the Germans and the Latins (Italians, Portuguese, Spanish, and Greeks). Here we go again, I thought.

The immediate reaction of the FX traders I was sitting with was that it was an excuse for them to retire; but they were spot traders.

On the way I home I started to think about how the trading software would have to be rewritten to handle the new currency. The main challenge was the change in the relationship between countries and currencies. The logical relationship before the Euro was that "one Country had one Currency" but in future "many Countries would have one Currency".

In reality, the relational databases didn't have one-one relationships because the Currency and Country tables were kept separate. In many cases the relationship between Countries and Currencies was already on a many to one basis. For example the USA, Guam, Panama, Puerto Rico all traded in Dollars. France and Monaco both traded Francs. The front office systems didn’t care which country they were trading with, and for the back office settlement systems the relationship between countries and currencies was typically done through the counterparty.

One of the questions I repeatedly raised at the time was: "What happens if a country leaves the Euro?"

"But it can't," always came the reply. (Not "it won't"). What does "it can't" mean? Of course, it really meant "it mustn't," as there was no "Plan B". Countries were asked to burn all their notes and not even consider “Plan B”.

We all had at least 5 years to prepare for the introduction of the Euro, and the introduction was phased in. When the European Monetary Union first introduced, the European Currencies kept in a tight band, then fixed the rates on Jan 1 1999, then finally phased the old Currency notes out in 2002.

The Euro has proved to be a useful currency for FX traders as it provided a very liquid instrument to trade in - the EUR/USD. The EUR/USD trader is now the senior trader on the desk and generally has a couple of juniors to run the book for him. For example in arbitrage systems having a EUR/USD means you can trade though Sterling, Yen or Swiss Franc and have the guarantee of a liquid EUR/USD leg to get out of if things go pear shaped.

Even those in favour of the Euro admit that the closer the economic and political integration in Europe became, the better the Euro would work. However, the French and Dutch have now rejected the European Constitution because they don't want closer economic integration, and the British (presumably) will reject the European Constitution because they don't want closer political integration. It now looks like European integration has come to a halt - and will possibly start reversing.

Recently (1 June 2005) in Germany’s Stern magazine, an article appeared, entitled "Der Euro macht uns Kaputt" (“The Euro is Destroying Us”). It was reported that the German Finance Minister Hans Eichel and Bundesbank President Axel Weber and economists have been having secret meetings on a possible failure of the European Monetary Union. Joachim Fels, Morgan Stanley's eurozone economist, briefed the group on the developing crisis in southern Europe, notably Italy. He warned of a "meltdown" risk that could break up the Euro-Zone.

A few days later, Northern League Welfare Minister Roberto Maroni said Italy should consider temporary re-adoption of the Lira. It would therefore be "better" to temporarily have a dual circulation of the Euro and the Lira in Italy, he said.

So the question is now, will Italy (or other Latin countries) be pushed first or will Germany jump before (with one or more other countries)?

It is certainly more likely that Germany will jump, possibly with Holland. This will leave the Euro as a “Latin Currency” and severely weakened, taking France down with it. Alternately the less weak Latin Countries (Spain and France) may help Germany push the weaker ones out of the Euro, in reality this would be extremely difficult.

Why is this important for Software Reality?

This is important because depending whether we face a jumping or pushing scenario affects how much time and how we test our computer systems for when a country leaves the Euro.

That with high unemployment in the Eurozone - before the structural economic reforms that are necessary. It is a significant risk (>5%) that a popularist politician will get voted in before the benefits of structural economic reforms are realised.

Banks must start to plan for one or more European countries leaving the Euro. We all thought that after the Y2K and Euro changes, we wouldn't be doing it again, but it appears we'll have to.

The possibility is real and banks have a duty to shareholders to mitigate against such risks. If we start now we may have a few years, which is just about the right timescale for planning these things.

Technically I don't think that there will be a great deal of software that needs to be rewritten. As I said earlier, the front office doesn't really care about countries and the back-office holds the relationship between countries and currencies in their counterparties.

An important aspect of software development is whether data providers such as Reuters and Bloomberg can convert their systems to handle the new currency. Whilst the trade capture software might not require a great deal of modification, any new currency would affect all financial instruments (especially FX), and a new German currency would have the greater impact on financial markets.

The options facing any government would be limited, and we may not be told what they are because any government will be secretive about such plans. In order for testing to take place, all the possible scenarios would need to be enumerated.

Here are a few examples:

1. Announce a new currency that would be on a fixed rate with the Euro. This period of fixed rates could not last very long, because it's been admitted that the currencies are diverging. I would suspect that the new currency would come under vast pressure almost immediately. In this scenario, software and client accounts would have to be modified to deal with the new currency during the transition period, possibly a few weeks.

2. Announce a new currency that would be on a floating rate with the Euro. This would be politically very damaging because the Euro accounts would have to be converted to the New Currency. I can't see Germany doing this because I would expect the New Mark to be worth more than a Euro. I can only see this happening to a currency that has been pushed. Again software, and client accounts would have to be modified to deal with the new currency during the transition period, but there would be a need to handle the floating rates between Counterparty accounts.

3. Freeze all bank accounts overnight (or over a holiday) and guarantee a conversion to a new currency. I don't buy into the theory that if a currency pulls out it couldn't do it overnight, especially if it's Germany. The reason for this is that notes in circulation are only a small fraction of the countries' currency. A German Government under pressure might want to give the people a sweetener, and what better way than to increase the value of their bank savings by changing their denomination to the New Mark. This third scenario would involve the least software changes, but would come as a shock, and there would be a lot of cancelled weekends or holidays.

The Software Reality is that banks must now face up to a huge risk of one or more countries leaving the Euro, and should start planning for that eventuality.

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