European Monetary Union may seem miles and years away.
But don't let it sneak up on you.

By Simon Boughey

ay 30 wasn't a day like any other at Johnson Controls. Treasurer Ben Bastianen was considering a fairly standard transaction-a five-year deutsche mark/ French franc swap that could lower interest costs for the global manufacturing company by picking up an initial 200 basis points of positive carry. But he realized that the outcome of the deal could be considerably different than expected if European Monetary Union begins as currently scheduled on January 1, 1999. "It's a wild card," says Bastianen. He concedes the effect of EMU on the swap would probably be negative. But eventually he did the deal anyway because a shorter-dated swap wouldn't have picked up enough carry.

Bastianen isn't alone in flying blind into EMU. But whether U.S. bankers and treasurers like it or not, European currency union has now achieved a political momentum which may make it very hard to stop. Much as Frankfurt seems a long way away if you're a treasurer in Des Moines, Iowa, a long position in deutsche mark forwards can make it a lot closer. The U.S. regulators, accounting standards bodies and the legal profession haven't taken much notice of EMU so far. But a few big U.S. corporates with debt outstanding in EMU-affected currencies have rewritten their offer documents to accommodate the possibility of monetary union.

The problems fall into several categories: legal, accounting, tax and financial impact. The scramble to sort out the contractual implications of EMU is just beginning, but issues like the possibility that contracts can simply be terminated upon EMU make end-users of all sorts quiver. The accountants haven't really considered the issue and the tax authorities may take a look once they realize that some hitherto untaxed transactions may become taxable. But for financial impact, it's clear. EMU is a minefield, and for end-users that haven't taken the possibility into account for transactions that extent beyond January 1, 1999-be they swaps or bond issues-there will be a cost impact, and it is more likely to be negative than positive.

Few economic concepts have seemed more illusory and few have had such a checkered history as EMU, but the so-called Eurocrats are very unwilling to relinquish the dream of currency union, perhaps as the first and most important step to full political integration. It now seems very unlikely that something will not happen.

Much as American bankers and end-users of derivatives might like to think that the event does not concern them, they are going to have to face up to reality pretty quickly. Any payment flow in any of the 12 currencies will be affected.

D-Day 1999

At present, it is intended that the Euro be introduced on January 1, 1999, the beginning of the so-called Phase Three of currency union, as the single currency for the 12 member countries of the European Community. It isn't clear which of the 12 currencies will actually join. The British hate the idea of EMU, the Germans are very skeptical, and the Danish rejected the whole idea nearly four years ago. But for whichever countries and currencies join, all payments in respect of securities and transactions will be payable in Euros at the conversion rate of one Euro for one ECU, a basket of the twelve currencies that is not used as currency itself. That, at least, is the projected schedule. For one indication of how seriously the Europeans take the issue, just look at derivatives activity this summer: the three financial futures and options exchanges in London, Paris and Frankfurt were bustling this August, traditionally a sleepy time. Volume on the London International Financial Futures and Options Exchange (LIFFE) was up 82 percent in August over the same month last year, a rise attributed partly to jitters about EMU.

Europeans, as one might expect, are watching developments more keenly than players in the U.S. Stephen Greene, an ISDA board member and chairman of the City of London Joint Working Group, says: "If this were simply a political exercise, monetary union would be a certainty. But it isn't. The trick is whether they (the politicians) can make the economic constellations line up to their political expectations." He adds that the crucial question is whether France and Germany will be able to meet the economic convergence criteria specified in the Maastricht Treaty without fudging the results.

Damned if you don't

Of course, the likelihood of the Euro actually becoming the single currency for the 12 member countries of the European Community is really beside the point. Banks and companies must take steps to prepare for it, because if it does take place and they are not prepared, disaster will ensue.

Even within the last few months, the pace of activity has quickened significantly, notes Jeffrey Golden, an attorney with Alan & Overy in London. In June the European Commission made significant progress toward establishing a legal framework for the single currency, and legislation is currently being considered. On June 12 the Marché à Terme des Instruments Financiers (MATIF) announced the formation of a study group to examine the likely impact of a single currency upon the Paris futures market. Its March and June 1999 three-month PIBOR futures will already close on a settlement price determined from a Euro three-month interest rate. Europe's biggest futures exchange-LIFFE-is making energetic plans to cope with EMU, claims chairman Jack Wigglesworth. Its Euromark, short sterling and Eurolire futures contracts already contain single-currency provisions.

Progress on this side of the Atlantic has been rather less marked. This, of course, is understandable. But U.S. banks have been quite wrong in thinking that this is an exclusively European issue. Nearly 100 percent of all swap contracts between U.S. counterparties, irrespective of the currency in which the deal is made, are governed by New York law. Perhaps half of all derivatives contracts are governed by New York law. The ISDA Master is governed by New York law. Consequently, New York law will have to be prepared to deal with the issues arising from European Monetary Union. "This is not some obscure European issue," says Greene. "The New York courts will be called upon to resolve continuity of contract problems, as will courts in every major financial center around the world. The only question is whether people really understand the dimensions of the potential problems raised by EMU."

The big worry concerns continuity of contract. It is feared by many market participants that their counterparties will regard EMU as sufficient grounds to terminate outstanding agreements, and there are three principal areas of confusion. Firstly, the contract may be assumed to have been frustrated because its actual terms have radically changed. For example, say a U.S. end-user with operations in Frankfurt has bought a deutsche mark/French franc forward to hedge imports of French machinery, and it has purchased this contract from a U.S. bank based in London. On January 1, 1999 the contract will convert to what is essentially a fixed annuity rather than a forward. Either counterparty might claim that as the contract is no longer an FX forward, it has been frustrated.

The second problem concerns the type of provision concerning force majeure that appears in the Master Agreement. Generally, contracts say that if, through no fault of the counterparty, some event occurs which prevents payment, it may be considered terminated. This clause is seldom invoked, but a counterparty may claim that EMU constitutes force majeure and take it to the courts.

Vanishing prices

Finally, and most intractably, says Greene, is the issue of disappearance of the price source. Say our two counterparties enter into a fixed deutsche mark versus floating French franc currency swap. On January 1, 1999, not only will the currencies disappear, but the floating rate on which the French franc payments are based-say TAM or TAG-may disappear as well. "No one tells you what to do if the floating rate price source disappears and is not replaced," warns Greene. "Market practice has yet to be established. People are working hard to identify the alternatives. Unless the market comes together on this, the possibility of disputes is very real."

There are additional issues: in the case of the French franc/deutsche mark FX forward, once the payments are converted to the Euro and it becomes, in essence, a fixed annuity, does it become taxable? How should it be accounted for? These are issues that the IRS and FASB need to decide. Equally, after conversion, a swap payment could now be considered a loan, in which case the capital treatment would be different. The banking regulators need to sort out the answer here. Then there are the so-called "plumbing" questions, concerning such niggling, but important, issues as different day-counts and rounding conventions.

None of these questions are unsolvable. Answers, tried and tested by market practice, can be found. But the point is that some direction needs to be provided by the courts and the regulators before currency union takes effect if lengthy and costly legal battles are to be avoided. As yet, however, progress has been limited. Halsey Bullen, project manager at the Financial Accounting Standards Board (FASB) admits he could see how "it [currency union] will be a problem" for financial accounting, but confesses, "I don't think anyone here or at other standard-setters overseas has given the slightest thought to it."

IRS shrugs shoulders

A spokesman for the IRS in Washington sang a similar tune. He says that no particular preparations had been made for tax treatment of transactions that change in character once currency union has taken effect. The general policy of the IRS, he explains, is not to anticipate events but to respond to them when they have taken place: "I don't think that we would really attempt a decision on issues that haven't happened yet. We do address taxpayers' problems when they are real ones, not hypothetical." Yet observers say that as New York law governs perhaps half the swaps transacted in the world, the effect of union upon tax treatment is enormous.

The Federal Reserve Board is also adopting a "wait and see" policy. "We will take it as it evolves. We are monitoring developments and making adjustments as changes become clear," says a senior official in Washington. The Fed is not making any changes until the market itself changes and until that time it is not making any fundamental plans. The official adds that most of the changes relate to what he calls accounting and stationary issues, and reiterates that "we can't do very much with regard to this until it happens." Neither did the Office of the Comptroller of the Currency (OCC) give any firm idea of how it would treat bank capital requirements when currency union becomes a fact.

U.S. banks and end-users that have either swaps or debt outstanding in a European currency have been a little more alert to the potential ramifications of currency union. Two years ago the Wall Street Committee on Transition to European Monetary Union was formed by Niall Lenihan, a partner with Davis Polk & Wardwell, a New York law firm, to look at these issues and the impact they will have on U.S. courts and banks. Lenihan declined to comment, on the grounds that "the Committee has not yet made any definitive recommendations." It hopes to publish a comment early in the autumn.

However, a source close to the committee agrees that U.S. lawyers and bankers are at last beginning to come around to accept the idea that this was an event that might actually happen-and one that would involve them: "There was skepticism last year," he says. "It was an issue which people did not think they needed to concern themselves. But the turning point was the point at the end of last year when they actually came up with a name for the new currency. The mood changed after that." He adds that interested parties are now phoning the Wall Street Committee on "a consistent basis."

Swaps, Eurobonds and medium-term notes or loans are the transactions that will affect U.S. counterparties the most. The question before the U.S. is whether the problems can be decided by contract amendment or by legislation. At the moment the European Council is drafting regulations to cover all eventualities, and it seems that the U.S.

will probably follow its lead in introducing all-embracing legislation. The advantage of legislation is that it would cover everything, whereas contract amendments would differ according to the type of transaction being executed. There would be much more potential for counterparties to claim that certain contract amendments did not apply to their specific deal. Necessary changes to legislation could be handled by the New York state legislature, but it is not yet clear if Washington would wish to become involved in what may be broad legislative changes to contract law.

Continuity clauses

Some of the biggest borrowers have begun to introduce continuity clauses to their debt offerings in European currencies. Unsurprisingly, General Electric Capital Corporation (GECC), probably the biggest Eurobond borrower among U.S. corporates, was the first off the mark. It now incorporates clauses in all European currency­denominated offerings which say that if currency union becomes a fact, all interest and principal payments after that date are to be denominated in the Euro at the agreed conversion rate. So it would be quite possible for an investor to receive coupon payments in lire in August 1998 and then in the Euro in February 1999. McDonald's has also incorporated continuity clauses, as have Morgan Stanley and the Republic of Italy for their Eurobond transactions, which are governed by New York law. One source estimates that there are perhaps a dozen U.S. issuers that have made similar provisions.

Arbitrage obsoleted

One of the major objectives of GECC's overseas borrowing program is to acquire low-cost debt through currency swaps of Eurocurrency issues. The sub-LIBOR margins that can be achieved in some of the marginal currencies like lire and pesetas are often quite substantial and can be in excess of LIBOR less 30 basis points. If all currencies are subsumed into the Euro, arbitrage possibilities will by definition be ironed out and borrowers like GECC may be forced to look elsewhere for low-cost borrowing.

The World Bank admits it may have to look for low-cost borrowing outside Europe once the Euro becomes a fact, but is not prepared to speculate on where that might be. "How EMU will affect arbitrage is difficult to predict. Any prediction will be bold and hazardous," says Hans Rothenbühler, director of the bank's funding operations department. With regard to its swap business and bond offerings in currencies that are due to convert to the Euro, Rothenbühler sees the World Bank following the decisions of sovereign issuers. For example, the German government will decide how to handle the transition from deutsche mark to Euro, and will thus provide appropriate guidance for other DM issuers such as the World Bank. Therefore from the perspective of the World Bank as a bond issuer, he does not "foresee too much trouble."

ECU swaps and ECU bond offerings raise more complex issues, however. Since the ECU is a basket of currencies and not legal tender itself, any trade involving it has incorporated complicated substitution clauses which might become subject to qualification and dispute, admits Rothenbühler. For a number of years the World Bank has not faced these issues directly since there were no issuance opportunities in ECU that met its funding targets. If such opportunities were to arise in the near future, the Bank will look carefully at the ISMA/ISDA recommendations that set market standards.

Bondholders neutral

"We have no view on whether EMU will happen or whether it will be a good thing or not," says one major bond issuer. This sentiment could apply to most U.S. institutions, whether they are end-users, banks, regulators or courts. Clearly there are many unanswered questions and opaque areas at the moment, and it is surely much easier to assume that currency union won't happen, or that if it does then solutions can be found at the time. But this may be a short-sighted approach. The U.S. is no longer isolated from the world economy as much as it may think, and currency union will affect many areas of its banking, particularly swap contract law. It might be wise to find some answers before 1999, even if 1999 comes and goes and there are still 12 European currencies rather than one.