The Euro Crisis


By Anthony Murray, May 2012


Q. Will the Euro break-up?

A. This has become a question of the possibility versus the probability of the Euro breaking up, with one or more states within the Eurozone exiting the single currency.  Such an event will either happen in an orderly or disorderly (unilateral) manner.  Most economists are now acknowledging the probability of that event.

Q. What would be the attraction for a member state to renounce the Euro as its currency?

A. The EU member state that is no longer able to fund its sovereign debt nor accept the tight Euro fiscal conditions and faced with runs on its domestic banks could re-take control of its monetary policy by leaving the Euro.  Although undesirable it could be analogous to a Chapter 11 type event except for a Country.  It is likely that the newly minted replacement currency for the Euro would decline vis-à-vis the Euro exchange rate used to swap the old Euro to the new currency thus making any exports more attractively priced. The corollary being that imports would become very expensive and there would be high inflation. The possibility of civil disorder may also arise, the outcome and impact of which may be difficult to gauge.

Q. What is the legal mechanism for a Euro break-up?

A. The treaties do not forsee or provide a procedure for a Euro break up (probably because it was not contemplated or the possibility was too painful to contemplate). In many ways it will be similar to seeking a divorce in a country that does not have any divorce laws.   It has also been described in a press a burning building with no escape routes.   If a controlled break up is to happen the treaties constituting and governing the Eurozone will likely have to be amended.  That can be time consuming, and as we have discovered time may be one thing that is now in short supply.  Alternatively an EU state can leave the Euro unilaterally. Or at the extreme end of possibilities an EU state can leave the EU and also withdraw from the Euro, but given the massive issues that departing member state would have in terms of having to re-negotiate trade deals with the EU and restrictions on its citizens its is in reality not a feasible option.  In effect, that state will have rejected the Euro and its other EU obligations.

Q. What would the potential impact be on other EU countries?

A. Other weaker EU countries may (or be forced to) follow and exit the Euro once the precedent has been set. Also the fear of Euro exit in those weaker countries may become self-fulfilling with downgrades of their debt and runs on their domestic banks.

Q. What does this mean for hedge funds?

A. Apart from any market dislocation from a break up event (e.g. increased volatility, liquidity issues, market disruption) there may be other legal or practical consequences funds need to think about in advance.  The obvious impacts will be to fund structures denominated in Euros or with Euro exposure.  It may require a close look at definition of “Euro” in the various documents with investors or counterparties to see if this will impact the fund’s reaction to the situation, and whether it could be construed to cover a successor currency. If a fund agrees to pay redemptions in Euros and underlying assets are converted into a new underlying currency a serious mismatch may arise, requiring a correction on the Net Asset Value of such funds.  Any hedging activities undertaken say by a U.S. denominated fund which hedges Euro exposure may be blown seriously off course. It may also lead to disputes with counterparties, as ultimately it will likely depend which counterparties are involved and where the assets or counterparties are based.   An evaluation should be undertaken to make sure that no unintended exposure to a successor currency is carried by the fund.


22 May 2012

Anthony Murray
917 678 9046

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