The price of failure is not something that traders like to contemplate, no matter how used to it they have become during the summer financial market crisis. But in the first weeks of 1999, they may be forced to confront failure on an unprecedented scale; the introduction of the euro could make it inevitable.
It will be failure through no fault of their own: not losses from unwise position-taking in emerging market bonds or equities, nor even through glitches in the new, euro-compatible computer systems they will be using. Trades will fail, leaving counterparties with unmatched positions, because of the misinformation that clients will mistakenly feed into the system. One senior banker calls it a "garbage in, garbage out" situation. "You can have the best systems in the world," he says. "But without the right instructions from the customer, deals won't settle." He adds: "What we'll control quite well is our own operations. But the game isn't played by a hundred institutions, but by thousands of people, many outside the euro zone."
Major trading banks, and some custodians, are quietly worried that customer orders, especially from clients in the US and Japan, will be littered with conversion errors during the first weeks of 1999, leading intermediaries into a desperate scramble to borrow cash and securities to cover unmatched positions, while they sort out the mess.
A big source of out-trades is expected to stem from a counterparty's choice of at least 15 national payment systems to make a euro payment. Multiply that by the number of euro-security depositories and tracking an instruction once it has gone astray could prove a nightmare.
Another banker adds: "All the highways have to work as normal, if they don't there's the potential for chaos. The question is: how much chaos can we survive?"
Of course, a failed trade isn't a default. It usually means either a technical or temporary delay in the settlement of a transaction. But it is still the failure to deliver either cash or securities, leaving banks with the need to borrow either for a short period, while reconciling the mismatches, which creates, potentially, a very high cost.
Euro-conversion is expected to be accompanied by errors in trade data multiplying. One obvious area of concern is derivatives trading, where confusion may arise from counterparties running cash-market securities positions redenominated into euros and associated hedge positions in derivatives contracts still denominated in the old national currencies. The chances for less-sophisticated customers confusing their Deutschmark and euro amounts is obvious. But to dealers' frustration, there has been little feedback from derivatives exchanges on how to deal with such confusion.
The head of the Emu working party at one European bank admits that in a normal trading day it may expect to suffer a failure in as many as 5% of trades. In the first weeks of 1999, this banker estimates that the figure could be as high as 15% to 20%. For a bank such as Citibank, a rise of 15% in trade failures would mean $15 billion suddenly not turning up.
The volume of trading seen over the new-year period will have a significant bearing on the extent of the problem. Many are expecting that during the week leading up to conversion weekend trading volumes will drop off, so easing settlement problems during the first week of 1999. But if markets are volatile, with lots of speculation surrounding the euro, trading volumes could be high, and the number of failed trades might increase alarmingly. In trying to prepare for and mitigate this problem, banks' back-office staff know that any attempt to damp down trading volume in this crucial period will prove deeply unpopular within their own firms. "I am not too worried about our proprietary position-taking, which is mainly conducted with other large counterparties who should be well up to speed," stresses the European banker. "And we absolutely cannot try to stop our traders from trading." Rather, his prescription is to encourage the banks' dealers to do everything they can to spread out settlement during the first weeks and months of the year, for example by taking advantage of flexibility in OTC derivatives transactions.
Some banks are clearly more worried than others. According to Ray Birchley, senior executive in charge of Emu coordination at HSBC Investment Bank, four months ago the bank feared that failed trades in 1999 could pose a major problem. But it has now reassessed this position and thinks the risks are less than first imagined. The bank was expecting to find that many clients would be making changes to their standing set of instructions (SSIs) for settlement, and that that would create a lot of confusion: "But we're finding considerably fewer changes than we expected," he says.
Others are less optimistic. The Emu systems head at a major European bank says: "The only uncertainty is how big the problem will be." This banker mentions that there have been some informal discussions between banks on how to head off the problem but that these have not progressed far because of banks' competitive instincts. Most banks will be managing their liquidity in early 1999, with the likelihood of high rates of trade failure in mind. One reason why some banks are not keen to discuss the problem is that they see in it the potential for profit.
Anticipating a slew of failed trades, banks could position themselves to take advantage of the fact that others will be coming into the market for cash or securities to cover their exposure. Traders doubt that such opportunism will be widespread. "I think we'll all be too pressed trying to work out what our own positions are," suggests one. The head of derivatives trading at another bank adds: "It think it will be prudent to be relatively liquid, and you assume that other people's liquidity ratios are going to higher than usual. But that will be a matter of prudence, not of trying to take advantage of the situation."
No European central bank or other market body had offered any guidance on the expected problem by the end of August, though as Euromoney went to press it appeared that the Bank of England was intending to mention it in a forthcoming quarterly report. But a few bland words of encouragement to dealers, to emphasize client education and to minimize their number of trades, won't help much. One banker complains that central banks are complacent on the question because they have simply accepted assurances of dubious worth from their national banks that all will be well. "I know how bad it is out there and I am worried," he says. "Firms have to test, test, test. It's no good saying they haven't enough time. They've got to make time." The whole issue highlights the problematic absence of any centralized, supervisory and regulatory agency in Europe competent to provide or approve technical assistance.