DERIVATIVES STRATEGY, June 1998

Derivatives Strategy magazine June 1998

Adapting Systems to the Euro

Converting software systems to the euro may make the Y2K problem look like a piece of cake.

By Ben Mattlin

The year 2000 problem may be the Godzilla of the computer world, but to technologists in the financial world, the new euro currency is beginning to look a lot like a hurricane, earthquake, tidal wave and tornado rolled into one. “The euro is an analytically far more complex puzzle,” cautions David Gilbert, president of C-ATS Software Inc. Gilbert estimates that the euro conversion will cost four times as much as fixing the Y2K problem.

So many types of instruments will be affected throughout the world, and so few terms have yet been defined, that the enormity of the changeover can defy comprehension—let alone technological solutions. In fact, Gilbert estimates that systems conversions worldwide could cost as much as $100 billion.

What makes adding a new currency so complicated? Newer systems built for handling new currencies may have a leg up, but they have never had to deal with the myriad uncertainties that surround the euro. Although exchange rates were published in early May, they will continue to fluctuate until the end of the year, and the notion of euro compliance remains relative at best. “Different compliance standards have been issued by different regulatory agencies,” explains Hanns Heiliger of Wall Street Systems. “And even those are just guidelines, not official rules. You can’t define the exact value of the euro before the markets are active in the euro.”

Conversion Hell Weekend is January 1–3, 1999. After that, the euro will become the official currency of 11 countries — Germany, France, Italy, Spain, the Netherlands, Belgium, Austria, Portugal, Finland, Ireland and Luxembourg. But not until the last day of this year will the exchange rates be irrevocably fixed. (During a transition period over the next few years, most participating countries will operate under a dual currency situation honoring the new and the old.) Also effective on January 1 next year, a new interbank reference index, Euribor, will replace the national monetary indices of the affected countries. At the same time, a new European Central Bank will succeed the current European Monetary Institute, and it will work with the National Central Banks of the member countries to form the European System of Central Banks. A new bureaucracy will be born whose members have yet to be announced.

“Different compliance standards have been issued by different regulatory agencies. And even those are just guidelines, not official rules.”

Hanns Heiliger
Wall Street Systems

In light of these developments, the best that can be done, Heiliger notes, is to set up parameters before the euro starts. “It’s much more complex than a new currency, especially when you get into the combinations of interest rates and currencies, derivatives, and bonds with different currencies.”

Another intricacy is that any transaction touching on the euro has to be run in a dual methodology. “It’s not like translating from one currency to another,” says Bob Richardson at FXpress Corp. “You have to maintain dual-currency reportability—local currency to the euro and then euro back to the local currency.”

This triangulation method, as opposed to a direct bilateral conversion, was prescribed by the European Commission in part to resolve possible rounding errors. Accommodating triangulation “changes a lot of the programming,” Richardson attests. Adds David Osborne, chief technology officer at Micro Modeling Asso-ciates: “With the euro, you are adding a new functionality to the system.”

Further complications come from the “no compulsion, no prohibition” rule, which states that every participant in every trade and contract has to decide separately whether and when to convert to euros—and there will undoubtedly be cases in which one party prefers to wait while the other doesn’t. Carolyn Coppola, associate director of the business development group at Summit Systems, argues that clients have to be free to convert “as they set their agreements with their customers and colleagues. Some may want to compare how transactions look in euros and the local currency even before the end of the year, or to gradually convert transactions over several years.”

For many, the problem is not the euro itself but the transition period. Marie Hollein, vice president and euro marketing manager at ABN AMRO, reports that the giant banking concern has spent some $250 million getting ready for the euro, and its special euro task force meets every two weeks. “A bank has to be one of the earliest adopters,” Hollein asserts.

ABN AMRO is not the only financial institution attempting to work out its own coping mechanisms. But Mark Simon, chief executive officer at software developer Inventure Ltd., wishes more institutions would call on him. “Our whole business is about serving the apparent paradoxes and challenges of getting one’s mind around living with different currencies,” he insists. Although Inventure’s FENICS software is touted to be euro-capable for pricing, analyzing and managing foreign exchange over-the-counter and exchange-traded portfolios, Simon acknowledges that his clients “still need to put together a plan for approaching the euro. More political risks are associated with the transition than any accounting risks.”

The preliminary setting of exchange rates on May 4 did a lot to reign in the monster, but many prickly gray areas remain. Key among them is the lack of a clear standard for “euro compliance.” Unlike “year-2000 compliant,” no official definition exists for software makers tackling the euro. “How can software companies claim they have solved the problems?” asks technology expert Maureen Callahan of the Callahan Company, a New York-based consulting group. Among the unresolved questions she cites: How to evaluate the historical data necessary for options pricing? How to handle existing contracts with a fixed reference rate? How to accommodate dual-currency bonds?

In fact, government bonds will be converted according to local standards, which vary. “Each country affected has to make specific changes in their laws about how to redenominate national debt,” says Alyce Campbell, vice president of product management at C-ATS Software and head of its euro task force.

Yet many affirm that the unanswered questions should not be a source of fear. The International Swaps and Derivatives Association has stepped in with recommended protocols that should ease the transition. One guiding point is called the “continuity of contracts,” which calls for minimal disruptions of existing transactions. Adhering to that principal may require some negotiation, but Blaise Labriola, president of Theoretics Mountain View Inc., observes that any volatility will be short-term. “After January 1, there will instantly be a market that will generate data to capture for pricing any transaction,” says Labriola.

ABN AMRO’s Hollein notes that what started as a political move is now driven by business interests. “To be competitive, even companies in ‘out’ countries will have to be euro ready,” she stresses. “The single currency creates a market of 370 million confused consumers.”

Imagine Software has taken a number of approaches to the problem. It is giving clients the ability to view positions of the legacy currency and the euro with a dual display. It has also set up conversion routines for all euro-convertible instruments that allow security and position data to be restated in terms of the euro. Stephen Klein, a senior design analyst at Imagine, notes that OTC-based instruments require a more flexible conversion approach because of the potential for divergence in methodology and the "No Compulsion, No Prohibition" clause, which allows for conversion anytime during the three year transitional period. As a result, Imagine has created an application-level facility to allow users to convert specific instruments or groups of instruments selectively based on the users’ conversion criteria.

Whatever strategy institutions pursue to cope with the euro, it is clear that they must remain flexible. “We don’t even know who will set interest rates yet,” warns Clare Porter, product manager at Infinity, a company of SunGard Data Sys-tems Inc., that provides enterprise applications for trading and risk management. “We can anticipate a lot of changes as more and more transactions are converted to euros, and more countries join in.”

This, at least, illuminates a central fact: The euro represents more than a change in accounting or software systems—it is nothing short of an overhaul of business practices and procedures. “The problems of the euro are not technology related but business related,” says Porter. “Technology needs to keep pace, and anticipate.”