BRICs, Currencies & Viability of Contracts

Currency Crises & Counterparty Risks…What does your CONTRACT say about that?

Not too long ago, my substack was “brainstorming” new ways to look at global economic risks. For the sake of full disclosure, everyone on the thread was a lawyer, so our command of classic principles of economics ranged from “very little” to “even less.”

Around that same time, we had begun to hear rumors concerning the return of gold ATMs and a renewed interest in crypto-enabled ATMs and kiosks. That was the backdrop that framed our discussion then.

Unfortunately, like any panel of “good economists,” we couldn’t agree on whether the global economy had lapsed back into recession, whether it had actually ever left recession, or whether the “next leg down” was years away or perhaps just around the corner. Would we be seeing “down rounds” in crypto startups? Of course, we hypothesized upside scenarios as well.?

Once we’d exhausted our collective anecdotes, theories, and hypotheses in support of one argument or another, the conversation inevitably turned to the heart of the matter…. If there’s risk out there (which none of us denied), then there had to be a commensurate amount of reward—somewhere. ?

But where? What kinds of risks are there?

Yes, of course, there’s risk everywhere in life – there are risks in getting out of bed in the morning or crossing a busy street…but we were talking about big ticket risks – “black swan” level risks.?

The types of risks that threaten not just nations, but continents…

And perhaps more importantly, even if we could identify those black swan caliber risks - how would we fashion that identification/recognition into a solution for which we could justifiably charge a fee?[1]

From our vantage point, risks/rewards are manifested via contracts. You either have a contract, or you don’t (hopefully, you do).? ?

So, when an issue arises, it, of course, begs the question, “What does the contract say about that?” ?

But let’s first describe a bit more about the direction the discussion thread went in…which went like this:

·?????? It’s early morning on a workday.

·?????? You wake to find your news feed jammed full of alerts and updates.? What has happened?? Two of the world’s largest reserve countries have failed as they no longer catch a bid.

·?????? What do you mean failed, no longer catch a bid?? We mean, they somehow seemingly skipped a hyperinflationary burnout and just reverted to the mean, intrinsic value of all fiat – i.e., ZERO.

This, of course, led the group into a discussion of various contract issues and mechanisms. Not surprisingly this doomsday discussion came to a head when we started to discuss payments, payment mechanisms, cross-border issues, and, of course, currencies (and consideration). Consideration?!

To keep it simple, assume that all contracts of all types are based on some form of “consideration”—i.e., THE THING that requires the contracting parties to perform. (That’s simplistic but sufficient for this discussion).

Consideration can take many different forms, but usually, that thing is money—and not just “money” in the general economic sense, but “money” referenced or denominated in a specific currency….

Ding, ding….

That’s when the bells started going off in our collective consciousness! Namely, how are we helping our clients manage contractual currency risk? Of course, this is not a novel issue; it’s been around as long as contracts.? Indeed, the forex markets are a vital part of global commerce.

And in that regard, it’s not unusual for traders, merchants, and the like to manage currency conversion risk via various types of contractual mechanisms and risk allocation devices, including hedging transactions.

However, our scenario is different than anything previously encountered because two reserve currencies have essentially fallen to ZERO overnight.?

In an instant, millions of contracts worldwide no longer had a currency of reference for the goods and services to be provided. ?How do we do business?

There are many recent and historical examples of currency failures, such as Zimbabwe and Weimar, Germany, to cite a couple. But those examples are of limited use.

In the Weimar situation, the world had yet to be globalized to the extent it is today—so the degree of interconnectivity amongst peoples, countries, and, most importantly, contracts—was not there. In the case of Zimbabwe, its currency was national, and therefore, its failure was limited in its ability to spread contagion beyond its borders.

Moreover, to a considerable extent, modern finance has mitigated some elements of currency fluctuation risks in terms of settlement protocols, etc.

Again, to cite the most recent examples, when the currency is used primarily for local and/or regional transactions, adverse impacts can generally be contained by the affected economies dealing with that currency.

But what happens when the currency that fails is a major point of reference in vast numbers of contracts around the globe?

What do you do then?

The recent COVID-19 pandemic and the so-called “global financial crisis” before that have been demonstrative in terms of demonstrating with absolute certainty that practically ANYTHING IS POSSIBLE. Indeed, since the global financial crisis, and COVID-19, we’ve learned that “black swans” or extremely improbable events can happen every weekend (e.g., the failure of Lehman Brothers, the demise of Bear Stearns, the bankruptcy of China Evergrande real estate group, etc.).

Therefore, it is no longer unthinkable that in a world awash in debt, derivatives, and counterparty liability, that one or more of the major global reserve currencies could fail or suffer a significant valuation crisis in the medium to longer term (or perhaps next week)….

And if it’s possible for one such reserve currency to fail, then the prospect for more than one failing is not outside the realm of possibility.

So, what else does the contract say about that?

Against this backdrop, there are two things that we know to be true with 100% absolute certainty, both with respect to the monetary side of this equation.

Firstly, we know that printing money diminishes the value of the unbacked currency already in circulation. Although such a simplistic view obviously doesn’t consider the destruction or creation of credit alongside such printing, the general premise is sound.

Secondly, and this point requires absolutely no nuance whatsoever, is the fact that every single (unbacked) paper (fiat) currency in the history of mankind has always reverted to its intrinsic value…ZERO!

Assuming that a reserve currency crisis was even a remote possibility, the discussion thread pondered:

·?????? What should we be telling our clients about all this thinking we’ve been doing?

·?????? Can/must a contract still be performed if the reference currency no longer exists or is hyper-inflating (e.g., can a severability clause be used to reform/fix it)?

·?????? Should companies right now be considering strategies that hedge their downside risks against suppliers/contractors/counterparties generally?

As always, discerning the correct answer starts with asking the right questions. ?As alluded to above, in this case, our questions revolve around the notion of consideration, so these are the types of questions we needed answered:

·?????? In the commercial context, what happens when a reference currency fails or is no longer available (e.g., euros for drachmas)?

·?????? What claim would one party have against another to require payment in an alternative currency (International Monetary Fund Special Drawing Rights (SDRs), for example)?

·?????? Could such claims be “specifically” enforced?

·?????? Does the applicable law stipulate an outcome?

·?????? What would such strategies entail?

·?????? Would having reference points for one or more precious metals (e.g., gold and/or silver) mitigate this risk?

·?????? How could such reference points be structured into new and existing contractual arrangements?

·?????? In the case of precious metals, what would the reference points actually mean—i.e., a claim to actual metal/derivative (e.g., mere certificate)?

·?????? Are there adverse/advantageous accounting consequences?

·?????? Do traditional legal concepts of force majeure/impossibility or frustration of purpose come into play?

·?????? Are there any potential windfalls from a contract using gold, bitcoin, or some other stable coin (again, just to name a few examples) as an alternative reference point?

Each of the questions listed above has a lot to unpack, and there aren’t necessarily any right or wrong answers or, at this point, right or wrong strategies.

However, the consequences cannot be understated.?

Imagine in this doomsday scenario that in the early days of such a crisis your business and its counterparties keep moving along as your competitors scramble just to consider how to manage their contracts.

In the not-too-distant future, smart contracts tied to mechanisms already in place, such as SDRs might be one type of solution.? A stable coin reference point could be another.

For now, what this all ultimately boils down to is reserve currencies and counterparty risks…

What does the contract say about that?

(Spoiler alert: The time to have a look at that contract is now! ??)

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[1] There’s a big smiley face emoji here, but you have to focus a bit more to see it. Also be advised that the fact pattern presented represents a composite of multiple events. No legal or investment advice is being given in this note - you'll need to consult a professional for that.

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