CHF: About to be hit by a Vollgeld earthquake?

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1 07 June 2018 CHF: About to be hit by a Vollgeld earthquake? Andreas Steno Larsen While markets have so far decided to neglect the referendum on Sovereign Money (Vollgeld) in Switzerland on Sunday, we warn against the 0% probability pricing of a Yes in the referendum. EUR/CHF could be headed above 1.30 in case of a yes. On Sunday, the Swiss will head to the voting ballots to cast their votes in one of the optional referendums that the Swiss democracy is well known for. While markets have so far not cared about the upcoming referendum, we warn against neglecting it, as it could have widespread financial consequences in case of a yes. The referendum will decide whether or not to give the Swiss National Bank (SNB) the sole authority of creating money. In other words, the Sovereign Money Initiative (Vollgeld initiative), as the proposalinitiators are named, aims to end the money supply created by private banks through the fractional reserve system. The Swiss Federal Council, the Swiss National Bank and the private banks have all warned loudly of the widespread consequences if the referendum ends with a yes to the Sovereign Money Initiative, which could include a perfect storm on the CHF in the immediate aftermath. The rules for the referendum are the following: 1. The majority of the votes cast must support the proposed change. 2. The majority of Swiss cantons must be in favour of the initiative. A simple majority is needed and there is no turnout-benchmark. In case of a yes, the constitutional text is amended immediately, while the change of the law text to implement the changes may end up in a prolonged process with di cult negotiations about the phrasing (likely to last at least a year). The process concerning the law text could possibly end up in a Brexit-like scenario with big di erences between the Swiss parliament and the Vollgeld supporters on the wording and the implications for the financial system of the referendum yes. Could the referendum end with a yes? So far only a couple of opinions polls have been published ahead of the referendum on Sunday, both indicating a relatively solid no. A poll on 4 May indicated that 35% plans to vote yes, while 49% opted

2 for no, with 16% undecided. The large number of uncertain votes also indicates that the turnout will be relatively low on Sunday. If history is any guide to radical proposals in former optional Swiss Referendums, support for the radical proposals loses steam as campaigning picks up ahead of the actual referendum. But the most recent poll indicates that no is not yet a done deal, as the number of yes votes has increased slightly. While our basecase is a solid no, a referendum yes is certainly not a 0% probability event. And the elections in both the US and Europe over the past few years serve as a warning not to rule anything out. What are the likely consequences of a yes? The big consequence is that private banks will no longer be able to utilise their current business model once the changes are implemented into law. This also means that the current functionality where banks can lend out the same CHF several times via the fractional reserve system will be banned. The proposed system will limit the banks ability to lend out, due to the full-reserve system that will be implemented. Hence, the banks will have to collect funds one to one beforehand in order to lend out and hence won t be able to increase the money supply through credit. This change is a big experiment not tried out in any major setting so far. The short-term plan in case of a yes is to convert current deposits at Swiss private banks to liabilities at the SNB, while the banks deposit funding will be replaced by interim loans from the SNB to the private banks (during a transitory period). This will likely have to take almost immediate e ect to limit the extent of negative consequences. A big CHF sell-o and a money market liquidity scare to follow a yes Judging from the current market pricing of the risks in the CHF, the market has so far completely neglected the risk of a yes in the referendum on Sunday. EUR/CHF still trades closely connected to the risk reversal in EUR/CHF that can be seen as a sort of risk premium related to the Euro-area turmoil. The recent comeback for the CHF has been accompanied by an increased risk premium in the EUR option market due to the uncertainty surrounding Southern European politics. Currently we see no risk premium priced into the CHF, which means that a potential referendum yes will be an absolute shocker for financial markets.

3 Chart 1: EUR/CHF still trades in line with the risk premium related to the EUR While it is di cult to forecast the series of events in case of referendum yes on Sunday, our base case is that it will lead to an immediate material sell-o in CHF and likely also to widespread flight-to-quality on financial markets. There is also a clear risk that the SNB needs to inject liquidity in a whatever it takes manner to restore calm in the Swiss interbank market already Monday, in case of a yes, as CHF money markets could freeze as a consequence of the big uncertainty surrounding the banks funding models day one after the referendum. There is also a risk of a big deposit flight from Swiss banks, also arguing for immediate SNB liquidity injections or maybe even capital controls, if the situation escalates dramatically. Judging from the relationship between the relative money supply of CHF vs EUR, a big short-term liquidity injection into the Swiss banking system could lead EUR/CHF as high as 1.3 or above in a very swift move a true Vollgeld earthquake. Long term the case for an even stronger CHF than today could actually grow, as it is a risk scenario that the SNB will get politicised in case of a referendum yes. A politicised SNB will most likely mean a very conservative supply of money (as a growing supply of money is the main concern of the Vollgeld initiative). If the SNB decreases the money supply by for instance 10% as the referendum is implemented into law (probably during ), this could be enough to send EUR/CHF back towards parity long term. It likely won t end up in this mess, but the probability of it happening is not zero.

4 Chart 2: Huge moves in EUR/CHF to be expected in case of a referendum yes Andreas Steno Larsen Global FX/FI Strategist andreas.steno.larsen@nordea.com

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