Bankers exchange $1.2 trillion worth of foreign currencies every day but have had little to protect themselves from loss if a trading partner goes broke before settling a contract.
Now Chase Manhattan Corp. has come up with a way to help money traders sleep better.
The bank recently began marketing a new derivative that enables trading partners to avoid actually exchanging millions of dollars worth of foreign currency. Instead, they would exchange the few thousand dollars' worth of difference that develops from the moment the contract is entered into until its maturity.
The derivative was created in response to prodding from the Bank for International Settlements, the central bankers forum in Basel, Switzerland. In the spring of 1996 the BIS urged banks to find ways to mitigate "settlement risk" before regulators did.
"For 25 years bankers have been trying to deal with this," said Dennis Oakley, managing director for global markets at Chase Manhattan Bank. "We think we've developed something that brings some stability."
The product is the latest twist in the rapidly evolving world of credit derivatives, which are instruments that aim to smooth out the risks banks incur as they go about their business of lending and trading money.
The problem faced by foreign currency traders face is simple: The $1.2 trillion worth of trades the BIS estimates are made daily are done over a variety of time zones. If an American banker wires dollars to Bangkok, it can be hours, or even days, before the other bank sends back Thai baht.
In that short period, catastrophic events can erupt.
In 1974 German regulators seized and liquidated Bankhaus Herstatt, an active player on the foreign exchange markets. The bank's counterparties were swamped with unpaid contracts.
More recently, the 1990 demise of Drexel Burnham Lambert, the liquidation of BCCI, and the failed Soviet coup d'etat in 1991, and the collapse of Barings PLC in 1995 showed how one institution's failure could have worldwide repercussions, the BIS said in its report.
Chase's new derivative is based on the premise that most foreign currency trading is done by banks seeking to hedge their positions in various currencies. They are not much interested in actually receiving the foreign currency, but are very interested in keeping their risks under control.
Tanya Styblo Beder, principal at Capital Markets Risk Advisors, a New York consultancy, sees the product becoming most useful to banks that trade currencies but lack offices worldwide to settle their contracts.
"Any contract between parties in New York and Tokyo can be settled in London, which eliminates a lot of the time zone problem," she said. "This derivative will probably be of most help to people who lack offices in those locations."
In the mechanism of the new derivative, the parties exchange only the difference in the currencies' values between the times the transaction is arranged and settled.
This concept differs greatly from typical futures or forward exchange contracts. Under these, commodities-whether Illinois soybeans or Swiss francs-can be delivered at some preset date.
But in "nondeliverable forwards," delivery of a commodity is not a possibility. These curious contracts have become quite popular in financial circles in the past five years, said Dan Flannery, executive vice president at the brokerage Prebon Yamane.
The volume has grown as banks and other corporations start doing more business in Latin American, Asia, and in the former Soviet republics, Mr. Flannery said.
Although some traders like these countries' economic prospects, most don't like their illiquid currencies.
So they've been using foreign exchange contracts, so instead of trading currencies they exchange the difference in the value of the currencies from the start of the contract until the end. These contracts are usually settled in U.S. dollars.
Chase's Mr. Oakley said the goal of the new derivative is the same.
Nondeliverable forwards "are for emerging markets, but why not do it for all currencies where there is liquidity?" he said. "That's the idea behind the new derivative."
