The Chicago Mercantile Exchange next month will unveil a new currency forward that will allow banks and thrifts to trade against interest rate movements between currencies -- and will require less credit to do it.
The new product is an exchange traded futures contract which replicates interbank outright forward contracts.
The new forwards may also be traded as a foreign exchange swap m combination with the Merc's, rolling spot contracts. Currency forwards are fixed amount and fixed date contracts with 16 expirations; one-year of 12 monthly expirations and one-year of quarterly expirations.
David Goone, the Merc's vice-president of currency and interest rate marketing, said because the currency forwards are traded with the exchange's clearing house as a counterparty transaction, counterparty and delivery risk are minimized.
He also said using the exchange is cheaper for banks than privately traded currency forwards. Moreover, the new instruments will require less capital committment by banks.
"It frees up a lot of their credit lines," Mr. Goone said. "[Banks] have to set aside a certain percentage of their notional amount for forwards deals."
For a bank to enter into a $50 million, 18-month forward deal, it would cost between $130,000 and $150,000 in capital charges. He estimated that the same deal using Merc currency forwards would probably only cost about $4,000 in commissions.
"Treasurers are concerned with capital charges," Mr. Goone said. "Most banks don't do deals for longer than a year because it ties up their credit lines. We're hoping banks will- be able to do a lot more business With this."
And capital requirement set-asides are rising. Currently, the Bank of International Settlements requires banks to set aside 5% for deals longer than one-year and 1% for shorter term deals. For those lasting longer than five years, the capital requirement is 7.5%.
As a result, observers say the average deal has dropped to about three or four months, from six months or longer.
"This ties up your credit lines a lot more than interest rate contracts do," said Mr. Goone. "A lot of customers don't get longer deals now. Banks will only do them as a courtesy for their best customers now." Initially, the new currency forwards will be listed only in Deutschemarks. Yen-denominated instruments are planned and Mr. Goone said listings in the British pound, Swiss franc and Canadian dollars are anticipated. Because exchange-traded contracts are marked-to-market each day, forwards and forward swaps traded on the exchange do not affect a bank's credit line and are not subject to the BIS capital requirements. A forward swap is the simultaneous purchase and sale of a pair of currencies.
Tanya Beder, co-owner of Capital Market Risk Advisors, a New York-based consultancy specializing in risk management and derivatives, agreed that the Merc's new currency forwards would tie up less of a bank's credit than a private transaction. "It allows a clear credit advantage," she said. "It also eliminates daylight risk." Daylight risk is the risk of making a payment to one time zone and receiving a payment from the counterparty in another too late to be credited that day. In such a case, because the valuation of currency contracts can change daily, the counterparty could lose money because of untimely payment.
Sources at several money center banks say they could structure similar products that would not need to be traded on the Mercantile Exchange.
"The banks could do it themselves," said Ms. Beder. "But then they still have the problem of putting their credit at risk, The risk would be reduced with the exchange behind it."
Less clear, however, is whether the need for less capital might tempt some financial institutions to leverage more in taking .a position. Wall Street analysts declined to speculate, but one privately says smart banks should only enter transactions that meet their hedging objective. "I think most banks will only enter a derivatives contract that meets a specific need," said the analyst, who asked not to be identified. "Anyone that goes beyond that is playing with fire."