Derivatives dealers are preparing for a most unusual situation: negative short-term interest rates in one of the world's major economies.
The International Swaps and Derivatives Association plans to issue an advisory next week on dealing with negative rates, attempting to provide practical guidance to traders in the event that rates in Japan slip below zero.
Since the end of March, the Bank of Japan has steadily cut interest rates, to the point where its discount lending rate now stands at 0.5%. The central bank's actions have come in response to a deepening recession and banking crisis that has resulted in the failure of two financial institutions and credit problems at scores of others.
Negative rates could limit the flexibility of Japan's politicians and central bankers in dealing with the nation's financial crisis and prompt investors to seek legal protection.
The low rates have already set off alarms among some participants in the derivatives markets. Chip Goodrich, vice chairman of the swaps and derivatives association and a managing director at Merrill Lynch & Co., said the group's guidance statement is a response to requests from members.
Most over-the-counter derivatives transactions are covered by master agreements drafted by the trade group. However, in their original form, these agreements did not address the possibility of negative interest rates.
Such a situation could arise in interest rate swaps whose terms call for a floating rate below a benchmark Japanese interest rate. With rates so low, these terms could create a floating rate that is in effect, less than zero.
By issuing an advisory on how to handle this possibility, the association is hoping to give members a way to avoid legal conflict.
Mr. Goodrich said the association's members have decided the best way to handle such a situation is to have the party receiving the negative interest pay that amount to its counterparty.
"We are also saying that if you want to reach a different result, here is a way to approach that in the legal document," he said.
Although short-term interest rates in Japan are at an historically low level, real interest rates - adjusted for inflation or other factors such as taxes - have fallen below zero many times in the past, said What is unusual in this case, however, is that the concern is about negative nominal rates.
A particular concern in the current case is the fear that the Japanese may have stumbled into the kind of "liquidity trap" that the economist John Maynard Keynes warned of. In such a situation investors refuse to borrow despite efforts by the financial system to make credit available.
Adding to the problem is the continued decline in the price of real estate and other assets. This has created a lack of short-term investment opportunities, Mr. Miller said.
"The prospects for investment are so dismal that people don't want to borrow," he said. "If you think prices are going to fall, then even a 0% interest rate is too high because you have to pay it back with more valuable currency."
While derivatives dealers are taking steps to limit any potential problems arising from the rate environment, some banks have taken advantage of the situation raise medium-term funds.
Daniel Schneider, a senior vice president with State Street Boston Corp. who heads the $22 billion-asset bank's money markets division, said it raised 5 billion yen, or nearly $50 million, in a yen Euronote offering earlier this month to fund its U.S. banking operations.
The two-year note, which was the first issuance of a yen-denominated bank note in Japan, carried a fixed coupon rate of 1.05%, about 18 basis points higher than Japan's treasury securities at that time.
Mr. Schneider said the bank had wanted to diversify its funding sources under a $750 million bank note program begun in 1991. With rates in Japan at such low levels, the bank felt it was the right time to issue the notes in Japan.
While rates have continued to fall since the Oct. 12 issuance, State Street was pleased with its offering. It retained its fixed rate obligations even though it swapped the yen denominated funds into U.S. dollars.
"We thought this would be a good way for us to gain some experience by using the foreign currency option, particularly to issue in Japan," he said.
At the same time U.S. banks are finding borrowing costs unusually low in Japan, Japanese banks are paying premiums for their funds. But few expect the problems to continue much longer.
One Japanese bond trader said certain big banks are likely to recover quickly.
"The good Japanese banks will again be able to buy funds at market rates eventually."