Australia's Westpac Banking Corp. is setting up a separately capitalized derivatives unit backed by a $100 million surety bond from New York-based Capital Markets Assurance Corp.

The unit, Westpac Derivative Products Ltd., is the first of its kind to use a third-party guarantee as part of its capital structure.

Similar derivatives trading units set up by other banks and investment banks have until now relied solely on their own capital or parent company guarantees.

Westpac officials were unavailable for comment on the move.

However, market sources said Westpac preferred to use third-party credit enhancement because it was cheaper than pumping additional capital into the derivatives unit in order to get a higher credit rating.

Banks and investment banks have been setting up separately capitalized derivatives units in order to obtain higher credit ratings for them. This improves the creditworthiness of the derivatives subsidiaries and makes them more attractive to trade with as a counterparty.

Banque Paribas, a French bank, recently set up its own derivatives unit.

$200 Million in Initial Capital

Several other foreign bank companies, such as Swiss Bank Corp., have acquired U.S. derivatives units but use the parent company to guarantee their transactions.

The Westpac unit, also known as WDP, has been formed by the Sydney-based bank with initial capital of $200 million.

Of that, half will take the form of paid-in capital from Westpac, while the balance will be provided through the Capital Markets Assurance surety bond.

Capital will be increased if the unit's exposure to counterparty risk increases.

WDP will be used to trade interest rate and cross currency swaps, interest rate options and forward foreign exchange contracts.

The unit has obtained an AAAt financial programs rating from Standard & Poor's Corp. and a prospective P(aaa) counterparty rating from Moody's Investors Service Inc.

John B. Caouette, chairman and chief executive officer of Capital Markets Assurance, said the surety bond offers a "cost-effective source of alternative capital for the subsidiary."

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