Two New Currency Products

The foreign exchange market is primarily an over-the-counter market. The $2 trillion a day market is conducted primarily over telephone and computer lines, with banks still the primarily market makers. However, anecdotal reports suggest that there has been a surge of interest in the foreign exchange market over the past couple of years. Due to the relative low entry barriers, high leveraging ability, and an intensified search for greater diversification amid global capital markets have become more integrated and arguably increasingly correlated, there appears to have been a dramatic increase in smaller participants in the foreign exchange market, especially hedge funds and commodity trading advisors. In recent weeks, two new exchange traded currency products have been launched.

The first is an exchange-traded fund (ETF) called the Euro Currency Trust (FXE) and trade on the New York Stock Exchange. The Trust’s objective is to reflect the price of the euro. Each share represents 100 euros, held in London, plus accrued interest. The yield is tied to the euro’s overnight index average, out of which fees (0.27%) are paid. The expense-ratio is 0.4%. Rydex Investments is sponsor and manager of the Trust and has a similar structure to the other ETFs that in effect “equitize” a non-equity investment, like gold. FXE was launched just in late December last year. In the 13 days of trading, through last Friday January 13, daily volume has average about 130k shares or representing notional value of about $15.6 mln.

The second is a futures contract launched by the New York Board of Trade last week that is based on a trade-weighted basket. The trade-basket includes currencies of five of the euro-zone’s trading partners, the US, the UK, Switzerland, Japan, and Sweden. It is a microcosm of the 23-currency basket the European Central Bank uses to calculate the single currency’s nominal effective exchange rate. The contract will trade in NY and Dublin and will have a quarterly expiration schedule (March, June, Sept and Dec).

These products may have speculative appeal. They both appear to make the foreign exchange market more accessible to as wider range of prospective investors. However, both contracts have some short-comings that suggest their use will likely be limited, especially in light of the dramatic reduction of barriers to access the spot market. For example, the Euro Currency Trust denies players two important characteristics of the foreign exchange market. Namely it is a truly global market and trades nearly 24 hours a day. An exchange traded product is only accessible while the exchange is open. In addition, while leveraging is an important attribute of the foreign exchange market, as an equity product, the leveraging is limited to the 50% margin requirement.

The futures contract appears to overcome the leveraging issue. The margin requirement on a futures contract is a function of volatility and how much one can lose in one or two days. In effect the margin requirement for equities represents a down payment on the purchase, while the margin requirement in the futures market is a down payment on a future loss. However, .a short-coming of the new euro-index is that there are already ample currency futures products for investors and speculators to express a view. Moreover, unlike equities, which limit the ability to short (i.e., the uptick rule), short-selling in the futures market is as easy as going long. One can short the more liquid dollar index futures, for example, which includes the euro, Swedish krona, British pound, Swiss franc and Japanese yen (it also includes the Canadian dollar, but it accounts for a minor 9%). Given the new accounting rules, favorable treatment is reserved for perfect hedges and few corporates will have an exposure that identically matches the composition of the euro-index basket.