INTERNATIONAL BUSINESS, FEBRUARY 1989
Richard Smith’s Creative Finance Lab
By DANIAL M. CLARK
CORPORATE TREASURERS AND bankers seeking a simple hedging mechanism to protect against changes in the spread of interest rates in different currencies may get help this year in the form of an innovative treasury product developed by Richard G. Smith Jr., a vice president of Marine Midland Bank.
Mr. Smith, who says the development and marketing of the instrument – the Forward Spread Agreement (FSA) – and its futures contracts is a “dream come true,” has been promoting the product for the last three years. It now seems that February may prove to be the most important month yet for the product, since the Chicago Mercantile Exchange will begin trading three FSA contracts this month.
Richard Smith, 38, has been involved in the futures market for much of his professional life. After graduating from Michigan’s Alma College in 1972, he did a brief stint as a campaigner for former Michigan Rep. James Harvey.
He then took a retail bank training position at Provident National Bank in Philadelphia and considered getting an accounting degree and becoming a CPA. “But after discussions with some friends of mine,” recounts Mr. Smith, “I decided that being a commodities broker was where my real interests lay.”
In 1976, Mr. Smith moved to St. Louis and became a commodities futures broker with Clayton Brokerage. His move into futures coincided with the boom in the financial futures market and the growth in trading Treasury bill futures contracts. He became active in the financial futures industry and, with other brokers, pushed for the adoption of a Eurodollar futures contract. In 1983, Mr. Smith was instrumental in convincing the Chicago futures exchanges to expand the back months offered for trading in the Eurodollar contract. That same year, he joined Marine Midland Bank as a trader with its Treasury division.
Mr. Smith came up with the idea of trading pure interest rate differentials – the premise of the FSA – in May 1986 while on assignment to set up an interest rate trading desk in Hong Kong for Marine Midland’s parent, Hong Kong & Shanghai Banking Corp. “I wasn’t really looking for a new product to create,” he recalls, “and I don’t think any worthwhile financial product is created like that. It is something that just arises naturally.” While the idea may have come naturally, getting any new financial product up and running takes time, patience and more than a little tinkering.
He proposed the idea in a memo to his superiors and spent the next six months refining the product and “going over mental hurdles” such as pricing, structuring, definitions of buying and selling, to test the new product. “The initial memo in which I outlined how it would be priced and structured has basically held up to this moment, though we had to make some subjective decisions about technical conditions of the contract,” he says.
Having decided to launch it as an inter-bank product, Hongkong & Shanghai distributed promotional material to banks and brokers. The first deal, in Hong Kong and U.S. dollars, was done with a Japanese bank on Dec. 4, 1986. Deutschemark and yen FSAs were introduced a month later. Mr. Smith and others embarked on speaking engagements in New York and London to introduce the product to banks, investment banks and corporations. As of November, 130 FSA deals had been completed in the inter-bank market.
Essentially, the FSA is an instrument representing an agreement between two parties wishing to protect themselves against future changes in the spread between interest rates for two different currencies. Since the instrument currently is denominated and settled in dollars, one of the currencies always will be U.S. dollars. The buyer of an FSA, therefore, wishes to protect itself against a rise in interest rates for the foreign currency (yen, mark or sterling) or a decline in U.S. dollar rates. A seller wishes to protect itself against a fall in a foreign currency rate or a rise in U.S. dollar rates.
“The FSA,” explains Mr. Smith, “offers a method of hedging cross currency funding where you have a liability in one currency and you’re funding interest-bearing assets in another currency on an ongoing basis.”
Users of the FSA include banks and anyone borrowing in one currency and lending in another, as well as forward foreign exchange swap traders who are entering into transactions to capture a move or change in interest rate differentials. For the past year, the FSA has been traded solely on an inter-bank basis and reaction by brokers has been favorable.
A big boost for the FSA should come this month when the Chicago Mercantile Exchange is expected to begin trading FSA futures contracts for yen, sterling and Deutschemarks alongside their Eurodollar contracts to call attention to the FSAs basic premise – trading an interest rate differential with a single instrument whose price is not affected by movements in foreign exchange rates.
Mr. Smith calls the new futures contracts the “King Pin ” of the FSA market. “There are banks that like the concept of an FSA but love the concept of an FSA futures contract,” he says. According to Mr. Smith the FSA futures will flourish because the three principal uses are in great demand. First, as an interest rate differential hedging or trading tool, i.e. a Eurocurrency interest rates vs. the Eurodollar rate. Second, the FSA futures complex will allow a U.S. dollar- based corporation a much easier and more liquid means of hedging Euroyen, Euromark, or Eurosterling interest rates by combining an FSA with a Eurodollar futures contract. Third, the FSA futures contract will allow institutions a means to more easily hedge cross-currency interest rate differential risk through spreading the yen, Deutschemark and sterling FSA futures contracts.
“This latter application will be very important, particularly as other FSA such as lira and French and Swiss francs, etc. come on board,” Mr. Smith says. He expects to see a first days trading volume of 5,000 FSA contracts traded for each of the three currency contracts. “Some people consider that to be wildly optimistic but I think it’s a reasonable expectation.”
Another boon to the FSA market, according to Mr. Smith, is the coming imposition of new capital adequacy guidelines for banks. The FSA involves no exchange of principal, only a settlement payment based on the interest rate differential so there is relatively little credit risk compared with a forward foreign exchange swap. And with the FSA futures contract, says Mr. Smith, “there would be no risk-based capital allocation for banks because futures is a cash business.”
Getting the FSA off the ground took a bit longer than Mr. Smith expected. Though he says there is firm support for the FSA in the inter-bank market, “I would have thought that the inter-bank market would have developed more before now. I’m not really discouraged by that nor do I necessarily see that as a negative.”
The FSA also came out after a stream of new products and at a time when banks started scrutinizing these new products much more closely. As an interest rate instrument, the FSA is a bridge between a money market and forward foreign exchange and so there was always a question of where it belonged and what line should be used for such an Instrument. “To get final approval for trading the FSA was not as easy as it was two or three years previously,” Mr. Smith asserts. With the futures contract that will soon be traded though, Mr. Smith sees a natural fit. “In the futures market, operations and accounting are more streamlined and it’s a cash business and not a credit line business,” he notes.
What is in the future for Mr. Smith and the FSA? For the FSA, according to the banker, the evolution should be into trading more currencies. FSA contracts also may be denominated and settled in currencies other than U.S. dollars. “Within three to five years, this could be a huge interest rate futures product,” he says.
As for Mr. Smith, the past few years have been hectic. “I’ve become a project unto myself,” he says. Now he can focus less on promoting his invention and more on overseeing its trading. “In some respects, come February, my life will be changed forever,” he reflects, “and in some ways it will return to normal.”