The currency swap market is the oldest and most creative sector of the swap market. This is not distinguished in market terms between the fixed rate currency swap and the currency coupon swap. There is no distinction in market terms between these two types of currency swaps because the only difference is whether the counter currency receipt/payment is on a fixed or floating basis- in structure and result, the two types of swaps are identical and it is a matter of taste (or preference) for one or both counter-parties to choose a fixed or floating payment. When the dollar is involved on one side of a given transaction, the possibility to convert a fixed rate preference on one side to a floating rate preference on the other side through interest rate swap market makes any distinction even more irrelevant. However, for those who like fine distinctions, there is a tendency in the market to regard the fixed rate currency swap market as more akin to the long date forward foreign exchange market (because when one is executing a fixed currency swap one may often be competing with the long-date Forex market) and the currency coupon swap market as more akin to the dollar bond/ swap market (because the dollar bond issuer compares the below LIBOR spread available in the dollar market to that available, say, through tapping the Euro market).
From the market point of view, the driving force of the currency swap market is creativity. Structures in the currency swap market range from the extremely simple to the complex, multi-faceted, multi-counterpart transactions whose economies exist in the dimensions available only to the mathematician. One is limited in the currency swap market only by the problem to be solved, one’s imagination, the skills of your personal computer operators and of course, the ability of your colleagues to find suitable counterparts around the world at the right time and price. As opposed to the dollar market, where capital commitment has become increasingly important, the key in the currency capital commitment has become increasingly important, the key in the currency swap market is still commitment to creative problem-solving and development of a swap distribution system on a global basis—classic investment banking.
Whatever distinctions one wishes to draw or not to draw between the two basic types of swaps in the currency swap market, there are many reasons why this market is the most creative and therefore, most interesting sector of the swap market. While still smaller than the dollar interest swap market, the currency swap market has great and perhaps even greater potential for growth than the dollar market, particularly in the light of the growth in local/ Euro capital markets in a wide range of currencies.
One can classify activity in the currency swap market into the same two basic sectors as the interest swap market – a primary and secondary sector. In the currency swap market, the primary sector is dominant across the yield curve and the key motivating forces underlying this market are “new money” and “hedging” in that order. “New money” or the willingness to execute swap-related public or private financing in one currency to achieve a finer cost or enhanced availability in another currency is the key motivating force behind the currency swap market, particularly for banks and sovereign entities. Such entities have had large capital and refinancing requirements in recent years. The capacity of any one market (eg: the Eurodollar bond market) to provide all of these requirements at the finest possible cost has been limited. Hence, many banks and sovereign have been willing to approach the private and public debt markets in currencies for which they have no natural requirements (but which the swap market can use) in order to reduce costs and / or gain greater access to a particular currency which is required. Restructuring, or “hedging” current debt portfolios, cash flows or investments, is clearly an influence of second order is comparisons to the influence of “new money”. The flexibility of loan repayment clauses and the fact that many corporate and sovereign entities have found their access to a wide range of securities markets greatly expanded in recent years means that even if the fundamental motivation of a currency swap is restructuring/ hedging, this would normally be preceded by an issuer first obtaining a cheaper cost of funds in the base currency through securities or near security transactions.
“Warehousing” in the primary market is not widespread due to the difficulty of covering the interest rate risks while the swap is in position. A swap arranger can cover the foreign exchange risks associated with “booking open” a position in a given currency but often times the arranger cannot cover against a movement in interest rates for that currency or is forced to use (generally poor) surrogate cover. This is due to the fact that currency swap rates generally move to the laws of their own supply and demand and do not necessarily relate to say, local government bond markets where cover in some currencies can be obtained (particularly sterling and Deutschmarks). But taking of position does not take place among a few selected players and such market-making is not done on a much wider spread basis versus capital market rates than in the dollar interest swap market. However, until better and more consistent relationship between swap rates and the available interest cover develops, position-taking in the currency swap market will remain very much akin to long-date forward foreign exchange dealing and less toward the classic arbitrage model of the swap market.
In sum, the primary sector of the currency swap market is dominated by “new money” considerations by issuers and on the other side, by greater access to a select few low interest-rate debt markets by often the same type of entities. There is, however, a greater diversity by type of participants in the currency swap market than the interest swap market with financial institutions, particularly banks, playing a smaller role in the currency market and sovereigns, supranational and corporate playing a relatively larger role than such entities do in the dollar swap market. Position-taking (capital commitment) is still less important than commitment to creativity and distribution capacity among arrangers. While the currency swap market is highly competitive, there is still the possibility to beat your competitor by being smarter, quicker and developing “niches” of special expertise in a particular currency.
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