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Central Bank Plans Forward Exchange Market

Banks and financial institutions may soon offer new ways for users of U.S. dollars to minimize the risks involved with the country’s new exchange rate system.

The Central Bank has designed regulations that would allow financial agencies supervised by the Superintendence of Financial Entities (SUGEF) to offer three different ways for people to mitigate risk, according to Central Bank economist Eduardo Méndez.

If passed by the Central Bank’s board of directors, the regulation will allow for forward contracts, currency swaps and interest rate swaps, he said.

The Central Bank implemented a new exchange rate regime in mid-October as part of a push to fight inflation. The new system, in which the Costa Rican colón is no longer pegged to the U.S. dollar in a system of daily mini-devaluations, means the price of the colón is determined more by market supply and demand. Still, the Central Bank can intervene if the colón rises or falls beyond established bandwidth limits (TT, Oct. 13, 20).

Because the price of the colón is now more volatile, there are more potential risks for those with dollars.

Importers and exporters who assume risk when making sales and purchases in dollars would likely use the forward contract, which Méndez said will probably be the most commonly used contract in the forward exchange market.

“This is for someone who needs dollars in, say, three months, but doesn’t want to run the risk of waiting to see what the exchange rate will be in three months,” Méndez said.

In a forward contract, two parties agree to make a transaction in the future, and negotiate the exchange rate that will be used for the future transaction, he explained. The parties, which could be importers, exporters, financial institutions or any other currency user, set the terms of time and price in the agreement. The new regulations may also allow for future contracts, which are basically forward contracts with standardized terms, regulated by oversight agencies and guaranteed by clearinghouses.

Mónica Araya, president of the Costa Rican Chamber of Exporters (CADEXCO), said the export industry is still waiting to hear from the banks regarding how much exchange rate insurance will cost.

Fluctuations in the exchange rate can mean big losses for importers or exporters, she said, “because we’re talking about exchanging a lot of money but with small profit margins.”

“The exporter will be paying the bill,” she said, adding that if no one regulates an exchange rate futures market, it could mean banks will make more money off exporters and importers.

Silvia Zúñiga, spokeswoman for the National Stock Exchange, said the effort to open an exchange rate futures market is being pushed by the Stock Exchange, which put regulations in place as early as June –before the new exchange rate regime was implemented – in anticipation of the more liberalized regime.

It is possible that with the exchange rate futures market the country could see the emergence of future traders, hedgers and speculators, who seek to make profits by predicting market moves and buying commodities on paper for which they have no practical use.

The difference between a forward contract and a currency swap is that in a currency swap, the two parties make a currency transaction at the beginning of the contract at a given exchange rate, and then agree to swap currency back at a future date at the end of the contract at an exchange rate negotiated at the beginning of the contract, according to Méndez.

In an interest rate swap, a currency transaction is made today, and both parties pay interest to each other on the currency they receive at a negotiated interest rate.

When the contract is completed, the currency is swapped back at the same exchange rate. It is normally the case that only the difference between the two payment amounts is turned over to the party entitled to it, instead of exchanging the full interest amounts.

Méndez said plans to allow for future contracts are still tentative, however, and Araya said many questions remain.

“We don’t yet know what the product will be, how (the market) will operate, whether it will be electronic, what documentation will be required, how much it will cost clients, or even who will manage it the Central Bank or the National Stock Exchange,” she said.

Méndez said the Central Bank has drawn up a rough draft of regulations that would create the new market, a draft on which leaders in the financial community are now giving feedback. He said the new regulations could be passed and put into effect as early as this month.



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