The market for currency-based products gets more interesting every day.

ELEMENTS, the exchange-traded note (ETN) consortium organized by Merrill Lynch, is launching a new set of currency ETNs that aims to exploit what some see as a shortcoming in the existing currency ETNs ... and aims to offer potentially better returns than the existing currency ETFs.

On February 21, ELEMENTS rolled out five new currency ETNs that offer exposure to foreign currencies and their home-market interest rates. The new funds are:

• ELEMENTS Euro (ERE)
• ELEMENTS Australian Dollar (ADE)
• ELEMENTS British Pound (EGB)
• ELEMENTS Canadian Dollar (CUD)
• ELEMENTS Swiss Franc (SZE)

Each note is linked to the performance of the named foreign currency against the U.S. dollar. If the euro rises against the dollar, for instance, the ELEMENTS Euro ETN (ERE) will rise as well.

In addition, each note makes semiannual dividend payments based on local interest rates. For instance, the euro note makes payments based on the EONIA interest rate, minus 0.25%. The notes charge 0.40% in annual expenses.

What's interesting about these notes is that two of them - the ELEMENTS Euro and ELEMENTS British Pound ETNs - have direct existing competitors in the ETN market. Barclays Bank offers the iPath EUR/USD Exchange Rate ETN (ERO) and the iPath GBP/USD Exchange Rate ETN (GBB). Like the ELEMENTS products, the iPaths charge 0.40% in annual expenses. They also accumulate interest in the same way, with ERO (for instance) gathering the EONIA rate minus 0.25%.

Why would anyone choose the new ELEMENTS ETFs? Because they make semiannual cash dividend payments to noteholders based on the interest income. The iPath ETNs, in contrast, incorporate that income into the value of the note ... a kind of "virtual interest" that is only realized when the noteholder sells.

When the iPath ETNs were launched, Barclays Capital believed that they would qualify for favorable tax treatment by the IRS. Particularly, it believed that by incorporating the interest income into the value of the note, taxes on that income could be deferred until the note was redeemed. Moreover, if noteholders held their notes for more than a year, that income would be taxed as long-term capital gains, with rates of just 15%. By contrast, interest income that is paid out to investors is taxed as regular income with rates up to 35%.

Recently, however, the IRS ruled that all profits from currency-based products would be taxed as regular income, including both currency gains and interest income. What's worse, noteholders whose products generate "virtual income" - like the iPath ETNs - will have to pay taxes on that income each year, even though they won't receive any cash until they sell the note. That means paying the tax man out of pocket.

Since that ruling, Barclays has filed for new currency products tied to emerging markets currencies that make interest payments, but it has made no move to amend the existing ETNs.

"We’re happy with the existing ETNs and we might consider launching additional interest-paying ETNs in the future," said Philippe El-Asmar, Philippe El-Asmar, Head of Investor Solutions, Americas at Barclays Capital. "

What About CurrencyShares?

These new notes also go head-to-head with competing ETFs from Rydex Investments. In fact, Rydex's CurrencyShares includes matching ETFs for each of these new ETNs.

Why would someone choose one over the other? The biggest difference is the structure. The ETFs are grantor trusts, meaning if you own shares of the ETF, you own a share of a bank account that physically holds the underlying currency. The ETNs, in contrast, are debt notes: The issuing bank promises to pay you an amount tied to the movement of the currency, with zero tracking error. If the bank defaults, the notes will be treated like other forms of debt, and you could be out of luck.

The practical risk of default is vanishingly small - the ELEMENTS notes are underwritten by Deutsche Bank, while the iPath notes are underwritten by Barclays Capital, two very strong banks. But as the Société Générale scandal showed, strange things can happen, and for some investors, it may not be worth the risk.

The ETNs do have advantages over the ETFs on a performance basis, however. The CurrencyShares pay out slightly lower interest income than the ETNs. All three sets of products are generally tied to the same interest rates, but in the markets where there is competition, the CurrencyShares arrogate a slightly larger fraction of the income to themselves, as shown below.

The actual payouts remain to be seen, and the theoretical advantage of the ETNs could not appear in practice. But on paper, they do appear to have an edge.

The choice, ultimately, comes down to three factors:

• Do you trust the ETN issuers, or are you worried about default?
• Do the slightly higher interest payments on the ETNs matter to you?
• What are the bid/ask spreads, and are they small enough on the well-established CurrencyShares ETFs to make up for the interest rate differentials?