In the coming months, regulators will address many critical and complex issues in the new financial reform legislation, but perhaps none as misunderstood as the regulation of derivatives.
These complex instruments are widely seen as a high-wire act used by Wall Street to make risky bets in search of big payoffs. But the use of derivatives to manage risk by corporate “end-users” plays an important role in providing the certainty businesses need to succeed, grow and create jobs.
Derivatives end-users include companies like Eaton Corp., the Cleveland-based maker of industrial components, and MillerCoors LLC, the multinational brewer. They bring finished products to market or produce the raw materials for these products. Farmers -- some of the largest end-users -- employ derivatives to lock in a price for their harvest and guard against bad weather or wild fluctuations in the demand for their crops.
Similarly, manufacturers use derivatives to lock in the price of commodities such as fuel so they can keep prices stable for their customers. The Commodity Futures Trading Commission estimates that there are 30,000 end-users in the U.S., a number we believe is low.
In recent years, the risks surrounding the speculative use of derivatives have become all too clear, and Congress wisely directed regulators to tighten the rules. At the same time, Congress attempted to write a clear exemption for derivatives end-users because their transactions did not meaningfully contribute to the financial crisis. The hedging they engage in reduces rather than increases systemic risk.
We say “attempted” because regulators are proposing rules that would wrongly include end-users. Such rules would penalize derivatives end-users that did not cause the financial crisis and, in the process, hurt American workers and threaten U.S. jobs.
We are thrilled that the House Financial Services Committee recognized the potential consequences and voted unanimously this week in favor of a bill that would exempt end-users from government-mandated margin requirements. With strong bipartisan support, we hope Congress will move quickly on the legislation to provide much needed certainty for end-users.
Among the more than 70 derivatives regulations that have yet to be completed are rules requiring bank dealers to ask their end-user counterparties for margin -- cash or cash-like collateral -- under yet-to-be-defined circumstances. In general, margin is a cash payment to the dealer to cover any decline in the value of the instrument. End-users may have to continually meet margin calls as market prices fluctuate.
The Office of the Comptroller of the Currency, one of the agencies charged with regulating this market, estimated the rules could force entities it regulates to sideline $2.05 trillion -- an amount 41 times greater than all U.S. financial-institution derivatives losses since the crisis began. This could translate to an enormous blow to economic growth without adding to financial stability.
The banking regulators have sent mixed messages about the purpose of this new requirement. End-users have been told that the rule simply codifies current market practice and therefore the impact should be minimal. Although it is true that many of these two-party transactions are backed by collateral today, the terms are set by the bank dealer based on an end-user’s risk profile.
Without any evidence that the two sides have been historically unable to price in this risk, or that these transactions could go bad in a way that could contaminate our economy, banking regulators are proposing to step into the middle of those transactions. They now want to mandate collateral requirements for all parties, review the amount of risk each party in the transaction has assumed, and, possibly, dictate when and how margin is collected.
Some regulators have asserted that margin rules are for end-users’ own good. They observe that margin tightens spreads, or the difference between the price at which dealers enter into swaps and the price at which they exit them. Lower spreads mean lower costs for end-users, because the spread is how the dealer makes money.
Although attractive on its face, this analysis oversimplifies the trade-offs that end-users actually face. End-users have long had the choice to margin their hedging transactions. They can, for example, use exchange-traded derivatives with their strict margin rules, or they can voluntarily post collateral in private, bilateral trades. Many end-users choose not to do this because they prefer to keep their cash rather than tie it up in a margin account, payments to which may rise and fall day by day as market prices fluctuate.
Congress agreed that end-users should be able to weigh the trade-offs between margin costs and liquidity, especially because end-users did not and cannot contribute to financial instability. According to the Bank for International Settlements, nonfinancial end-user derivative trades are less than 8 percent of the global market, and that risk is dispersed among tens of thousands of firms.
In addition, of about $2.1 trillion in worldwide credit losses and writedowns reported by financial institutions since the crisis began, only about 3.2 percent resulted from derivatives. The majority of those losses came from American International Group Inc., which would not be eligible for an end-user exemption.
These are among the reasons that Federal Reserve Chairman Ben S. Bernanke wrote on Nov. 29, 2010, to Senator Mike Crapo, the Idaho Republican, “The Board does not believe that end-users other than major swap participants pose the systemic risk that the legislation is intended to address.”
Another criticism of the end-user exemption is that large Wall Street firms might try to claim they are exempt from margin requirements. But if a bank is a major market-maker in derivatives, it would be subject to substantial new requirements under the Dodd-Frank law’s Title VII as a “swap dealer.”
Banks Not Exempt
Even if a bank weren’t a dealer, and had a derivatives book large enough to pose a systemic risk, it would be regulated as a “major swap participant.” And all speculative trades, whether executed by large financial institutions or by end-users, will be ineligible for an exemption. In short, there is no way that a Wall Street bank could avail itself of an end-user exemption.
If margin requirements are imposed on end-users, companies will be forced to divert cash to use as collateral during periods of market stress, sidelining billions of dollars from more productive uses.
Bringing more transparency and accountability to the derivatives market should be a victory for the American people, but if regulators overreach and fail to distinguish between end-users and speculators, we will simply be taking one step forward and two costly steps back.
(Thomas J. Donohue is president and chief executive officer of the U.S. Chamber of Commerce; John Engler is president of the Business Roundtable and a former Michigan governor; and Jay Timmons is president and CEO of the National Association of Manufacturers. The opinions expressed are their own.)