Readers should check out the lead article in the Wall Street Journal today, “Risk Rule Riles Main Street,” by Victoria McGrane, to get a sense for just how convoluted and acrimonious the debate over derivatives regulation has gotten. Several of my blog posts have been devoted to ongoing commentary on the need for proper systemic risk protections — beginning with adequate regulation and oversight of the $500 trillion derivatives market.
Even beer makers are weighing in as banking and securities regulators struggle with designing and implementing appropriate controls over derivatives trading activities, including whether to exempt so-called “end-users” from the regulations.
Here’s an example that illustrates the issues at the heart of the end-user debate: a company we’ll call “Beer Co.” uses aluminum in mass quantities. To protect itself against rising aluminum costs, Beer Co. can arrange with a bank or broker to create a customized hedge, known as a “swap transaction.” The parties in this transaction, known as “counterparties,” typically agree to exchange payments based what is called a “notional amount.” In our example, let’s say Beer Co. wants to hedge against price increases on $100 million worth of aluminum. So, for the next 6 months, the broker agrees to pay Beer Co. any increase in the value of a $100 million pot of aluminum. At the same time, Beer Co. agrees to pay 2 percent interest on that same $100 million value to the broker. In very simple terms, Beer Co. is swapping interest payments for any increases in aluminum prices. This is known as a six-month, customized swap transaction. Suffice to say, if the price of aluminum goes down, the payments and terms may or may not be much more complicated.
A Brewing Debate
That is the basic structure of a derivatives transaction involving corporate end-users. In theory, counterparties could agree to swap the returns on any type of asset, for any period of time, and based on any amount of notional value. That is where the $500 trillion comes in, the total amount of notional value on which various swap-bets have been placed. The debate now centers on whether this massive pool of instruments should have additional transparency and regulation, and whether Beer Co., or its broker, should have to post financial backing and collateral to guarantee its obligations.
As you might expect, companies like Beer Co. that are end-users of things like aluminum and countless other commodities and raw materials are fighting tooth and nail against posting any collateral. They have formed their own Washington lobbying group and even warned that the cost of a six-pack of beer will go up if end-users are not offered an exemption to collateral-posting requirements. I can hear the chants now: “Hands off Our Brew — Let Derivatives Exemptions Through!”
For their part, regulators from the U.S. and around the world are mired in an ambitious rule-making agenda and are putting out an often confusing and uncoordinated assortment of proposed regulations. And for now, investor protection advocates are left wondering about two issues. First, every exemption provided for OTC derivatives, whether for certain users or instruments, weakens derivatives oversight. Secondly, we have faced round after round of delays in addressing regulatory gaps for derivatives. Short of prompt and coordinated action, many worry the labyrinth of these complicated and interconnected financial instruments will fuel yet another crisis. I’d buy a round or two to avoid that.
Let us know your views on the issue.