Should Derivative Reform Include End Users?

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One of the key pieces of financial reform is Blanche Lincoln’s proposal to force derivatives to be cleared on an exchange instead of being traded over the counter in private deals. However, end users like airlines or agribusiness companies, which generally use derivatives to hedge price fluctuations, hate the idea that this would apply to them as well as to banks that use derivatives for speculation. The Wall Street Journal reports:

In a clearinghouse, akin to a cooperative, all parties to derivatives deals chip in to cover losses if any one goes under. To make that work, companies that use derivatives, either to hedge or speculate, post collateral, in case the bets go against them. End users hate this idea. It “will have a significant drain on working capital at a time when capital is highly constrained and credit is in short supply,” David Dines, head of risk management at commodities giant Cargill, told a Senate committee in 2009.

Maybe so. But as Wallace Turbeville has pointed out, the collateral problem could be taken care of easily: the bank selling the derivative could simply extend a conventional loan at the same time they sell the derivative (which the customer would then post as collateral) instead of taking on the collateral risk themselves (which essentially rolls a loan and a derivative into a single package). What’s more, customers would almost certainly get a better price than they do now with packaged products. The problem, Turbeville says, isn’t so much that corporations couldn’t get the loans as the fact that a conventional loan is carried on a corporation’s balance sheet as debt, while the embedded loan in a packaged derivative isn’t.

If Turbeville is correct, the current method of selling OTC derivatives is basically designed to take advantage of an accounting loophole: by packaging a loan together with a derivative, corporations get to pretend that they’re carrying less debt than they really are. That’s probably not something that federal rules should encourage, which means that maybe everyone should just get over their phobia of including end users in the new rules. The derivative market would get more stability and transparency, end users would get lower prices, and investors would get a better picture of corporations’ true short-term debt exposure. And as Tim Fernholz points out, there’s another bonus: if we just go ahead and include end users in the rules, we don’t have to worry about writing complex exemption language that banks will almost certainly eventually figure a way to work around. What’s not to like?

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