Greenwich Associates: Derivatives reform has 'Costs and Consequences'

Tuesday, June 1, 2010 Stamford, CT USA — It is not only banks and other derivatives market participants that should be considering how their businesses will be affected by the primary costs and secondary consequences of new derivatives rules in the bills now headed into the U.S. Congressional conference committee process.

Because of the central role that derivatives play in the U.S. banking system and in global financial markets, costs imposed by new regulations will have a far-reaching impact on banks' ability to lend, the price and availability of credit for companies and consumers, and on companies' ability to protect their bottom lines against volatility in commodities and financial markets.

A new report from Greenwich Associates, Derivatives Reform: Reducing Systemic Risk, But at What Cost?, highlights some of the costs and consequences associated with the new rules. These costs are not reason in themselves to oppose legislation, which includes some constructive changes that — if properly implemented — will make derivatives markets more robust. To date, however, debate over the new rules has focused almost exclusively on uncovering the role that derivatives played in the global market crisis, the risks derivatives pose to the financial system and the allegedly unscrupulous behavior of derivatives dealers. While these are all important issues to address, they must be balanced by an objective look at the purpose derivatives serve in the modern financial system and the costs that will be imposed on markets and the economy in exchange for tighter regulation.

Centralized Clearing and Exchange Trading
The centerpiece provision of new derivatives regulation would shift the clearing of swaps transactions to "derivatives clearing organizations" and the trading of these instruments to exchanges. The primary goal of this initiative is to move risk from the balance sheets of individual banks and market participants to central entities where it can be aggregated, netted out and mitigated through the imposition of margin and capital requirements. Most market participants agree that the move to centralized clearing would be a constructive step in managing systemic risk in derivatives markets.

However, achieving this goal will require unprecedented levels of standardization in derivatives contracts. This standardization could prevent companies from customizing derivatives agreements to the precise specifications of their liabilities. If it does, it will create mismatches that could actually increase risk and volatility in company P&Ls by reducing the effectiveness of hedges or even eliminating companies' ability to hedge some risks. Also, by creating such mismatches, the bill could prevent some derivatives from qualifying for treatment as hedges under current U.S. accounting rules. These derivatives would become subject to mark-to-market accounting standards, which would introduce significant levels of volatility to corporate P&Ls, effectively preventing their use in many cases.

Even companies that qualify for "commercial end-user" exemptions will face higher costs. The shift to central clearing and exchange trading would reduce activity and liquidity in the OTC market. Significant new costs will be added to the system for all participants if banks are forced to use centrally cleared and exchange-traded derivatives to lay off risks incurred in the facilitation of OTC trades for exempt end-users.

Position Limits
The ambiguous language used throughout both bills gives extraordinary leeway to regulators who will be empowered to interpret and apply less-than-specific rules and definitions. Nowhere is this concern greater than in the area of position limits. The Senate bill empowers the SEC to set position limits and orders "swap execution facilities" to reject any trade that would cause a customer to exceed those limits. This provision is aimed at preventing speculation in energy markets. The position limit rule meant to address this questionable issue is at best heavy-handed and at worst, due to the lack of specificity about how position limits would be determined and implemented, could devolve into government price fixing.

Fiduciary Requirement
It is difficult to assess the potential costs and benefits of a proposal included in the Senate bill that would require derivatives brokers to act as fiduciaries in transactions with municipalities and other government agencies, pension plans, endowments, and retirement plans. The reason: It is impossible to envision how such a requirement would work. By definition, the two sides of a swap transaction have conflicting interests. While increased transparency and tough disclosure rules about potential conflicts of interests make sense as methods of protecting market participants, the fiduciary requirement as it currently exists in the bill seems just short of nonsensical.

Separation of Banking and Derivatives Trading
There is less reason for concern about another controversial part of the current bill: the proposal that would ultimately force banks to establish separate subsidiaries for derivatives trading. The worst-kept secret in Washington is that this provision was accepted into the Senate bill only as a means of burnishing Congress' "tough on banks" credentials and is not expected to be included in the final law.

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