"The best minds are not in government. If they were, business would steal them away." -President Ronald Reagan

STATUS:

The use of derivatives has become an integral part of our economy because they allow companies to effectively manage risk that arises through the normal course of business, and most have done so without creating adverse consequences.  While many falsely blame the use of derivatives as the cause of the nation's financial crisis, for the most part, problems associated with derivatives were a symptom of the housing bubble, reckless government policy and misguided government regulation.  However, on October 2, 2009, Rep. Barney Frank (D-MA) released his proposal, touted as the cure for the "lacking and lagging regulation of OTC derivatives," representing yet another instance of government over-reach in an innovative free market by forcing derivative transactions to be more standardized and cleared through regulated clearinghouses.

BACKGROUND:

A derivative is an agreement to transfer risk, the value of which is derived from the value of an underlying asset.  The underlying asset could be a physical commodity, an interest rate, a company's stock, a currency, or virtually any other tradable instrument agreed to by the two parties.  An over-the-counter (OTC) derivative is a bilateral, privately-negotiated agreement that transfers risk from one party to the other.  The size and scope of the OTC derivatives market provides companies with the needed flexibility and customization for hedging various risks.  Just as important, many businesses' use of derivatives encourages job creation and keeps prices stable and low for consumers.  Derivatives provide customized hedges to help businesses like farmers, grocery stores and energy companies to manage price volatility, so that retail prices can remain as stable as possible during periods of drought or the harsh winter months.  "Cleared transactions," standardized derivative contracts that are processed on an exchange or through a clearinghouse, provide liquidity with stricter oversight than the OTC market, but the hedging needs of many institutions cannot be adequately satisfied through these exchanges.
 
With non-cleared transactions in the OTC market, firms can structure and execute customized hedges by selecting the specific terms that precisely match their business needs (currency, payment dates, variable rate index, reset dates to name a few).  For instance, swaps are popular among businesses of all sizes because they are tailored to help mitigate or eliminate various risks and uncertainties associated with each company.  Rather than worrying about potential losses due to fluctuations in interest rates, foreign currency exchange rates or commodity prices, businesses that enter into customized swap agreements can focus on their core business.
 
The following is an example of a typical interest rate swap transaction:

A manufacturer needs to fund the construction of a new plant and the subsequent long-term financing once the construction is complete.   A bank will offer the manufacturer a floating rate loan to fund the construction and permanent financing of the plant.  The manufacturer is concerned that rising interest rates could cause its interest payments to exceed the expected income from plant operations.  The manufacturer would prefer a fixed rate, but the bank is reluctant to offer a fixed-rate loan because its own funding is based on short-term floating rates.  The bank is willing to offer the manufacturer an interest rate swap (an OTC derivative) to fix its rate of interest on the loan.  The bank does not require the manufacturer to post cash or liquid collateral because it will "cross-collateralize" the swap with the loan-that is, the property that secures the loan will also secure the interest rate swap.

ISSUES OF CONCERNS:

Kills Jobs:  The Frank proposal would authorize government regulators to arbitrarily impose capital requirements for non-cleared derivatives without any recognition of the risk management processes utilized by dealers or any consideration of the actual risk of loss.  Such unrestrained authority would permit government regulators to use capital requirements as a penalty to discourage the use of OTC derivatives and force businesses to centrally clear transactions.  Also, the proposal would require the unnecessary imposition of new capital requirements for cleared swaps.  Under the proposal, clearing houses would have to be well-capitalized, so any additional capital requirement imposed by the regulators could cost jobs, investments or make it less likely that corporations would be able to engage in responsible risk management.  On October 7, 2009, Steven Holmes of Deere & Company testifying on behalf of the Business Roundtable stated, "We have a number of contracts that extend well into the future.  If these existing contracts are not permitted an exemption from clearing and collateral requirements, we would have to terminate the transactions at significant cost."  Lastly, the proposal gives the regulator the full discretion to set margin levels for businesses who do not pose systemic risk.  A margin is a requirement to collateralize/secure a derivative position with cash.  If businesses are forced to post cash collateral in unlimited amounts, it would create significant and unnecessary working capital problems for those businesses and adversely affect the economy.  Currently, borrowers are able to enter into a derivative on an unsecured basis relying on their creditworthiness.  If they are required to margin their positions, they will have to use their working capital to fund the liability, which otherwise would simply be an unrealized loss that they pay off over time.  Testifying at that same October 7th hearing, John Hixson of Cargill, Inc. stated that it would cost approximately $1 billion in additional money that Cargill would have to borrow.  Then, Cargill would have to decide whether to continue with the construction of a new facility or whether to put that money in margin.
 
Empowers Government:  The proposal is intended to improve derivatives regulation and reduce systemic risk, but the proposal represents yet another example of government intrusion into the free market.  The proposal contains overly broad definitions, aggressive implementation dates, authorizes new capital requirements and enables government bureaucrats to arbitrarily ban "abusive transactions."  The definition of "Major Swap Participant" and "Major Security-Swap Participant" would be so broad that it could capture any swap market participant deemed by bureaucrats to be in need of monitoring.  The proposal would provide bureaucrats with the sole authority to determine what swaps are standardized and thus subject to mandatory clearing.  These unnecessary government burdens could impair the usefulness of derivatives as an innovative risk mitigation tool, thereby increasing risk exposure of the many market participants that have come to depend on them.
 
Creates Another System of Failure:  Like the Office of Federal Housing Enterprise Oversight and HUD, the former regulators of the failed Fannie Mae and Freddie Mac, and the proposed CFPA, Rep. Frank's derivatives proposal sets up a new byzantine regulatory structure that depends on two agencies that historically have not been able to work well together (SEC & CFTC) having to cooperate on a number of issues.  This proposal represents another example of Rep. Frank "rolling the dice" with the taxpayers' money (as he infamously remarked in regard to expanding the role of Fannie Mae and Freddie Mac at the expense of safety and soundness), which is sure to be used to pay the consequences of more misguided government policies and regulatory errors.