Raw Finance

Chairman of the U.S. House Financial Services Committee Barney Frank, D-Mass., has proposed that many classes of derivatives be processed through a centralized clearing system.  However, this may cause international companies that use currency derivatives to hedge against exchange rate risk to pay higher costs for such insurance.

Derivatives in residential mortgage-backed securities and other markets were a well-known cause of the 2008 credit crisis.  When Lehman Bros. filed for bankruptcy in September 2008, no one had any idea how many derivatives transactions the company was a party to because derivatives were not regulated or required to be cleared, and thus, there was no reporting requirement.  As it turned out, Lehman was party to nearly 1 million derivatives transactions, with counterparties all over the world.  This surprise, and the subsequent attempts by the counterparties to cancel a large percentage of those transactions, caused credit markets to seize up.

Now, the rush to bring more transparency to derivatives trading through legislation is causing ripple effects as certain trading that had nothing to do with the financial crisis is caught in the cross-hairs.  According to a column in the Financial Times, “About $3,200 [billion] of currency is traded daily around the world. About two-thirds of that trade is in derivatives that are used frequently by companies during the normal course of business to hedge the risk that currencies move sharply between a deal being struck and completed.”

Two potential consequences of bringing the currency derivatives trading under a central clearinghouse are higher costs for companies and a higher collateral requirement.  The Financial Times reports, “Some companies have shrugged off entreaties from their banks to lobby members of Congress over derivatives reform, concluding that their interests could be better served by the broad shift to central clearing and exchange trading.”  However, ”Others—such as Caterpillar this week—have argued they face costly margin requirements under some versions of the regulatory reforms now under way.”

The Financial Times also included some poignant comments from industry professionals:

“This isn’t about us protecting our business, central clearing is about deliberately introducing concentration risk into the market – its nuts,” said the head of foreign exchange at one of the largest forex banks.

One senior official at a large US bank added: “Companies are already baffled why they’re caught up at all in this given that what they do here didn’t contribute to the crisis. Now they’ll be baffled squared.”

A certain amount of reform in banking and securities is necessary to bring more transparency to markets so central banks and regulators will have a better handle on conditions and, hopefully, would better able to spot extreme risks before they blow up.  However, as usual, Washington wants to rush through legislation without carefully considering all of the consequences and carving out reasonable exceptions to alleviate the negative consequences.  The more things change….