Managing Risk Isn't Scary

Dec 2, 2011

A "derivative" sounds like a scary thing, a boogie-man that creeps out of the closet late at night and causes huge gyrations in financial markets. That's the horror story caricature of derivatives.

In the real world, businesses and farmers don't use derivatives for wild speculation. They use them to lock in the prices of fuel and raw materials to manage the risk of price fluctuations and reduce uncertainty.

For example, a chemical company can use derivatives to lock in a price for natural gas over the next twelve months to make it easier to know their production costs over that time. It's a little like a family buying in bulk when they find a good price on toilet paper. With derivatives, businesses and farmers are better able to plan for future investments and growth.

The benefits of derivatives by end-users are threatened by the new financial reform law that, unless changed, would impose burdensome margin-requirements on derivative end-users.

Chamber President and CEO Tom Donohue co-wrote an op-ed with Gov. John Engler, president of the Business Roundtable, Jay Timmons, president and CEO of the National Association of Manufacturers to urge regulators to avoid new derivatives rules that "would penalize derivatives end-users that did not cause the financial crisis and, in the process, hurt American workers and threaten U.S. jobs."

The rules' cost could be enormous with no benefit:

The Office of the Comptroller of the Currency, one of the agencies charged with regulating this market, estimated the rules could force entities it regulates to sideline $2.05 trillion -- an amount 41 times greater than all U.S. financial- institution derivatives losses since the crisis began. This could translate to an enormous blow to economic growth without adding to financial stability.

The op-ed's authors note that last year, in a letter to Sen. Mike Crapo (R-ID), Fed Chairman Ben Bernanke wrote, "The Board does not believe that end-users other than major swap participants pose the systemic risk that the legislation is intended to address.”

They conclude:

If margin requirements are imposed on end-users, companies will be forced to divert cash to use as collateral during periods of market stress, sidelining billions of dollars from more productive uses.

Bringing more transparency and accountability to the derivatives market should be a victory for the American people, but if regulators overreach and fail to distinguish between end- users and speculators, we will simply be taking one step forward and two costly steps back.

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