Wednesday, April 13, 2011

The Second Derivative

It’s probably good news that an article appeared in yesterday’s WSJ about how so-called “end users” of derivatives think the derivatives regulations are a little too stringent. If they’re being honest, then perhaps the regulations have a chance of succeeding at suppressing some of the financial hocus-pocus that probably isn’t too helpful.

But let’s give them a chance: the argument isn’t totally implausible. Basically, a lot of real-world companies—called end users—have reasons to want to use various types of the derivatives class. The classic example is farmers, who like to lock in the price of their produce and livestock through options, but a similar idea animates airlines’ use of derivatives to make sure the price of their oil is predictable. And if you want to make sure you pay a predictable interest rate, an interest rate swap might be in your interest (though why you don’t take your loan out at a fixed interest rate is really beyond me). So there are reasons to want derivatives and, well, then there’s this:
Craig Reiners, director of risk management at beer giant MillerCoors LLC, said the derivatives rules were designed to reduce threats to financial stability, whereas companies such as his "pose no systemic risks." If end users aren't shielded, the rules "would have a very harmful effect on our risk-management of the business and for that matter ultimately the cost of a six-pack of beer." MillerCoors uses over-the-counter derivatives to hedge against price volatility in areas such as aluminum, hops and energy.

The Coalition for Derivatives End-Users, an umbrella group for firms including Caterpillar Inc., Ford Motor Co., MillerCoors, Boeing Co., Duke Energy Corp. and Procter & Gamble Co., argues that regulators "misinterpret" the law and don't have the authority to impose such requirements. It also said the proposals could "divert working capital from productive uses at the costs of economic growth and jobs, or send a vibrant, secure swaps market overseas."

The rule basically requires that banks selling these derivatives set aside collateral against the possibility that they, ah, cannot pay their obligations. Since that’s so, while these kind of derivatives pose no systematic risks at the moment, it’s easy to see how in a collateral-less world a sudden move in a commodity price or interest rate might topple the whole structure: a bunch of companies ask for the cash from their derivative (which is in many cases effectively buying insurance), the highly-leveraged bank doesn’t have any liquidity handy and so must sell assets at a below-market price and…we see where this is going, right? Good. So let’s avoid it.

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