In 1973, the Arab Oil Embargo and ensuing oil crisis in the US prompted Congress to react with new regulation. The Corporate Average Fuel Economy (CAFE) Standards introduced fuel efficiency benchmarks that were intended to “reduce energy consumption by increasing fuel economy.” Now more than 40 years later, the unpredictable outcomes of fuel economy regulations are instructive, especially as we embark on a similarly ambitious regulatory scheme for OTC derivatives. They teach that regulations are likely to have unexpected and undesirable effects, even while achieving their broad objectives.
The current fleet-wide fuel efficiency standard in the U.S. of 27.5 miles per gallon will increase to 54.5 mpg by 2025. These ever-growing standards have forced automakers to rethink their entire line-ups, generally emphasizing economy over other factors like performance, safety, size and comfort. But performance is not something auto enthusiasts are eager to sacrifice, so automakers are innovating to overcome the performance loss. McLaren, Ferrari and Porsche now offer road-ready hybrid supercars that pack nearly 1,000 horsepower, 200+ mph top speeds and kinetic handling. Formula 1 race cars employ a Kinetic Energy Recovery System that collects otherwise wasted energy created during braking and offers it to the driver in bursts of power. Such innovations will trickle into consumer automobiles over time.
The quest for efficiency is also naturally leading to smaller engines and lighter weight vehicles. The V8 is becoming an endangered species as full-size sedans and even half-ton pickups are increasingly dropping them from their base models, if not their entire engine portfolios. Automakers are also shaving weight by innovating with lightweight materials. While these kinds of innovations will reduce fuel bills, this benefit comes at a cost – estimated at $5,000-6,000 for each new vehicle. Also, smaller vehicles tend be less safe. For example, a 2009 crash-test study comparing the Honda Accord and Fit showed that the smaller vehicle was more likely to result in leg and head injuries.
Just as Congress reacted to the ’73 Arab Oil Embargo with CAFE regulation, the 2008 financial crisis prompted financial regulation in the form of Dodd-Frank. Like the CAFE standards, Dodd-Frank’s reforms will force changes that are beneficial to some market participants and to the market as a whole. One early example is a tightening of bid-offer spreads for certain trades executed on swap execution facilities – new electronic platforms mandated by Dodd-Frank for financial entities.
The new requirements will also create outcomes unforeseen by the Act’s architects and that are costly for market participants. Indeed, some of these are already apparent. Central clearing – Dodd-Frank’s signature derivatives reform – is prohibitively expensive for financial entities that transact infrequently. Swap reformers were likely not aware when they designed this requirement that clearing members would charge minimum annual transaction fees of $60,000+ per year. Rather than reducing risk, the universal application of this requirement to all financial entities will cause some market participants to stop risk-mitigating hedging behavior that is socially beneficial.
Additionally, some foreign swap providers – fearful of becoming subject to US regulations – have determined not to transact with US companies. Transacting in excess of $8 bn with US entities will subject these entities to tens of millions in cost associated with registering as a US swap dealer. An odd result of this regulatory incentive is thus that US companies can effectively be encouraged to concentrate their counterparty risk amongst a small set of US financial institutions. This exacerbates a challenge precipitated by the financial crisis, wherein important financial institutions including Lehman Brothers, Bear Stearns, Wachovia and Merrill Lynch all disappeared as swap counterparties.
These examples show that it can be difficult to predict what will come from regulation. Certainly markets will maximize efficiencies where they can. But the regulations themselves will create new risks and difficulties not all of which will have been intended. No one can say for sure what a 54.5 mpg auto industry will look like in 2025, or even whether any of us will be driving by then, or if automated cars will have made passengers of us all. The same goes for regulation; while the market has become acquainted with the look and feel of Dodd-Frank, there are still many issues and processes that are far from crystallized, not to mention the uncertainty around ongoing regulations in Europe, Canada, Asia, and Switzerland. At Chatham we are thinking hard about what regulatory developments mean for the markets and our clients, so if you want to talk through the impacts of regulation on your business, give us a call.
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