“Are these the shadows of things that must be, or are they the shadows of things that MIGHT be?”
Ebenezer Scrooge spoke these famous words as he came to terms with a dire vision of the future – a dark future born of his miserly ways. So too, these words could aptly describe a possible outcome of derivatives regulation.
Given the complexity of the derivatives market, Congress delegated significant authority to regulators to determine how the Dodd-Frank Act should be applied. They gave regulators – including the CFTC, SEC and Federal Reserve – one year to write an unprecedented number of rules. Main Street businesses that use derivatives to reduce uncertainty (“end users”) have been watching the rulemaking process closely, concerned that hedging could become too costly or burdensome.
In some respects these concerns have diminished, as regulatory authorities have proposed several commonsense rules after incorporating significant feedback from market participants. However, the most significant issues have yet to be addressed. Most notably, end users are concerned that they will be forced to post margin for their hedges. This would result in the sidelining of substantial sums of cash–up to $1 trillion across all segments of the US economy 1–capital that could be deployed productively toward job-creating activities instead of sitting idle.
This same concern animated hundreds of companies–including the likes of 3M, MillerCoors, and Walt Disney–to write letters to Congress emphasizing that “access to customized derivatives helps businesses maintain operations, invest in new technologies, build new plants and retain and expand workforces.” They said requirements to tie up their resources “could prevent companies from using these important risk management tools,” an effect which would be “detrimental to businesses, the economy and job creation.”
Congress responded to these concerns, but not as thoroughly or precisely as was hoped. It created an end-user exception to central clearing requirements, but failed to definitively replicate this exception throughout the legislation. Thus uncertainty remains over whether end users could be subject to the very requirements the exception intended to shield them from. Acknowledging this possibility, the principal authors of the legislation expressed that this was not their intention. Senators Dodd and Lincoln wrote that the Act “does not authorize the regulators to impose margin on end users.” Representatives Frank and Peterson echoed these sentiments in the House. Chairman Peterson observed: “[W]e have given the regulators no authority to impose margin requirements on anyone who is not a swap dealer or major swap participant.”
However, preliminary signals from regulatory authorities suggest these statements of Congressional intent may not be heeded. Earlier this month, CFTC Chairman Gensler requested public comment on “the appropriate margin requirements” that should be applicable to various market participants. While he expressed support for focusing such requirements on financial entities, his comments betray a belief that regulators indeed possess authority to impose margin on end users – an authority Congress did not intend to give.
In a recent letter on the subject, Federal Reserve Chairman Ben Bernanke indicated such authority was not necessary to mitigate systemic risk, writing, “The Board does not believe that end-users other than major swap participants pose the systemic risk that the legislation is intended to address.”2 However, many remain deeply concerned that regulators will enact rules requiring these very firms that do not pose systemic risk to post margin. End users emphasize that such a requirement “would place an extraordinary burden on and competitively disadvantage” them.
In the coming months, we shall see whether end user concerns are well founded. It is with these thoughts looming that we return to Ebenezer Scrooge. Just as Scrooge changed his ways after considering the dark future that stood before him, so can regulators act to forestall the unintended consequences of imperfectly drafted legislation.
1 Based on estimates from Tabb Group ($2.2 trillion worldwide), ISDA ($1 trillion), National Corn Growers Association & Natural Gas Supply Association ($700 billion), BusinessRoundtable/KeyBridge Reasearch ($33 billion for initial margin only applied to non-financial S&P companies)
2 Letter from Federal Reserve Chairman Ben Bernanke to Senator Crapo