Senate action on OTC derivatives is anticipated to wrap-up this week. Among issues that observers of the debate are keeping a close eye on is a provision (“section 716”) which would require banks to spin-off their swaps desks. Despite calls to remove the provision from Timothy Geithner, Paul Volcker, Ben Bernanke and Sheila Bair, 716 has yet to be removed from the Senate product, as Senators fear taking action that could be construed as pro-Wall Street. To the extent it remains in the Senate bill, it all but guarantees a conference to merge the House and Senate versions of the bill, as the provision has been widely criticized as benefiting foreign banks at the expense of US banks, moving derivatives into unregulated domains, and creating weaker swap counterparties for end users.
Speaking of end users, one or more end-user oriented amendments from Senator Saxby Chambliss (R-GA) are anticipated to be offered and voted on. These amendments would help Main Street businesses in the following ways:
1. Narrow regulatory discretion to encompass large and medium-sized Main Street businesses in clearing, margining and exchange trading provisions of the bill;
2. Ensure that end users can continue to efficiently hedge balance sheet risks – like hedging debt;
3. Ensure that regulators focus capital requirements on derivatives risks only;
4. Limit potentially inadvertent application of the swap dealer definition to end users;
5. Ensure that those that assist commercial customers by providing them with an insubstantial amount of derivatives are not subject to a regulatory regime applicable to Wall Street dealers;
6. Expand end user definition to include a limited set of financial end users and owners of physical assets;
7. Adopt House bill approach to foreign currency derivatives; and
8. Shift reporting burden from end user to swap dealer.
These changes recognize that end users did not contribute to the financial crisis and could not do so. The following graphs further emphasize this fact. The first, shows the magnitude of derivatives activity (as measured by notional) for swap dealers as compared to even fairly large end users. Note that end user hedging is so insubstantial that it does not show up on the graph.
The second compares the hedging activity of large end users to systemically important financial institutions like AIG and Long Term Capital Management (“LTCM”). Again, the graph reveals the insubstantial degree to which even large end users could jeopardize financial stability.
The final graph examines the magnitude of derivatives activity of systemically significant financial institutions like AIG and LTCM and compares it to that of financial end users that use derivatives solely for risk management purpose. Again, the graph reveals the substantial gap represented by the derivatives activity of systemically significant speculators and that of even large financial end-user hedgers.
Policy makers have a challenging task of accomplishing competing objectives: containing systemic risk and not harming the economy. How could indiscriminate application of derivatives reform hurt the economy? The Natural Gas Supply Association and the National Corn Growers Association estimates that $900 billion would be withdrawn from the economy to satisfy an indiscriminate central clearing mandate. The Business Roundtable estimates that solely based on initial margin requirements of central clearing, 100,000-120,000 jobs would be lost. It should be noted that this analysis is quite conservative, as it includes only non-financial companies in the S&P 500 and excludes the effect of variation margin – which could be multiples of initial margin.
Some have suggested that end-user oriented improvements to the bill could create a loophole that would “eviscerate the reform bill.” The argument is predicated on a fear that swap dealers like Goldman Sachs or hedge funds could use the end user exemption as a vehicle through which to deal in swaps or speculate. The Chambliss amendments contain a clear and specific framework for addressing this concern. They do so by (1) ensuring that any speculative trade is subject to clearing/margining requirements, (2) specifically excluding hedge funds and swap dealers from the end user exemption, and (3) granting regulators strong authority to prevent evasion and abuse.
A strong end user exemption should rightfully be understood not as a loophole, but as a policy tool that allows Congress to both contain systemic risk and limit harm to the economy. We would therefore commend the Chambliss end user amendments to you and urge that you encourage your Senators to support them.