The Senate Banking and the Senate Agriculture Committees have each reported their derivatives legislation for a possible Senate floor vote next week. The House passed its bill in December. What happens next is of critical importance to businesses (end users) who use derivatives to manage their normal business risks – such as risks to rising interest rates, commodity prices or currency rates.
Here are the common elements of the bill where end-users agree. First, systemic risk is properly addressed by requiring that those who pose a threat to the financial system through their dealing or speculative trading to fully cash-collateralize their trades with each other, either through clearing or margin arrangements. Second, all derivatives will be properly reported to a central trade repository so that regulators will have access to information to identify and deal with concentrations of risk, and detect manipulation and market abuse.
However, end users are concerned that both Senate bills go far beyond needed reforms in ways that could harm businesses and the economy.
Of the two Senate bills, the Senate Agriculture bill more specifically addresses some concerns of end users than does the Senate Banking bill, however both bills need substantial improvement. For certain end users – generally those that make stuff – the Senate Ag bill has an exemption from clearing, margin and mandatory trading rules when end users are hedging “commercial risk.” The Senate Banking bill says that, in order for an end user to qualify for the ability to POSSIBLY receive a CFTC exemption, a series of tests that must be passed. Since the CFTC has been very aggressive in saying that they would like to see as many derivatives cleared and fully margined as possible, end users have legitimate concern about delegating such authority to regulators. End users want a sensible end user exemption which does not grant sweeping authority to regulators if an end user is neither systemically significant nor speculating. Such an exemption would provide for language exempting such end users from clearing, margin and trading requirements.
A problem for end users that currently exists in both Senate bills but does not exist in the House bill is the issue of capital requirements. Banks and other swap dealers set aside capital as “loss reserves” for any derivative they do. These reserves are typically set by banking regulators. The House bill says these capital charges should be “appropriate for the risk” but the Senate bills say they should be “substantially higher” (Banking) and “significantly higher” (Ag). End users are concerned that inappropriately higher capital charges will raise the cost of hedging normal business risks.
If a derivative is cleared, another problem for end users in both Senate bills (but not in the House bill) is the mandatory requirement to electronically trade. Electronic trading has its place and has been growing in popularity for certain types of transactions (e.g., short dated currency forwards). However, end users don’t want to be restricted from transacting directly with their banks if an electronic trading platform is not cost-effective. The mandate for reporting to a central trade repository will already achieve transparency on all derivatives for regulators, and also for all market participants, as pricing data is mandated to be reported to the public on a confidential basis.
Of the remaining issues, the following are the main concerns from end users in the Senate Banking bill. The definition of “Major Swap Participant” should only be an identifier for those large enough to pose a threat to the financial system, but the definition currently includes anyone who can expose their counterparty to a “significant loss” which is subjective and too low a threshold.
The Senate Ag bill doesn’t offer an end user exemption for “financial entities”, and therefore imposes similar requirements on a neighborhood accounting firm and a community bank as it does on Wall Street banks. This is problematic for financial end user firms who use derivatives to manage normal business risks and have no ability to threaten the financial system.
Finally, the Senate Ag bill has an indirect problem for end users – the requirement that commercial banks must stop offering derivatives. End users are already concerned that there are too few derivative counterparties and therefore too little competition, so this would likely make the problem worse if dozens of banks – including regional and community banks – suddenly stopped offering derivatives to their borrowers.
Over a hundred corporate treasurers and finance professionals from businesses across America have spent significant time educating members of Congress on the importance of these issues to Main Street companies. Often for the first time, they have trekked to Washington and many more have called and written letters because they have a front row seat to how these provisions will impact business investment and job creation. They are in this debate because proposals to reshape one of the world’s largest financial markets aren’t yet right, and they need to be improved.