Sunday, April 18, 2010

Derivatives End-User Exemption

Ezra Klein discusses the end-user exemption issue:

The expectation is that if derivatives move onto a more transparent, competitive market, fees for financial firms will go down, which should be good for end users. But the end users have been very worried about derivatives reform. [Goes through various theories of why end-users are opposed to mandatory central clearing.]
...
Those theories make some sense. I'd also like to hear what Economics of Contempt thinks of this issue.
Ask and ye shall receive! To be honest, I really don't care about the end-user exemption issue — and that's the point. The end-user exemption is almost by definition a sideshow, and it's truly bizarre that certain progressives have decided to make this is a Huge Battleground in derivatives reform. So while part of me doesn't care whether progressives make killing any end-user exemption a priority, another part of me doesn't want to see progressives make this another one of their "litmus tests" for OTC derivatives reform, because you know what? They're wrong.

What you have to understand is that OTC derivatives reform divides the universe of swap users into four categories:

        1. Swap dealers (e.g., Goldman Sachs, JP Morgan)
       
        2. Major swap participants (MSPs) (e.g., Blackrock, AIG, Paulson & Co., Pimco)
       
        3. Non-MSP financial institutions (e.g., Money-market funds, most equity mutual funds)
       
        4. Commercial end-users (e.g., Duke Energy, Con Ed, Cargill, Archer Daniels Midland, McDonald's)

The only people we're talking about exempting from the clearing requirement are the commercial end-users, and even then only when they're hedging commercial risk (a superfluous limitation if you ask me, but whatever).

The overriding reason we're moving standardized/liquid derivatives onto clearinghouses is to mitigate the systemic risk posed by purely OTC derivatives markets — in other words, to make sure the market can handle the failure of a single counterparty. But commercial end-users by definition aren't big enough users of swaps to pose a systemic risk. If a company that would otherwise be a commercial end-user is a big enough player in the swaps market that its failure would pose a systemic risk, then it will be classified as a MSP, not a commercial end-user. Moreover, all swaps, cleared and uncleared, will have to be reported to a registered swap data repository, which the CFTC will have full access to. This allows the CFTC to monitor swaps users on an ongoing basis, so if a company that's originally classified as a commercial end-user ramps up its swaps use too much, the CFTC can reclassify it as a MSP. As long as all the major swaps users are required to use clearinghouses, then who cares if commercial end-users are exempt?

So why are commercial end-users so opposed to mandatory central clearing? It depends. I've seen some end-users who are concerned about telegraphing their business decisions (i.e., acquisitions for which they need to pre-hedge). But by far the biggest reason is that central clearing would tie up way too much of their cash. Clearinghouses require counterparties to collateralize their exposures by posting daily variation margin, which means that commercial end-users would have to post cash collateral based on the day-to-day fluctuations in swaps prices. Given the generally higher level of volatility in the swaps markets, this has the real potential to tie up a significant amount of commercial end-users' cash. This is a legitimate concern, and there's no serious policy reason why we shouldn't have any end-user exemption at all.

Like I said, though, I don't really care about the end-user exemption issue. The percentage of derivatives falling under the end-user exemption depends, of course, on which derivatives are ultimately subject to the clearing requirement, but we're really only talking about, at most, ~5% of swaps. The main reason is that the majority of OTC derivatives that will be forced onto clearinghouses will be interest-rate derivatives (e.g., IR swaps, caps, floors), and the biggest end-users of IR derivatives are commercial banks and other financial institutions — that is, MSPs and non-MSP financial institutions.

So not only is the end-user exemption a sideshow, but it's also a sideshow that doesn't make policy sense to oppose.

32 comments:

Byrne said...

Wow. It seems that forcing commercial end-users to adhere to a clearing requirement would actually increase systemic risk. There is no long-term risk that, e.g., McDonalds' potato-price hedges will swing in price so wildly that the company will be insolvent--but if they have to put up margin frequently, there is a chance that the margin issue could eat of all of a company's available cash.

This could most conceivably happen in businesses with high capital requirements that have a long-term payoff. E.g. an oil exploration company locks in the value of their proven reserves, but expects to actually get the revenue a year or two in the future. If the price of oil rises significantly, they have losses on their hedges, even though the oil they own has gone up in value to compensate.

Basically, it's introducing an automatic maturity mismatch into any business that hedges.

Anonymous said...

How does requiring posting of variation margin 'telegraph' any business decision?

If an entity can't pony up the variation margin for an interest rate swap (which is usually minimal and declines over time), the entity has no business executing the swap.

The only valid exemption that I can see for excluding any entity from variation margin would be an entity that has executed a loan with a bank and is using the swap to hedge the interest rate risk on that loan AND the bank certifies quarterly that the collateral backing the loan are sufficient AND the payments on the loan are parri passu with the payments on the swap.

Howard Lothrop said...

You saw exactly this situation several years ago with grains as prices rose rapidly. The good, risk-averse farmer sold his crop forward. Then, as prices rose they had to put up increasing amounts of collateral (cash margin)to cover the obligation that the now more valuable grains might not be delivered. Put many grain elevators/farmers out of business, or at least with a major loss as contracts were sold out from under them, liquidated to pay margin. Then, to add insult to injury, grain prices fell and they had a double whammy. Cash Margin does not cover all sins.

Anonymous said...

howard makes a good point. the problems were particularly acute in wheat and cotton.

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