There's a Derivative in Your Cereal

110 cereal Horia Varlan flickr.jpgOver-the-counter (OTC) derivatives are perhaps the most feared and despised of all financial creations, even more than sub-prime mortgages. After all, Warren Buffet famously referred to them as "financial weapons of mass destruction." Though few know it, Americans' everyday lives are touched by the hidden hand of OTC derivatives. They can affect the grains in our breakfast cereal, the steel in our SUVs, the rates on our loans to the currency with which we pay for it all. Many of the inputs used to produce the goods and services we depend on are hedged with OTC derivatives, so to reduce the risk of cost increases. With the enactment of the Dodd-Frank financial regulation bill signed by President Obama last week, the cost of such hedging is likely to increase and the impact will be widespread.

Though portrayed as obscure financial enigmas, OTC derivatives are quite common and widely used by Main Street. According to survey results released by the International Swaps and Derivatives Association (ISDA), 94% of Global Fortune 500 companies use derivatives to manage business risk. The survey reveals that derivatives are heavily used far beyond Wall Street, in sectors such as healthcare, consumer goods, and technology.

Of course, some criticisms of derivatives are deserved. The infamous failure and subsequent bailout of AIG was due in part to its use of credit default swaps as one of several vehicles through which it bet on the sub-prime mortgage market. In the months following the collapse of AIG, it was clear that the OTC derivatives market was squarely in Congress' crosshairs. Early proposals to ban OTC derivatives altogether were a wake-up call for businesses, which understood that requiring all derivatives be standardized to trade through exchanges would limit their ability to precisely manage risk. Exchanges would also require firms to divert large sums of money from operations and new projects to meet daily margin calls for additional cash cushion as prices fluctuate.

Not accustomed to engaging with policymakers, many corporate treasurers soon found themselves on Capitol Hill. Their message was clear: an OTC derivatives ban would mean less business investment, fewer jobs, less hedging and, counter-intuitively, more risk. The efforts of businesses to explain these problems to lawmakers produced widespread recognition in Congress that the economy would be harmed if all derivatives users were treated the same. This recognition resulted in the legislation's so-called "end-user exemption," to shield Main Street businesses that use derivatives for hedging. Opponents moved quickly to frame the exemption as a "loophole," however, creating a tug-of-war that ultimately narrowed the exemption to include only non-financial firms.

To be sure, this decision will serve to reduce credit risk in the financial system, one of the Obama administration's primary objectives. But this comes at a cost, which may outweigh the limited benefit gained by treating community banks the same as financial giants such as AIG. While it is difficult to precisely quantify the cost of this decision, estimates from ISDA and the Business Roundtable suggest the figure could reach into the hundreds of billions of dollars. Consumers won't feel such costs directly, but rather indirectly through higher interest rates on loans, more expensive insurance policies, lower and more volatile returns on retirement investments, and in many other ways.

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Sam Peterson is a senior advisor at Chatham Financial, a global interest rate and currency risk management firm that advises over 1,000 derivatives business end users in a wide range of industries including real estate, health care, retail, manufacturing, technology and financial services.

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