There's a Derivative in Your Cereal

By Sam Peterson

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.

Beyond the impact on financial firms and their customers, the bill will make hedging more expensive for most corporations, including non-financial businesses. These costs will emanate from provisions -- such as margin and capital requirements -- that require banks to sideline cash to cushion against potential losses. Much of these costs will be borne by businesses and ultimately the consumers of their products and services. Those costs could be significant.

Though the specifics of the requirements are not yet known, examining the cost of applying one of the provisions to a common hedging strategy helps give a sense of its impact. As an example, take a manufacturer who has borrowed $100 million to finance a new plant. To eliminate the risk to rising interest rates, the manufacturer can enter into a swap to lock the interest rate. While the manufacturer is not required to set aside cash to protect against changes in the value of the derivative, its bank counterparty might be. Under current market conditions, the cost of this requirement -- one of several in the bill that will impact transaction cost -- could amount to as much as $1.1 million for a ten-year hedge. At least a portion of this cost would be passed on to the manufacturer.

One could argue that everyone should gladly pay more to avoid another devastating financial crisis. Though this perspective is not without merit, there comes a point at which these costs will become too great to bear and could deter some firms from hedging their risks. What happens if they stop hedging? Such a decision could cause firms to scale back plans for expansion, raise prices on their products and services, or adjust pricing more frequently to reflect volatile cost inputs. Also, as these businesses experience more volatile business outcomes, investors will see more volatile stock prices.

In many parts of the derivatives legislation, Congress dispensed with prudence in favor of getting tough with banks. Perhaps that was in response to justified outrage against the excesses that caused the financial crisis, or because lawmakers did not appreciate that the impact would reach far beyond Wall Street. In such cases, the law affords regulators with no choice but to take a heavy-handed approach wherein negative unintended consequences are unavoidable.

In other areas, the extent of unintended consequences is now largely in the hands of the regulators, who have some discretion in providing exemptions, thereby limiting collateral damage. As they begin the important work of transforming the 444 pages of legislative text into actual rules, regulators need only look at their bowl of breakfast cereal and think of grain price fluctuations as a reminder that the impact of derivatives regulation will be all around them.

(Image Credit: Horia Varlan/flickr)

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