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.