Derivatives Hole in Financial Regulation Still Needs to Be Plugged

If regulators or Republicans don't work to fix this problem, hedging will become prohibitively expensive for Main Street firms

Unless you work in the derivatives market you probably don't remember back in late-June when Congress' failure to fix language in the financial regulation bill left open a problem that could cost Main Street firms up to $1 trillion. Although it was an issue that could have been easily resolved, Democrats in the Senate worried that doing so could delay the bill's passage by a few days. Six months later, the problem hasn't been fixed.

Ben Protess at DealBook reminds us today that this hole in the so-called end-user exemption within the financial reform bill is still outstanding. In short, the financial regulation bill forces most derivatives to be traded over exchanges. But Congress sought to exempt Main Street firms from that requirement when they use derivatives for hedging purposes. Forcing them to use exchanges could result in huge hedging costs for these firms, because they would have to put lots of money aside to cover potential changes in the value of their derivatives. Since these companies are generally hedging real commodities or other assets they have on-hand, such a requirement would be unnecessary.

Unfortunately, some wording was changed in the financial regulation bill during the conference committee which could result in these firms having to pay margin requirements anyway. This led most Republicans and some Democrats to attempt to revise this wording to exempt non-financial firms from this language as well. Even the derivatives regulation's author Sen. Blanche Lincoln (D-AR) supported this clarification, but it was blocked by her Democratic colleagues in the Senate.

It is possible that regulators could interpret this language the way that the Main Street firms want. Protess reports:

Gary Gensler, chairman of the Commodity Futures Trading Commission, has said he opposes enforcing onerous margin requirements on end users.

But in an interview with DealBook, he said, "I'm only one commissioner."

If the CFTC instead decides to enforce margin requirements on these firms, then the duty will fall back to Congress to fix this regulation. The good news is that Republicans broadly favor making the change, and they will have more power to shape legislation in 2011.

This change should be near the top of Republicans' "to do" list when the new Congress convenes next month. If this problem isn't solved, then it could throw cold water on the merely luke-warm recovery. If firms are suddenly required to come up with millions or billions of dollars to double-pad their derivatives used for hedging, then they'll have less money to invest in growth and hiring. As the Dodd-Frank bill's regulation becomes gradually implemented in the months to come, this problem will become more serious.