The Banks’ Unfair Fight Against Derivatives Reform

Sen. Blanche Lincoln (D-Ark.) has written an aggressive proposal to regulate the derivatives market. (WDCpix)

This week, Sen. Chris Dodd’s (D-Conn.) financial regulatory reform bill moved to the floor of the Senate. And with that bill close to passage, Wall Street and lobbyists turned their attention to Sen. Blanche Lincoln (D-Ark.) and the Senate Agriculture Committee’s proposal to regulate derivatives, a $450 trillion market and a major source of investment-banking profits.

[Economy1]Derivatives are essentially a type of financial insurance. They let two parties trade a contract derived from the price of some underlying security, currency or commodity. For instance, say you were a major airline. You might go to your bank to purchase a derivative locking in the price of gas, just in case a summertime oil shortage pushed up prices at the pump. In this case, you would be an “end user,” meaning you actually take delivery of the good. About 90 percent of the derivatives market involves financial firms trading derivatives like credit-default swaps back and forth for profit — and just 10 percent involves end users, non-financial firms using derivatives to mitigate risk.

Still, end users have become the unlikely center of the fight on derivatives legislation. With the reputation and credibility of big financial firms weak, companies in industries from agriculture to aviation came forward to say that this legislation might not only dampen big business’ profits but also hurt them. On Tuesday, the U.S. Chamber of Commerce and other business lobbies — via a group called the Coalition for Derivatives End-Users — took to the Hill for a flurry of meetings between corporate representatives of those worried end users and members of Congress.

“The legislation has the potential to take hundreds of billions of dollars out of the economy through margin and capital requirements,” says Cady North, a lobbyist at Financial Executives International and a member of the Coalition for Derivatives End-Users’ steering committee. “We estimate that the bill could require up to $900 billion in capital expenditures.” Moreover, the Coalition argues, the bill will increase the cost of derivatives for end users. (The Coalition declined to provide a list of participating executives or their companies, or a list of the legislators or assistants with whom they met, and the Chamber of Commerce did not respond to repeated requests for comment.)

But there’s just one problem. The Lincoln bill forces financial firms to put up collateral and use clearinghouses when they trade derivatives, but specifically exempts end users from those requirements. Banks are using their end-using clients as proxies to help kill off the legislation, lawyers and lobbyists contend. And for most end users, the opposition to the bill makes little sense.

Other lobbying organizations representing end-using white-collar companies said they had no issues with the legislation. For instance, Michael Griffith, a legislative analyst at the Association for Financial Professionals, which represents 16,000 of “the folks that manage your average companies’ money,” says he has no issues with it. “We’re pretty happy with what the Agriculture Committee approved,” he says. “It has a broad end user exemption on it, and we haven’t had many complaints from our members.”

“I know the banks are screaming about it,” says Brian Kalish, the director of AFP’s finance practice. “[My members are] getting panicky emails from their bankers. But [of] my members, no one’s panicking.”

But this week, some end users got more than panicky emails from their banks. Lawyers and lobbyists say that banks clearly misled companies about how the legislation might impact their business costs. In one case, a derivatives broker told a company that the legislation would force it to pay the same fees and put up the same collateral as financial firms, even where it explicitly would not.

“I’ve heard of a few folks who use derivatives [as end users who] called up their banks to talk about the legislation,” another lobbyist said. “Of course, their bankers told them to expect the whole market getting disrupted, price increases, collateral calls. Now, for most of them, they’re buying swaps to hedge. The legislation specifically exempts them.”

Legislators this week repeated the concern. Senate Banking Committee Chairman Dodd said he sees evidence of the bankers’ influence when end users lobby him. “The end users have been basically used by the major investment banks,” he told the Huffington Post’s Ryan Grim on Tuesday.

Indeed, Lincoln took pains to ensure most end users are not impacted by the legislation. Some firms with “captive finance entities” — financial-products divisions within big, diversified companies, like Cargill — might not qualify as end users on some transactions, and might have to post collateral when they use derivatives to speculate rather than hedge. But they represent a small proportion of end users, who represent a small portion of derivatives users.

Furthermore, the legislation might eventually drive end-users’ costs down. Many derivatives experts — off of Wall Street, at least — believe that Lincoln’s reforms will increase competition and transparency, reducing prices. Robert Litan, a derivatives expert at the Brookings Institution, explains, “In a world of nontransparency, the world the derivatives market is in right now, the way I understand it, if you try to call four or five dealers, to shop around, none give you a real price. They might quote you an indicative price. If you commit, then they give you pricing information.”
The White House concurs. Jen Psaki, the deputy communications director, recently argued, “The unregulated OTC derivatives markets were at the center of the recent financial crisis. The Wall Street banks that dominate this market want to keep it unregulated so they can make money off regular firms.”