End User Exemptions

I've been talking with Mike at Rortybomb about derivatives and bankruptcy, and the pending financial reform legislation. But being a professor, I of course have more to say about the ongoing debate about exempting certain "end users" of derivatives from the proposed rule that all derivative trades go through a central clearing process and trade on an exchange.

The key complaint that "end users" have is this new trading and clearing structure will require collateral to be posted to ensure the "out of the money" party's ability to perform on the deal.  For railroads, manufacturers, and others who use derivatives as hedges, this means that cash or other cash-like stuff will be parked somewhere, unavailable for use. And their ability to use derivatives will be limited by their ability to post collateral.

First, I'm beginning to wonder about how you define "end user," which is why I've been using the obnoxious quotes up to this point. A hedge fund is an end user of derivatives. Really anyone who has an unbalanced position in derivatives could be considered an end user. Congress has to be really careful on this slippery slope.

Second, if the "end users" of the world think that getting out of clearing and exchange trading gets them out of posting collateral, they might want to think about that some more. There is nothing in the new law that would prevent a big bank from demanding both mark to market and "additional" collateral in connection with an OTC trade. Indeed, since these banks are going to be under increased regulation, they may be required to get collateral from big customers. So if the end users get their exemption, what have they achieved? Exposure to the risk that the big bank will fail, taking their collateral with it.

Comments

[Richard Levin]

One definition of an "end user" contract, which has been developed by a committee of the National Bankruptcy Conference, is a derivative commodity contract "for the purchase or sale of a commodity actually used or sold by the debtor in the ordinary course of its business, including a hedging contract for actual business operations". This would not include a financial contract that involved only money, such as an interest rate swap, but perhaps it could be adapted. The difficulty is that for a financial institution, the "commodity" it uses in the operation of its business is money.