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Friday, April 16, 2010

Key Issues in Derivatives Reform

Rena S. Miller
Analyst in Financial Economics

Financial derivatives allow users to manage or hedge certain business risks that arise from volatile commodity prices, interest rates, foreign currencies, and a wide range of other variables. Derivatives also permit potentially risky speculation on future trends in those rates and prices. Derivatives markets are very large—measured in the hundreds of trillions of dollars—and they grew rapidly in the years before the recent financial crisis. The events of the crisis have sparked calls for fundamental reform. 

Derivatives are traded in two kinds of markets: on regulated exchanges and in an unregulated over-the-counter (OTC) market. During the crisis, the web of risk exposures arising from OTC derivatives contracts complicated the potential failures of major market participants like Bear Stearns, Lehman Brothers, and AIG. In deciding whether to provide federal support, regulators had to consider not only the direct impact of those firms failing, but also the effect of any failure on their derivatives counterparties. Because OTC derivatives are unregulated, little information was available about the extent and distribution of possible derivatives-related losses. 

The OTC market is dominated by a few dozen large financial institutions who act as dealers. Before the crisis, the OTC dealer system was viewed as robust, and as a means for dispersing risk throughout the financial system. The idea that OTC derivatives tend to promote financial stability has been challenged by the crisis, as many of the major dealers required infusions of capital from the government. 

Derivatives reform legislation before Congress would require the OTC market to adopt some of the practices of the regulated exchange markets, which were able to cope with financial volatility in 2008 without government aid. A central theme of derivatives reform is requiring OTC contracts to be cleared by a central counterparty, or derivatives clearing organization. Clearinghouses remove the credit risk inherent in bilateral OTC contracts by guaranteeing payment on both sides of derivatives contracts. They impose initial margin (or collateral) requirements to cover potential losses initially. They further impose variation margin to cover any additional ongoing potential losses. The purpose of posting margin is to prevent a build-up of uncovered risk exposures like AIG's. Proponents of clearing argue that if AIG had had to post initial margin and variation margin on its trades in credit default swaps, it would likely have run out of money before its position became a systemic threat that resulted in costly government intervention. 

Benefits of mandatory clearing include greater market transparency, as the clearinghouse monitors, records and usually confirms trades. Clearing may reduce systemic risk, by mitigating the possibility of nonpayment by counterparties. There are also costs to clearing. Margin requirements impose cash demands on "end users" of derivatives, such as nonfinancial firms who used OTC contracts to hedge risk. H.R. 4173, as passed by the House, and Title VII of the comprehensive financial reform proposal, the Restoring American Financial Stability Act of 2010 (RAFSA), as amended and passed by the Senate Committee on Banking, Housing and Urban Affairs, provide exemptions from mandatory clearing for certain categories of market participants. If exemptions are too broad, then systemic risks, as well as default risks to dealers and counterparties, may remain. The bills seek to balance the competing goals of reducing systemic risk and preserving end users' ability to hedge risks through derivatives, without causing those derivatives trades to become too costly. This report analyzes the issues of derivatives clearing and margin and end users, and it discusses the various legislative approaches to the enduser issue.

Date of Report: April 8 2010
Number of Pages: 21
Order Number: R40965
Price: $29.95

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