Two Posts on Derivatives Reform, from the Mind of a Trader and an End-User

New Deal 2.0 has two excellent entries that are must reads if you are interested in derivatives regulation. Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co. first takes you through derivatives trading from the point of view of a trader:

A level playing field is anathema to the trader. Successful traders must have advantages over their counterparties. This is the job description. While a trader may emphasize his or her superior intellect and courage (and therefore individual responsibility for profits, especially useful in compensation discussions), these are far less important than institutional advantages. The best traders deploy those advantages effectively to secure higher trading profit….

Do individual banks “corner” specific markets? Perhaps so. But, more importantly, these trading dynamics have moved a significant portion of the pricing functions in important sectors of the economy (e.g., certain energy markets) into the hands of a limited number of large and sophisticated financial institutions. Given the potential for profit, is it any wonder that the leading positions at financial companies are increasingly occupied by former traders?

A trader views these advantages as central to his or her livelihood. Fairness, a level playing field and social utility are not important considerations to a trader. In fact, for a trader to perform the functions that are desirable, such as accurate pricing of commodities, this is appropriate. They “eat what they kill,” which makes them ruthlessly efficient. This is not necessarily a bad thing. Robespierre is reported to have said, “First, we behead the speculators.” Demonizing traders for doing what comes naturally similarly distracts from the real problem. Traders, perhaps more than almost anyone else, must be constrained by external rules.

However, if financial institutions continue to be primarily trading entities, the incentive to secure short-term profits by dominating markets will ascend over the need to preserve long term bank lending and investment banking relationships. Behavior that damages society as a whole must be controlled by regulation, since the leadership of the financial institutions will not curb it. If the packaging of credit and derivatives trading are considered inappropriate advantages, required collateralization through clearinghouses or other middle men would address the problem.

And follows that up with derivatives trading from the point-of-view of an end-user (my bold):

End users have dramatically increased their use of derivatives to hedge risks in recent years. Trading desks sprang up at many financial institutions to address this need and sometimes to engage in proprietary trading for profit. The results from these new enterprises have been mixed, to say the least. Trading complex and illiquid derivatives in a marketplace dominated by well-capitalized financial institutions and hedge funds has been a challenge….

Based on all of this, why do end users resist requirements to collateralize so strenuously? Remember that the cost is not the amount of collateral; the collateral is returned if there is no default. The cost is the difference between the cost of borrowing the funds used as collateral and the investment return on the collateral while it is posted.
One reason for resistance is convenience and avoiding operating expense. However, many end users trade on cleared exchanges as well as in bi-lateral markets, so the processes for collateralization are familiar. This suggests that additional factors enter into their motives.

It may be more productive to focus on factors other than costs. Companies that use derivatives to hedge their business risks receive advantageous treatment under accounting rules. Current hedge accounting rules provide that price movements that change values as described above are not recorded as profit or loss. The theory is that the value of the derivative and the value of the hedged item are inversely related.
While this rule makes sense, it does not make sense to ignore the embedded debt (in the form of foregone collateral) in a derivative….

This is far from trivial. Most agreements to forgo collateral require immediate funding of collateral if adverse credit events occur. It becomes a demand loan-a loan that can be called for repayment at any time. This can cause a liquidity crisis at the very time that the company is most vulnerable, resulting in a death spiral. Such events have occurred several times in the past. After the Enron meltdown, the ratings agencies responded by trying to measure the risk of a liquidity crisis resulting from this phenomenon, but it is difficult to craft general rules to measure the risk. The problem continues and periodically threatens the marketplace.

These arrangements are pervasive in the market. A line graph representing bi-lateral credit exposures in certain markets would look like a plate of spaghetti with a multitude of credit arrangements. What a challenge for the credit officers and legal teams for each of these companies to make sense of it all!

It is worth checking out both if you want to learn more about this.