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By Huw Jones
February 28, 2011 6:24 AM EST
To get a measure of what financial markets think about plans to make trading in derivatives more uniform and transparent, ask no further than the regulators themselves. Thomas Huertas, a senior UK Financial Services Authority official, said recently that unless the plans to centralize trillions of dollars' worth of contracts were thought through carefully, it could be a bit like "putting a Chernobyl in the back yard."
With its echo of Warren Buffett's description of derivatives themselves as "financial weapons of mass destruction," Huertas' choice of language reflects how potent the industry has become, not to mention hard to understand and difficult to tame.
Yet that is just what regulators are trying to do, and they've got a fight on their hands.
Big companies regularly use derivatives as a form of insurance to guard against jumps in the price of everything from cocoa to interest rates. An airline will buy jet fuel derivatives so that if prices spike, the contract helps to make up the difference in price, enabling the carrier to budget and plan ahead. If jet fuel prices fall, the loss made on the derivatives contract is canceled out by savings from cheaper refueling bills. It's the same with barley for beer or aluminum for cans, or any other commodity you can think of.
For investment banks, this business is a high-margin, low-volume trade they are loath to lose.
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The new regulations, which should make derivatives trades easier to follow, are likely to shift some trade onto exchanges -- which companies and banks alike say would boost their costs.
More than 90 percent of derivatives contracts between banks and other banks, or between banks and companies, are currently drawn up directly between the buyer and seller on what is known as over-the-counter (OTC) market. OTC is an enormous sector which on paper is worth nearly $600 trillion, roughly 10 times world economic output.
But OTC is opaque: regulators have found it hard to see who is selling and who is buying. That's especially true when things go wrong, as they did so spectacularly in 2008. When U.S. bank Lehman Brothers collapsed, authorities struggled to pin down who was exposed to derivatives contracts negotiated by the bank, raising worries about contagion. When U.S. insurer AIG's hoard of derivatives turned toxic it required a $182 billion bailout from American taxpayers.
A few months after AIG, leaders of the world's 20 leading economies (G20) agreed that derivatives contracts should be standardized, centrally cleared, reported and, where appropriate, traded on an exchange or similar type of electronic platform.
The changes are due to come into force next year, which is why airlines, beer makers and plenty of other companies are so worked up. The OTC market has largely been left to its own devices since it took off in the 1970s, when the collapse of the Bretton Woods system exposed businesses to risks like currency swings, for which derivatives offered a hedge. Now big business worries that the extra layers of complication will make life far more costly.
"The proposals would lead to a large increase in cash collateral required from airlines, which they do not have," said Brian Pearce, chief economist at the International Air Transport Association (IATA). "Hedging would become much more expensive because of the cash requirements."
Regulators privately say industry estimates on the extra costs of the new rules are, in the words of one, exaggerated "hogwash."
"The costs from the absence of transparency and standardization in derivatives were huge during the crisis and implicated taxpayers which must not happen again," says Michel Barnier, the EU's financial services chief who has written a radical reform of the sector.
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