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Institute for Workplace Studies----------------- Professor Samuel B. Bacharach
School of Industrial & Labor Relations-------- Director, Institute for Workplace Studies
Cornell University
16 East 34th Street, 4th floor---------------------- Stuart Basefsky
New York, NY 10016 -------------------------------Director, IWS News Bureau
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Congressional Research Service (CRS)

 

Key Issues in Derivatives Reform

Rena S. Miller, Analyst in Financial Economics

April 8, 2010

http://opencrs.com/document/R40965/2010-04-08/download/1013/

[full-text, 21 pages]

 

Summary

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. This report will be updated as events warrant.

 

Contents

General Background ...................................................................................................................1

Market Structure and Regulation .................................................................................................2

Derivatives Reform.....................................................................................................................4

End Users ..................................................................................................................................5

Legislative Proposals and Exemptions for End Users...................................................................7

Safeguards Applicable to Uncleared OTC Swaps.......................................................................17

Hypothetical Examples .............................................................................................................17

 

Figures

Figure 1. Derivatives Market Structures: Exchange and Over-the-Counter (OTC)........................3

Figure 2. OTC Swap Counterparties ............................................................................................6

 

Tables

Table 1. Comparison of Derivatives Titles of H.R. 4173, as Passed by the House, and Restoring American Financial Stability Act, as Amended by the Senate Committee On

Banking, Housing and Urban Affairs........................................................................................8

 

Contacts

Author Contact Information ......................................................................................................18

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This information is provided to subscribers, friends, faculty, students and alumni of the School of Industrial & Labor Relations (ILR). It is a service of the Institute for Workplace Studies (IWS) in New York City. Stuart Basefsky is responsible for the selection of the contents which is intended to keep researchers, companies, workers, and governments aware of the latest information related to ILR disciplines as it becomes available for the purposes of research, understanding and debate. The content does not reflect the opinions or positions of Cornell University, the School of Industrial & Labor Relations, or that of Mr. Basefsky and should not be construed as such. The service is unique in that it provides the original source documentation, via links, behind the news and research of the day. Use of the information provided is unrestricted. However, it is requested that users acknowledge that the information was found via the IWS Documented News Service.

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Institute for Workplace Studies 
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