Keeping watch on derivative trading regulation

by Morton Sosland
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Of all the issues being addressed in the current debate about changing financial regulations in the wake of the recession of the past several years, questions centering on financial derivatives merit careful attention from America’s food industry. This is not meant to imply that the arguments concerning the varied roles of commercial and investment banks or the need for additional consumer protection should be neglected. But it does indicate that the outcome of the derivatives debate promises to have an enduring impact on the food business through the way it will influence regulated futures exchanges and their clearing operations. These exchanges historically have provided essential hedging for important swaths of the food industry. The way in which they operate has been and will be affected by the final resolution of the debate on derivatives.

Derivatives are nothing more than contracts promising delivery of goods and services at a fixed price at a fixed time. Wheat futures contracts are an example of a derivative that has been in existence for centuries and has served as a hedging medium with scant negatives. The claim is made that the success of wheat futures is due to the confines of regulated commodity exchanges that in turn offer central clearing to protect against failure of market participants. The reliability of these markets was tested by wildly fluctuating futures prices of recent years that saw quotations soar and drop amidst unprecedented volume. All of this occurred without a trade failure.

That outcome is strikingly different from the chaos that ruled the non-cleared derivatives market. There the threat of failure or the reality of failure in the case of the Lehman Bros. investment banking business wreaked havoc and threatened economic collapse. Once the impact of the Lehman bankruptcy became understood, the Federal Reserve and the U.S. Treasury found it necessary to inject massive sums of public money to assure that the unregulated, non-cleared derivatives market, often involving bilateral, secret dealings, could be sustained. Credit default swaps and interest rate swaps, where volumes far exceeded trade on regulated exchanges, loomed at the center of the economic crisis that has just passed.

In the wake of this near disaster, the debate now centers on whether the government should require clearing of “standardized” derivatives through regulated clearing houses, mainly using the facilities of the exchanges overseen by the Commodity Futures Trading Commission. The main implication of this idea, which is supported by the Obama administration, is that not only would derivatives trading be regulated, but participants would no longer be dealing bilaterally. The aim is avoiding the “too interconnected to fail” or “too complex to fail,” instead of the “too big to fail” applied to banks.

Objections to mandating regulation and clearing tend to focus on the belief that government dampens innovation. No one questions the entrepreneurship that went into the previous massive growth of derivative trading. Derivatives were created to meet almost any conceivable need, and even some “needs” that were unknown until the offerings were made. Derivatives often were designed to hedge risks into a much more distant future than anything then available on regulated futures markets. Derivatives were suggested for complex commodity mixes and ingredients, and even for a few finished products. In instances, private derivative offerings were specifically designed to compete with hedging available on regulated exchanges, with an edge claimed in costs as well as added risk taking. These usually depended on assumptions about the financial strength of counter-parties.

Much of the current debate is focused on determining how best to protect the integrity of financial markets. No industry is more dependent on these markets than are food manufacturers, and for that reason alone, the industry has a major stake in how these issues are settled. It seems likely that the environment in which derivative trading existed in the past will change, but just how this will occur is still uncertain.

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