Who Will Pay For Derivatives Reform?

While banks and corporations are lobbying hard against derivatives reform, citing an arbitrary cost burden, there are still no hard estimates on what the financial impact would be, or who will pay for it.
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) -- With all the doomsday predictions of how derivatives reform will impact the financial industry, it's worth asking how much the measure currently being debated in Congress will cost.

The short answer: "It's difficult to say," according to Luke Zubrod, a consultant with Chatham Financial who works with derivatives end-users.

The overall cost estimate has been a moving target for the past several months. As Congress comes up with changes to the bill -- seemingly by the hour -- the estimates change as well. At the moment, there appear to be three main components to consider.

The two primary "costs" deal more with liquidity than costs, though they would tie up money nonetheless. The latest Senate bill would require certain end-users to post margins on trades and require broker-dealers to post capital against the risk that a trade goes bad. (The Senate failed to get the necessary 60 votes to invoke cloture, end debate on the bill, late Wednesday).

Corporate customers are against this idea because it could mean taking on new debt to use as cash collateral, or tie up funds that could be used to grow the business.

"It may not be a terribly expensive activity, no more expensive than having a company borrow money to meet the collateral requirements, but it's a question of companies not wanting to set aside precious working capital to take care of derivatives trades," says Zubrod, "If they don't want to do that, they won't hedge, and

the ultimate cost of that is taking on more risk and more volatility."

In theory, the cost of doing business would then rise, either shrinking profit margins or creating higher consumer prices. In other words, if you think summer travel is expensive now, imagine the price if


(DAL) - Get Report



(CAL) - Get Report

couldn't hedge their fuel costs.

Or, if the price of a can of soda seems to have risen a lot in recent years, imagine how much it would cost if


(KO) - Get Report

couldn't hedge against currency swings. Most of its revenue comes from Europe -- while its workforce is centered in the U.S. -- and it gets bottling materials from other parts of the world as well.

On the banking side, the biggest uncertainty -- and potentially the biggest cost -- may be capital requirements. Banks fear that regulators will impose overly stringent requirements in an effort to snuff out the market for exotic derivatives. While those types of bets brought down

American International Group

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and put

Goldman Sachs'

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feet to the fire, it's been a profitable business for Wall Street, and helped mitigate risk for clients with specific insurance needs.

Zubrod considers this the "big story to come that will unfold in the next six months to two years." Banks and end-users alike are lobbying hard to set capital standards that are not onerous but based on what they consider to be the actual risk of loss.

It's still unclear how that story will play out. That's especially true because of exemption provisions that would place cost burdens on some market participants, but not others, or prevent rules from being applied to legacy contracts that are already in place.

The only cost that seems to have a hard number applies to a rule that banks have been lobbying the hardest against: The Lincoln amendment.

Sen. Blanche Lincoln (D., Ark.) proposed that major banks be required to spin off their derivatives businesses into separate affiliates or get rid of them entirely. Sen. Chris Dodd (D., Conn.) attempted to soften her proposal by giving the industry a two-year window to adjust to the change. But

he backed off that suggestion

by Wednesday afternoon, after facing tough opposition from regulators, fellow lawmakers of both political parties and the industry itself.

The Securities Industry and Financial Markets Association says that, based on regulators' estimate of $1.1 trillion in credit exposure from derivatives activity at the end of 2009, bank affiliates would require $110 billion in capital support. Yet SIFMA says even those figures are "a significant under-estimate of the impact" because capitalization would likely be based on "worst-case, peak exposure" of over $2 trillion.

That would cost the industry more than $200 billion to create and capitalize the proposed derivatives affiliates.

"The result could be a substantial reduction in available capital at a time when many policy makers believe banks need more capital, not less," SIFMA says in a cost-estimate document it provided to


. "A further result would be a contraction in credit from U.S. banks of $100s of billions in the aggregate."

It's also worth noting that any meaningful cost estimates are coming from the very entities that are lobbying for or against the reform measure - whether industrial groups, advocacy groups, financial groups, regulators or politicians.

When asked whether there's substance to the industry's claims that costs will rise, Craig Holman, a lobbyist for the consumer-advocacy group Public Citizen admitted that he wasn't sure.

"I'm not certain if they are going to face higher costs, but let's look at the cost to the economy on a whole because of what happened," he says.

In any case, five large firms -

Bank of America

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JPMorgan Chase

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(C) - Get Report


Goldman Sachs

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Morgan Stanley

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- represent about 97% of the market. They have lobbied the hardest against the provision, whether individually or through trade groups, as has

Prudential Financial

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CME Group

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, the exchange on which commodity derivatives are traded. They may face a tough decision in the weeks ahead, once the reform proposal becomes law: To exit the business entirely, spin it off, or find a profitable way around it.

While SIFMA says the cost burden would fall mostly on the financial industry, rather than customers, that's not entirely clear. For instance, SIFMA also says the cost of interest-rate swaps clearing alone could raise the price of a $200,000 home mortgage by "at least $6,000 to $10,000 and probably more." So if those costs are passed down to the homebuyer, why wouldn't other derivatives costs be passed onto end users?

As a result, the Coalition for Derivatives End Users expressed concern about the affiilate-spin-off measure as well. Industrial firms that largely comprise its membership fear they will get stuck with the burden of capitalization.

"If banks were required to spin off their swaps desk...end users would have to pay the freight to compensate them to incentivize them to create these new entities," says Zubrow. "How much that would cost is something of a mystery."

-- Written by Lauren Tara LaCapra in New York