The law of unintended consequences dictates that massive, complicated and sweeping bills passed by Congress can lead to unanticipated, often undesirable, outcomes.
As Congress prepares to pass a historic financial reform bill, what can be done to ensure that negative unintended consequences are kept to a minimum?
The Senate bill provision dealing with the derivatives market seems rife for unintended consequences. If left unchanged, it could restrict capital, undermine economic growth and job creation and increase the level of uncertainty for businesses and consumers.
This provision takes aim at Wall Street — but hits Main Street squarely on the jaw.
Now, when one mentions derivatives, even among financial professionals, eyes begin glazing over. While these transactions can be complicated, the underlying principle is simple. A derivative is an agreement between two people or two parties that has a value determined by the price of something else. That “something” could be a commodity, like wheat, a foreign currency, or an interest rate.
In general, investors use derivatives for two basic things—hedging risk or speculating to make a profit.
Hedging attempts to reduce risk—it’s almost like insurance. The goal is not to make money, but cushion against potential losses. For example, with house insurance, you are hedging, or protecting, yourself against fires, or other unforeseen disasters.
But derivatives are also used to acquire risk, rather than hedge against it. Some enter into a derivative contract to speculate on the underlying asset’s value, betting the other party will be wrong about the future value.
It’s widely agreed that the speculative uses of derivatives—especially the infamous credit default swap—contributed to the 2008 financial collapse. Many of these derivatives were traded over the counter, or privately negotiated.
This is where Congress comes in. It rightly determined that over-the-counter derivatives designed to speculate could pose risk to the entire financial system.
It rightly determined that more transparency and oversight is needed. It rightly determined that major players should back up trades with cash.
So far, so good. But their solution goes too far. It could subject thousands of Main Street companies to the same requirements intended to curb abuse on Wall Street -- even if these companies are hedging against risk and pose no threat to financial market stability.
But why should you care?
First, without such an exemption, companies across the country – from mutual insurance companies to community banks, to large industrial companies -- would have to tie up hundreds of billions of dollars in working capital to meet new regulatory requirements.
Such requirements could affect these companies’ ability to meet financial obligations. It could threaten job creation and weaken their ability to compete globally.
A survey and analysis by the Business Roundtable and Keybridge Research found a subset of these requirements could lead to a loss of 100,000 to 120,000 jobs within the S&P 500 companies alone.
Second, the proposed Senate derivatives rule would breed further uncertainty. Not only would end users have to post collateral, the amount would change every day -- making planning difficult.
Such uncertainty will cause some businesses not to hedge, causing prices on everyday products to fluctuate on a daily basis as the costs for basic commodities go up and down. One day your beer could cost $2.50, the next, $4.75.
Third, if companies are unable to access the over-the-counter market affordably, larger companies might simply do transactions abroad, where foreign governments may implement balanced regulatory regimes that clearly differentiate major players from Main Street businesses.
Companies that can’t readily move risk management activities overseas could move entire businesses to match the currencies of their cost and revenue.
It might be difficult for many to realize how a provision in the Senate finance reform bill on a subject as obscure as derivatives could affect their pocketbook. But that’s where we are.
The bill needs to be fixed before final passage. Our economic recovery, jobs and your bottom line depend on it.