Wednesday May 16, 2012
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Letters from Businesses on OTC Derivatives
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| Action on Banking & Financial Services |
See also: At a Senate Banking Committee hearing on June 22, 2009, I submitted the following opening statement:
Recent events in the credit markets have highlighted the need for greater attention to risk management practices and the counterparty risk in particular. The creation of clearing houses and increased information to trade information warehouses are positive steps to strengthen the infrastructure for clearing and settling credit default swaps. While the central counterparty clearing and exchange trading of simple, standardized contracts has the potential to reduce risk and increase market efficiency, market participants must be permitted to continue to negotiate customized bilateral contracts in over-the-counter markets.
Many businesses use over-the-counter derivatives to minimize the impact of commodity price, interest rate, and exchange rate volatility in order to maintain stability in earnings and predictability in operations. If Congress overreaches and bans or generates significant uncertainty regarding the legitimacy of decisions to customize individual OTC derivatives transactions there will be enormous negative implications on how companies manage risk.
At this time I would like to highlight a few examples from end-users about what are the possible effects of severely restricting access to customized over-the-counter derivatives on companies’ ability to manage risk and on the prices they charge customers.
David Dines, President of Cargill Risk Management: “While margining and other credit support mechanisms are in place and utilized every day in the OTC markets, there is flexibility in the credit terms, credit thresholds and types of collateral that can be applied. This flexibility is a significant benefit for end users of OTC derivatives such as Cargill in managing working capital. Losing this flexibility is particularly concerning because mandatory margining will divert working capital from investments that can grow our business and idle it in margin accounts. While it depends on market conditions, the diversion of working capital from Cargill from margining could be in excess of $ 1 billion. Multiply this across all companies in the U.S. and ramifications are enormous, especially at a time when credit is critically tight.”
Kevin Colgan, Corporate Treasurer of Caterpillar: “Our understanding of currently pending regulation in this area is that it would require a clearing function which would standardize terms like duration and amount. Any standardization of this type would prohibit us from matching exactly the terms of the underlying exposure we are attempting to hedge. This, in turn, would expose us to uncovered risk and introduce needless volatility into our financial crisis.”
Mark Grier, Vice Chairman of Prudential Financial: “Without customized OTC derivatives, Prudential would be incapable of closely managing the risks created in selling life insurance, offering commercial loans, and proving annuities for retirement.”
John Rosenthal, Chief Hedging Officer of MetLife: “Standardized derivatives cannot be used effectively to hedge all types of financial risk. Any increased risks would result in higher costs to offer and maintain these products. In either situation the increased costs of an inefficient derivatives market would be reflected in the pricing to our customers. To the extent the costs and / or risks associated with an inability to appropriately hedge these products became prohibitive; these products could be no longer available to customers.”
Janet Yeomans, Vice President and Treasurer of 3M: “Not all OTC derivatives have put the financial system at risk and they should not all be treated the same. The OTC foreign exchange, commodity, and interest rate markets have operated uninterrupted throughout the economy’s financial difficulties. We urge policy makers to focus on the areas of highest concern.”
At this time, I would like to submit into the record the complete letters. It is possible that I will receive additional letters in the next few days and I would also like to enter those letters in the record.
While the derivatives market may seem far removed from the interests and concerns of consumers and jobs that is clearly not the case. Legislative proposals to alter the regulatory framework of over-the-counter derivatives is a very technical subject matter and the potential for legislation to have unintended consequences of legitimate transactions is considerable.
We need to better understand the following questions:
How do businesses use customized OTC derivatives to help stabilize prices and mitigate risk? What are the possible effects of severely restricting access to customized OTC derivatives on businesses ability to manage risk and on the prices they charge customers? What safeguards are in place to ensure that derivatives portfolios are a tool for hedging risk, rather than a source of risk? What does standardized mean, and how much of the OTC markets can and should be shifted on exchanges?
Additional letters from businesses:
Randall Durling, Director-International Finance Boeing: "By restricting access to customized OTC derivatives, there are a variety of impacts that may occur. The most significant impact being that Boeing is unable to manage its variable cost structure which would require us to pad the sales price of our products to absorb the variable costs."
Craig R. Reiners, Director-Risk Management MillerCoors: "Standardization of OTC products centrally cleared would make it increasingly difficult to meet hedge accounting criteria and would therefore require companies to mark-to-market positions, increasing earnings volitility and distracting from operating results."
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