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Misunderstanding derivatives endangers Main Street
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06/02/09 01:51 PM ET
Every so often a term enters the public square that takes on significance far beyond its true meaning — Star Wars as the strategic defense initiative, for example. In the midst of the most dramatic economic crisis most of us have ever seen, derivatives has become such a word — a misunderstood label that carries freight far beyond its real meaning. But to react to symbolism, and take actions to curtail the use of derivatives based on this misunderstanding, would seriously harm Main Street businesses.
Today, the issues before the Congress relating to the financial meltdown are not tidy and simple. That is especially true when it comes to derivatives. The government rescue of AIG is the story of what happens when a company fails to understand and manage risk in a prudent manner.
AIG’s problem was not with derivatives, but with the way AIG mismanaged its derivatives business. That is when derivatives came to be perceived as negative baggage and took on a unique, symbolic position in the lexicon.
In fact, the story of derivatives is mostly one of important contributions to businesses and the economy. Lost in the justified outrage about financial misbehavior is the fact that derivatives actually play an important function in helping Main Street businesses in every congressional district around the country manage the financial risks they face every day.
When companies focus on importing soft goods or manufacturing computers or building engine parts, they need to properly manage the risks from fluctuating interest rates, currency exchange rates, suppliers’ credit ratings or myriad other financial factors. Over-the-counter derivative contracts enable companies to manage those financial risks, thus freeing up capital for their core business operations.
Thousands of businesses, from local car dealerships to multinational corporations, use derivatives every day to manage risk. Twenty-nine of the 30 companies that comprise the Dow Jones Industrial Average use derivatives. And, because derivatives aid the flow of credit and increase liquidity in the financial system, they are crucial building blocks for financial and economic recovery. Yet the misunderstanding of the AIG situation and the true nature and usefulness of derivatives has caused some in Congress to overreact to the perception of derivatives and not the reality.
One overreaction is a proposal to trade all over-the-counter derivatives on an exchange. Although well intentioned, such a proposal would hamper the use of these very important financial tools that businesses rely on. Companies would not be able to acquire derivatives that are customized for a particular company’s needs, thus compromising the ability of businesses to manage financial risk. Companies would experience volatility in their earnings that they would otherwise have been able to hedge against.
Credit to small businesses would be tightened by banks, which would be obligated to increase their regulatory capital. Resources that would otherwise be used by a company to run or reinvest in its business would instead be needed to post collateral.
To be sure, derivatives have played a role in this crisis, and lapses in meaningful and effective regulation of some firms have contributed to significant losses and anger. To address these issues, a consensus is forming around the creation of a systemic risk regulator that would oversee institutions whose activities can pose a risk that would reverberate throughout the financial system. The systemic risk regulator would be empowered to identify and act to correct activities of any institution that posed a systemic risk, like the AIG situation.
As Congress begins the process of debating regulatory reform initiatives we need to ensure that strong regulation is balanced with the correct financial products and tools to maintain and improve our economic competitiveness.
It is right and necessary that Congress modernize financial regulation and take steps to prevent the kind of risky activities that took place in the capital markets. However, it is important that we do not exacerbate the damage by taking away vitally needed liquidity during these difficult economic times. To do so we must get beyond the symbolism and understand the true functions of derivatives and their benefits for the economy.
McMahon, who represents one of the largest concentrations of financial service workers in the United States, is a member of the Financial Services Task Force of the New Democratic Coalition.
Today, the issues before the Congress relating to the financial meltdown are not tidy and simple. That is especially true when it comes to derivatives. The government rescue of AIG is the story of what happens when a company fails to understand and manage risk in a prudent manner.
In fact, the story of derivatives is mostly one of important contributions to businesses and the economy. Lost in the justified outrage about financial misbehavior is the fact that derivatives actually play an important function in helping Main Street businesses in every congressional district around the country manage the financial risks they face every day.
When companies focus on importing soft goods or manufacturing computers or building engine parts, they need to properly manage the risks from fluctuating interest rates, currency exchange rates, suppliers’ credit ratings or myriad other financial factors. Over-the-counter derivative contracts enable companies to manage those financial risks, thus freeing up capital for their core business operations.
Thousands of businesses, from local car dealerships to multinational corporations, use derivatives every day to manage risk. Twenty-nine of the 30 companies that comprise the Dow Jones Industrial Average use derivatives. And, because derivatives aid the flow of credit and increase liquidity in the financial system, they are crucial building blocks for financial and economic recovery. Yet the misunderstanding of the AIG situation and the true nature and usefulness of derivatives has caused some in Congress to overreact to the perception of derivatives and not the reality.
One overreaction is a proposal to trade all over-the-counter derivatives on an exchange. Although well intentioned, such a proposal would hamper the use of these very important financial tools that businesses rely on. Companies would not be able to acquire derivatives that are customized for a particular company’s needs, thus compromising the ability of businesses to manage financial risk. Companies would experience volatility in their earnings that they would otherwise have been able to hedge against.
Credit to small businesses would be tightened by banks, which would be obligated to increase their regulatory capital. Resources that would otherwise be used by a company to run or reinvest in its business would instead be needed to post collateral.
To be sure, derivatives have played a role in this crisis, and lapses in meaningful and effective regulation of some firms have contributed to significant losses and anger. To address these issues, a consensus is forming around the creation of a systemic risk regulator that would oversee institutions whose activities can pose a risk that would reverberate throughout the financial system. The systemic risk regulator would be empowered to identify and act to correct activities of any institution that posed a systemic risk, like the AIG situation.
As Congress begins the process of debating regulatory reform initiatives we need to ensure that strong regulation is balanced with the correct financial products and tools to maintain and improve our economic competitiveness.
It is right and necessary that Congress modernize financial regulation and take steps to prevent the kind of risky activities that took place in the capital markets. However, it is important that we do not exacerbate the damage by taking away vitally needed liquidity during these difficult economic times. To do so we must get beyond the symbolism and understand the true functions of derivatives and their benefits for the economy.
McMahon, who represents one of the largest concentrations of financial service workers in the United States, is a member of the Financial Services Task Force of the New Democratic Coalition.
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