Sounding Alarm on Derivatives Rule's Cost

Article excerpt

The latest eye-popping number is $30 trillion, produced by lobbying firms and banks to support their view that many new regulations will be expensive.

Imagine a situation in which the world's banks have to find as much as $30 trillion to comply with just one new regulation. That might be something of a stretch, given that the gross domestic product of the United States is about $15 trillion, and the world's 10 largest banks hold $25 trillion in assets.

Yet a banking industry group recently looked into a new rule and sketched out a possibility in which banks would be forced to come up with as much as $30 trillion in cash.

The potential cash call is outlined in a letter the International Swaps and Derivatives Association, or I.S.D.A., sent in September to regulators. It is the latest eye-popping number that lobbying firms and banks have produced to support their view that many new regulations will be enormously expensive -- and the big, scary numbers seem to be gaining traction.

Some of the concern may be warranted, especially in Europe, where certain stressed banks have had trouble borrowing regular amounts in the markets. But a deeper look at the industry association's figure of $30 trillion suggests that many of the worries might be overdone.

The gargantuan sum relates to the market for derivatives, which are financial contracts that banks and investors use to bet on interest rates, stock prices, the creditworthiness of corporations and the like. Derivatives played a central role in the 2008 financial crisis. The market for many contracts was opaque, which stoked panic when certain players started to falter.

Before the financial crisis, big participants like large banks on Wall Street were often able to avoid following certain rules intended to make the market safer. One of those practices involves something called initial margin. This is the cash or easy-to-sell assets that parties have to set aside at the outset of a derivatives trade. If one side cannot pay up, the other side can make a claim on the initial margin.

Now, regulators want to tighten up the margin rules. To do so, they are introducing regulations aimed at pushing derivatives trades through entities called central clearinghouses. These organizations effectively agree to pay out if one side of the original trade cannot pay.

Because of that pledge, clearinghouses have to make sure they can pay if one party defaults. One way that they do so is to demand margin from the parties that trade through them. But a large number of derivatives trades will not necessarily go through clearinghouses, even after the overhaul is in place. Such trades will still be arranged directly between two financial firms.

Regulators have proposed rules that would require firms to supply initial margin on such so-called bilateral trades, too. Those rules, which would not apply to existing trades, may not come into effect until late 2013 in the United States.

The I.S.D.A. and many others want to stop or water down those margin rules on bilateral trades. In its paper, the association argued against initial margin rules, saying they were "likely to lead to a significant liquidity drain on the market, estimated to be in the region of $15. …