Derivatives can reduce risk

The debate on the regulation of derivatives is reaching fever pitch, and the clash of interests is deafening. One small part of the market is in danger of being drowned out: those non-financial companies that use derivatives to reduce operational risk.

There is a clear case for exempting them from rules designed to curb the financial players who dominate the market. But that poses an equally clear danger: the sudden appearance of ostensibly non-financial firms that turn out on inspection to be Goldman Sachs or Morgan Stanley in disguise.

So how those non-financial users might be properly defined is a central question. But first, a couple of illustrations of how regulation might do them unintended harm.

For specimen one, consider corporate pension funds. Trustees of those funds are now able to hedge most of their risks, from inflation to longevity. But the one big risk remaining for funds in deficit is bankruptcy by the corporate sponsor.

One obvious hedge is to buy protection through credit default swaps (CDS) written on the sponsor's bonds. But the "naked" purchase of protection, we are told, is an abuse. CDS should only be permitted for those who hold the bonds in question.

But in this case, that would defeat the object. The natural course for a fund would be to buy CDS equal to the deficit. But if it had to buy the sponsor's bonds in equal amounts, default by the sponsor would simply double the deficit through the writedown of those assets.

Objection

Note, in passing, that one common objection to naked CDS purchase that it violates the principles of insurance does not apply here. Under insurance law, a policy is valid only if the policyholder has an insurable interest that is, would derive harm rather than benefit from the event in question. The harm being insured against here is self-evident.

Specimen two involves the proposed shifting of all derivatives contracts on to exchanges. The risk here is that companies would have to post margin every time the market moved.

Take Rolls-Royce, the UK aero-engine maker. Its revenues are in dollars and most of its costs in sterling, so the hedging of foreign exchange is essential.

On its latest balance sheet, Rolls had foreign exchange derivatives worth £14.5 billion (DhDh80.9 billion). In 2008 the fair value of those fell by £2.6 billion, before rising £2 billion in 2009.

Rolls has net equity of just £3.8 billion. So in 2008 it would have had to devote two- thirds of its balance sheet to margin payments, rather than making engines.

That £2.6 billion charge, please note, does not fall on Rolls' banks as things now stand. They are in the business of matching their positions, and need only post margin on the net difference. They are both ways in the market, while the bona fide user is one way.

So how might that bona fide user be defined? Plainly, not by mere sector classification. General Electric might be a manufacturer, but has a vast and active financial subsidiary.

At least four possible criteria come to mind. The first is whether a company is a "major swaps participant" that is, whether its operations in the markets are big enough to pose systemic risk.

Second, is the company running a book in a given instrument, rather than dealing on a one-off basis? Or third, does it hold itself out as willing to deal, so that market participants can come to it for a price? And fourth, does it qualify for hedging treatment under accounting rules?

That last one, it should be said, is tricky. Many companies, Rolls-Royce included, do not use hedge accounting for the likes of foreign exchange derivatives, for a variety of reasons. It involves an extra burden of record-keeping, and can only be applied to contracted orders for the coming year, rather than forecast business.