By Dan Wilchins - Analysis
NEW YORK (Reuters) - The Obama administration’s plans to move derivatives trading to exchanges could end up hurting companies that use the products, because accounting rules often make customized, off-exchange products a better choice for corporations.
In the end, the administration will have to limit the scope of the reforms it is looking for, press for new accounting rules for derivatives, or risk killing the market for corporate derivatives, experts said.
In a statement on Wednesday, President Barack Obama’s administration said it was overhauling regulation for over-the-counter derivatives, which are instruments like stock options that banks trade privately instead of on an exchange. These instruments have been linked to the decline and fall of multiple large financial institutions over the last year.
The administration said it is looking at measures including moving standardized trades onto regulated exchanges and encouraging banks and other regulated institutions to make greater use of exchange-traded derivatives.
That plan would not likely work well for most corporations, which typically enter non-standardized trades with banks in order to get better accounting treatment for their transactions.
“If we end up with most over-the-counter derivatives moving to an exchange, it would be terrible for companies,” said Dennis Rosenfeld, president of Quantitative Interest Applications in Bainbridge Island, Washington, which advises companies on how to use derivatives. “Risk management would become much more difficult.”
At issue is a U.S. accounting rule known as “Statement 133,” or “FAS 133,” which requires corporations to record derivatives on their books at fair value, with changes in the value affecting the company’s income. That’s a big negative for companies, which typically do not want the value of their derivatives -- an item they often have little control over -- to affect their earnings.
There is a way for companies to avoid recording derivatives at their market value, though: they can qualify for something known as “hedge accounting” if they can demonstrate that the derivatives they are using are designed to reduce risk rather than take risk. But qualifying for hedge accounting means the derivative must match the original exposure very closely, which typically requires custom-tailored instruments.
Custom tailored instruments can’t really trade on an exchange, which is why QIA’s Rosenfeld sees the Obama administration as unlikely to move the interest-rate, currency, and commodity derivatives that companies use to exchanges.
Charles Mulford, a professor at Georgia Institute of Technology’s College of Management, said it would make sense for the Obama administration to allow corporations to enter custom derivatives contracts with banks, and require the trades to be cleared through a clearinghouse.
“They’re more interested in curtailing the risk and increasing transparency, and they’re probably less interested in people that are using derivatives to hedge risk,” Mulford said.
In theory, corporations outside the financial sector use derivatives to reduce their risk, an activity that the government probably does not want to discourage.
That stands in contrast to financial companies like American International Group (AIG.N) that used derivatives to take outsized risks that harmed the financial system, which the government would want to prevent.
If the Obama administration really does push for most derivatives trading to move to an exchange, said Marc Groz, managing member at risk advisory firm Topos LLC, “accounting rules will have to change.”
Rulemakers at the Financial Accounting Standards Board already started that process last year, when they put a draft for rule changes that would make it easier for companies to qualify for hedge accounting. The rules would also make qualifying for hedge accounting less beneficial to the company, making the change not as palatable as might have otherwise been, said a derivatives salesman at a bank.
Still, if most trading moves to an exchange, and accounting rules are not changed at all, “my business will face some problems,” the salesman said.
Reporting by Dan Wilchins; Editing by Gary Hill