June 9, 2009 / 8:35 PM / 10 years ago

Central clearing of derivatives seen adding risk

NEW YORK, June 9 (Reuters) - Proposals to require that all contracts in the $450 trillion derivatives market be centrally cleared could tie up valuable capital and constrain the liquidity of companies that use the contracts to hedge their businesses, derivatives users and dealers warned on Tuesday.

The use of central clearinghouses is viewed as key to removing systemic risks posed by the contracts, should the failure of a large dealer spark a chain of losses globally. The issue arose after the collapse last year of Lehman Brothers and insurer American International Group.

Requirements by clearing houses to post higher margins against the trades, and impose stricter rules on the type of collateral used, however, would create new risks for companies that regularly use derivatives to protect against currency, interest rate and commodity fluctuations, users said.

“Capital currently deployed in growth opportunities would need to be maintained in a clearinghouse. This could result in slower job creation, lower capital expenditures, less research and development and/or higher costs to consumers,” said Timothy Murphy, foreign currency risk manager at diversified manufacturer 3M Co (MMM.N).

Murphy was giving testimony before the House Financial Service’s Capital Markets Subcommittee in Washington.

“We urge policy makers to focus on the areas of highest concern, such as credit default swaps,” he said.

Companies use over-the-counter (OTC) derivatives to customize hedges to their specific exposures when exchange-traded products, which are more standardized, do not reflect their actual risks.

Collateral, also known as margin, is posted against these contracts to protect against the risk of a counterparty failing.

In many cases, companies secure their derivative trades with property or other assets, which are also used to back their bank credit agreements.

Clearinghouses, however, would require companies to post liquid collateral such as cash or short-term government debt, which could come at a much higher cost.

“The effect of forcing such companies to face an exchange or a clearinghouse would limit their ability to manage the risks they incur in operating their business and have negative financial consequences for them via increased collateral and margin posting,” said Don Thompson, associate general counsel at JPMorgan (JPM.N), who also testified at Tuesday’s hearing.

“These unintended repercussions have the potential to harm an economic recovery,” he said.

Interest rate and foreign exchange derivatives comprise the vast majority of trades in the market, with around $403 trillion in outstanding volumes, according to data by trade group the International Swaps and Derivatives Association.

Volumes in credit derivatives stand at around $39 trillion with equity derivatives making up another $9 trillion.

Thompson said that a number of JPMorgan’s clients, including natural gas producer Chesapeake Energy Corp (CHK.N), are concerned about the effects of proposed regulation.

Jennifer Grigsby, treasurer at Chesapeake, in a letter sent to Treasury Secretary Timothy Geithner last month warned that proposed new margin requirements “would prove to be a significant liquidity drain on American companies.”

“At a time when the U.S. economy needs more free-floating capital, posting cash margin on an exchange would prove to have the opposite effect, in fact, risking a more serious liquidity crisis,” Grigsby wrote. (Reporting by Karen Brettell; Editing by Leslie Adler)

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