During the debate leading up to passage of the Dodd-Frank bill a large number of end-users lobbied to shape the bill’s provisions concerning the OTC derivatives markets. One of the main objectives of their lobbying was inclusion of an exemption for end-users from the mandate that swaps be cleared. Clearing would require that end-users post margin on their positions, while under the old system dealers could sell an OTC swap without any margin requirement. As a part of the lobbying effort a number of end-user trade associations attempted to quantify the capital drain that an undifferentiated clearing mandate would impose on them.
What is striking about these calculations is that they each assume that dealers charge NOTHING for the privilege of posting no margin. A wonderful free lunch if you can get it.
For example, the Edison Electric Institute, a trade association for electric power companies, joined with a number of other energy-related trade associations to produce a report titled “OTC Derivatives Reform: Energy Sector Impacts”. The report is a compendium of little numerical examples, one for each of the lines of business represented among the sponsoring organizations: an independent oil and gas producer, a rural electric cooperative, a publicly-owned electric utility, a public gas utility, a large electric power company, a regulated transmission & distribution utility, a regulated natural gas utility, a wholesale power developer, a competitive electric power supplier, a large natural gas producer and a regional transmission organization. Each example is constructed on the premise that the hedges negotiated under the old OTC system involve costless margin.
The Natural Gas Supply Association, together with the National Corn Growers Association, produced a press release (April 2010) with one of the most quoted figures for the total cost of imposing the clearing and margin requirement on end-users: “Looking beyond our industries to the entire derivatives market, we estimate this provision would drain a staggering $900 billion of productive capital from the U.S. economy – effectively cancelling out the entire economic stimulus package of 2009.” To see the calculation behind the $900 billion figure, one has to contact the NGSA, which we did. Once again, existing swaps are assumed to be open with zero margin and the end-user pays NOTHING for this privilege.
The Business Roundtable, too, attempted to quantify the economy-wide impact in a report based on a survey of some of its members. The report concludes that “a 3% margin requirement on OTC derivatives could be expected to reduce capital spending by $5 to $6 billion per year, leading to a loss of 100,000 to 120,000 jobs, including both direct and indirect effects.” This calculation, too, assumes that under the old system companies are granted swaps with zero margin and at NO COST. The calculation has other weaknesses, too. For example, the $5 to $6 billion annual reduction is really just a one-time reduction. But these other weaknesses, while relevant to the overall public debate, do not reflect the fundamental illusion driving so much of the agitation among end-users. That illusion is the belief in a free lunch.
In the debate leading up to passage of Dodd-Frank, these calculations went largely unchallenged. But the debate is going to be revisited as the rulemaking process grinds forward and the details of the end-user exemption and the terms for clearing and margins are specified. All signs are that many end-users continue to be under the illusion that they can get a free lunch from their dealers. Some know this is untrue, but the calculations are simple and helpful. We can expect these issues to be revisited. But this time calculations like these should not go unchallenged. If we want to understand the potential costs of imposing a clearing requirement we need a reasonable basis for evaluating the cost of credit under both the old and any proposed version of the new system. In estimating the cost under the old system it is clearly wrong to assume a zero cost. Dealers don’t offer unmargined swaps without charging a fee. The hard part is estimating what that fee might be. But we all know it’s not zero.