The Collateral Boogeyman is back

Victoria McGrane at the Wall Street Journal‘s Real Time Economics blog covers the new release from Keybridge Research on the potential impact of collateral requirements that flow from the Dodd-Frank reform of OTC derivatives markets. The headline is “Study: Strict Derivatives Regulation Could Cost 130,000 Jobs”. What is the substance behind those numbers?

The Keybridge release gets to its headline number in basically 4 steps:

1. Estimate the notional volume of derivative contracts outstanding at US companies (S&P500): $3,344.9 billion.

2. Apply a 3% factor to these trades as the estimate of the collateral required: $110.05 billion.

3. Assume this collateral requirement is a deadweight cash flow cost to the companies.

4. Estimate the impact of a drop in cash flow on capital expenditure and therefore jobs.

There are many potential points of contention in this calculation. But the big unexamined assumption is inside #3. There are two problems here–one micro and one macro.

The micro mistake is the delusion that absent a collateral requirement companies are able to trade derivatives at no cost to their balance sheet. This is plainly not true. If you don’t back up your derivative trades with a cash collateral account, then you are backing them up with a promise that you are good for it, i.e. with credit. Companies have limited debt capacity, so using credit is costly, too. A regulation that requires using cash instead of credit costs the company on one side, but loosens its constraints on the other. The net effect on the company’s free cash flow is zero. Keybridge’s oversight here is a first order mistake. One could argue that the cash requirement is costlier than credit, but then you would have to figure out by how much. That would be an extra, very difficult step in the calculation, and any reasonable estimate for the differential would drive the headline number down enormously, possibly to zero.

The macro mistake is to ignore the entire purpose of the regulation. The collateral requirement is an indirect result primarily of the clearing requirement. The objective of this and other elements of the reform is to reduce the total risk in the system. Some of the reduction should come from canceling offsetting positions that simply add to total credit risk. Some should come from reducing systemic risk. It’s always possible to ignore the systemwide purpose of a regulation and claim it is costly due to the burden it imposes on each transaction. You could do this for fire codes, for food and drug regulations and so on. But the only sensible way to examine the net impact of the regulations is to think through the full systemwide impact. One can have a good debate about whether or not the Dodd-Frank reforms will reduce the total risk in the system, and about what contribution a collateral requirement may make. But simply ignoring the systemwide impacts is not a useful contribution to reasoned debate on the matter.

_________________________

Previous posts directly related to the micro issue include this one and this one. Previous posts on the macro issue include this one, this one and this one.

2 Comments

  1. Posted February 16, 2011 at 4:19 am | Permalink

    No, the cost won’t necessarily increase. First, because corporations already have to pay their relationship bank for the credit required to trade derivatives. An uncollateralized trade is equivalent to a package of two instruments: (i) a collateralized trade, and (ii) a line of credit for the collateral. A requirement to collateralize all trades is just a requirement to break that package into its components. The corporation posts the collateral on the trade with its relationship bank, and then turns around and gets the line of credit for the collateral from its relationship bank. Second, because the macro/systemic consequences of the reform are what determines the total credit and systemic risk in the system, which is what determines the total cost that has to be covered by corporation fees. If the total risk goes down, the total fees can go down, too. See our various posts on OTC Derivatives Reform for a fuller elaboration of these points, plus the seminar presentations referenced there.

  2. Posted February 15, 2011 at 3:11 pm | Permalink

    Perhaps it won’t be 130,000 jobs and maybe not even 130. But won’t the cost of using derivatives increase for corporations (say, via higher fees charged by their relationship banks, etc)?

16 Trackbacks

  1. By NERA Doubles Down « Betting the Business on March 19, 2012 at 5:03 am

    [...] on this issue commissioned by lobbyists seeking to loosen the regulations–see here and here. Our critique of the earlier Keybridge study applies equally to NERA’s study: If you don’t back up your [...]

  2. By Betting the Business on July 18, 2011 at 5:51 am

    [...] of a firm went up—the lead study financed by the Coalition can be found here, and our critique here. Now that the Coalition has sensibly abandoned this argument, participants in the discussion should [...]

  3. [...] earlier this year in a “study” commissioned by the Business Roundtable–see analysis here, here and here. Maybe that’s the point. Although the earlier work has been discredited, if the [...]

  4. [...] — kill jobs. This report’s analysis was, as MIT economics professor John Parsons blogged, a bogeyman based on premises that are “clearly not [...]

  5. [...] As I discussed earlier this week elsewhere, the provocatively-titled Wall Street Journal article “Study: Strict Derivatives Regulation Could Cost 130,000 Jobs” echoing the “government regulations hurt business” talking-point was defused by professors John E.  Parsons and Antonio S. Mello, who pointed out, “It’s always possible to ignore the system-wide purpose of a regulation and claim it is cost… [...]

  6. [...] MIT’s John Parsons eviscerated the report, convincingly noting that it didn’t make any sense on a couple of levels (RTE updated [...]

  7. By OPISO » Deceptive Lobbying on Derivatives on February 16, 2011 at 1:21 pm

    [...] feel bad about that – but such duping is very dangerous for financial-system stability. (See this post by my colleague John Parsons, who cuts nicely to the analytical heart of the matter – and who [...]

  8. [...] feel bad about that – but such duping is very dangerous for financial-system stability. (See this post by my colleague John Parsons, who cuts nicely to the analytical heart of the matter – and who [...]

  9. [...] feel bad about that – though such duping is really dangerous for financial-system stability. (See this post by my co-worker John Parsons, who cuts easily to a methodical heart of a matter – and who also [...]

  10. [...] feel bad about that – but such duping is very dangerous for financial-system stability. (See this post by my colleague John Parsons, who cuts nicely to the analytical heart of the matter – and who [...]

  11. [...] John E. Parsons and Antonio S. Mello, in turn, criticized the key findings in the report. [...]

  12. [...] This post was mentioned on Twitter by iTreasurer, noamscheiber. noamscheiber said: Wall St. trying to reopen the derivatives debate with bogus study. Great pushback here http://bit.ly/hNuvR7 and here http://nyti.ms/fTM228. [...]

  13. [...] derivatives market “could cost 130,000″ jobs.  My MIT colleague, John Parsons, deftly takes this apart on his blog today – pointing out that the technical basis of this report is very weak (or [...]

  14. [...] Sadly, no. MIT economist John Parsons debunked a report, heading Johnson to conclude: The Keybridge request itself is pristine lobbying masquerading as [...]

  15. By FT Alphaville » User fees and CFTC funding on February 14, 2011 at 4:40 pm

    [...] John Parsons (H/T Baseline Scenario) has subjected their underlying logic to some thought. The full (short) post is worth a read but here are his two main points: A regulation that requires using cash instead of [...]

  16. [...] derivatives market “could cost 130,000″ jobs.  My MIT colleague, John Parsons, deftly takes this apart on his blog today – pointing out that the technical basis of this report is very weak (or [...]

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