The Progressive Policy Institute (PPI) just released a Policy Brief by Jason Gold and Anne Kim on “The Risks of Over-Regulating End-User Derivatives”. The piece recycles bad arguments made previously by others, and offers absolutely nothing new. For example, to quantify the potential job losses attributable to requiring margin from end-users, the authors repeat the discredited numbers produced 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 numbers are recycled through enough other outlets, then they can be naively quoted in future lobbying work. We’ve already addressed the Brief’s main arguments in previous posts (start here or here), and won’t rehash those points again now.
However, one of the central premises of the Brief is a delusion shared by many other commentators on end-users and margins, and it would be useful to take this occasion to puncture that delusion and return the discussion to the real historical facts and sound economic theory underpinning margins and end-users.
What is the delusion? It has two parts.
First, these authors, along with many others, think of margins as something imposed by government fiat. They don’t see margins as an innovation of the private market.
Second, these authors think that margins are and should be alien to end-users. Margins are only appropriate to impose on financial companies, because only financial companies pose systemic risk.
Actual history is at odds with both parts of this delusion.
The practice of margining derivative trades arose organically with the creation and evolution of commodity derivatives markets, when the vast majority of derivative trades were conducted among end-users. In all of the diverse commodities, from grains to meats to coffee and cocoa to metals of various sorts and so on, shippers, traders, processors and other end-users came together to create derivative markets. They established their own rules which they imposed on one another by agreement. The practice of margining developed gradually within this system. It is impossible to read any history of these markets without noting this fact. There are many such histories around, but some recent ones with diverse points of focus include:
- Peter Norman’s The Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets;
- Emily Lambert’s The Futures: The Rise of the Speculator and the Origins of the World’s Biggest Markets; and
- Edward Swan’s Building the Global Market: A 4000 Year History of Derivatives.
At various historical points the government also got involved with margining rules, for better or worse. But even when the government got involved, it was primarily to regulate margining among the very end-users that dominated the commodity derivative market. It is only in the late 20th century that derivatives markets assumed the outsized role they now have for non-end-users, i.e. for financial companies. The concept of margining in commodity derivatives markets among end-users long precedes this development.
At various historical points in the evolution of these markets, the differences between the interests of financial companies and non-financial companies has loomed large. But these conflicts never presumed that the concept of margining applied to one and not the other.
A short thumbnail sketch of any history, like that of derivative markets as given here, is bound to oversimplify. But I think my basic point is fair: margining derivative transactions is a practice that was historically imposed by end-users on end-users for the efficacy of economic transactions among end-users. Pretending that it is a practice only imposed by government and one only appropriate to be imposed on financial companies is at odds with history.
The delusion is also at odds with actual practice in the OTC derivatives market, even pre-Dodd-Frank reform. A large percentage of OTC swaps sold by dealer banks to end-users are margined. This is not mentioned in the PPI’s Brief. Instead, they lean on the imagination of a pre-Dodd-Frank world free of margining for end-user derivative trades, a world that is now threatened by the irrational government imposition of margins on end-users. But if it is so irrational, why does the private market already impose margining on such a large fraction of trades? And if private companies find it economically sensible to impose margins on end-users, then the PPI’s simple logic about the damage that is likely to be done with government regulations breaks down. The burden of determining the “right” margin requirement is one the PPI authors attempt to finesse using the delusion about margins.
We can have a reasonable policy debate about the wisdom of government regulations on margining of end-user derivative transactions. But if it is to be reasonable, it must be grounded in fact, not fancy. The fact is that margining is actually an innovation created by end-users of derivatives for the improved functioning of commodity derivative markets. Margining is not something just for the other guy, the financial company.