Realism’s Beachhead

The Wall Street Journal’s Andrew Peaple uses this morning’s Heard on the Street column to address the demand by some derivative dealers for a broad exemption to the new Dodd-Frank clearing mandate. The issue is how to deal with companies that operate both types of businesses–an end-user business focused on producing physical products, and a financial business including derivatives dealing. The law already exempts the former–under certain circumstances and provisos–but the whole point of the law is to bring the latter under appropriate regulation. What to do about companies that do both?

Peaple acknowledges that it would be unworkable to give a blanket exemption to any company just because they happen to do some business in the physicals:

A full exemption from Dodd-Frank would hand commodities companies like Shell a significant competitive advantage over banks, tempting them to expand activities. Conversely, banks could acquire commodities-producing businesses and claim exemption from the rules, too. Commodities companies, meanwhile, need to show their over-the-counter trades don’t present a systemic risk. Few disclose details on their exposures.

This is a welcome dose of realism. Proponents of the blanket exemption have so far avoided addressing these obvious problems.

Peaples then falls in behind an alternative proposal:

The solution is to give partial exemptions to companies that have relatively small derivatives-dealing operations, but a primary focus on commodities production and selling. Cargill suggests companies that earn less than 30% of revenue from derivatives dealing should be treated this way.

This does not sound very workable. A small derivative dealer would be regulated because the company’s companion physical operations are smaller still, while a large derivative dealer would be unregulated because the company’s companion physical operations happen to be very large. Quite often the scale of a company’s physical operations are unrelated to the scale of its derivatives dealing business, so why should the regulations be contingent on the relative size of the two? Moreover, measures of revenue are subject to manipulation by accounting convention, and we shouldn’t be creating dubious incentives here.

But Peaple is moving in the right direction, so let’s pursue the issue. The problem is that he is trying to author a new solution where longstanding regulatory practice has already worked out a straightforward solution. There is no need to reinvent the wheel here. The most obvious and simplest approach is to treat the derivatives dealing business of a company as a derivatives dealing business, while ignoring the rest of the company’s activities. All derivatives dealing should be covered by the law. All end-user commercial hedging should be exempt. The two are mostly readily separable. Many companies already operate with the two largely managed as distinct operations. If a company wants to shield its end-user business from inclusion, then the regulations should give it a clear standard for organizing its derivative dealing in a separate unit. The law’s reach should be to that separate unit, but need not extend to the rest of the company’s operations. This type of regulatory boundary setting is the norm in corporate organization.

Peaple’s column is another marker that realism finally has a beachhead in the discussion of the end-user exemption. We can only hope that realism will press on as the rules are worked out in detail.

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