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July 16, 2013

Land Mines in the Derivatives 'Path Forward'

Last week’s announcement of a “Path Forward” by the U.S. Commodity Futures Trading Commission and the European Commission is an important step toward coordinating the rules for derivatives trading. However, the agreement’s failure to address conflicts in rules for clearinghouses—which will handle the vast majority of the trades and the trillions of dollars of collateral posted by the world’s largest banks—is a troubling omission. There is still much work to be done.

The $630 trillion market for derivatives is a testament to their importance for corporations in the United States and elsewhere that seek to hedge financial risk. The two most important types of derivatives are interest-rate swaps and foreign-exchange swaps, which together account for about 90% of outstanding derivatives globally. Interest-rate swaps allow corporations to manage the risk that their borrowing costs will rise in the future. Foreign-exchange swaps allow corporations with revenues or expenses in a foreign currency to hedge the risk that the value of that currency will rise or fall.

Another derivative, the credit-default swap, allows corporations to hedge against the potential default of another corporation—for example, a major funding source or supplier. However, credit-default swaps (which amount to $25 trillion globally) are regulated by the Securities and Exchange Commission and are outside the new agreement.

The financial crisis demonstrated that trading in derivatives can bring down a multitrillion dollar corporation like the insurance giant AIG and potentially threaten the entire financial system. The U.S. government said the bailout of AIG was necessary because the corporation lacked sufficient collateral to pay its credit-default swap counterparties, which included Goldman Sachs and Deutsche Bank .”

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Read full Wall Street Journal article here

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