Derivatives: No special deals for Wall Street

As Congress debates the final language for reforming Wall Street, a behind-the-scenes battle is raging over the arcane details of derivatives regulation.

Currently, derivatives trade in an opaque, completely unregulated $600 trillion "dark market." The risk that this presents to the U.S. economy is incalculable, and the new legislation rightly seeks to create transparency by forcing most derivatives transactions to clear through a central counterparty, or clearing house.

The clearing house would stand in the middle of the transaction and guarantee both sides of the trade. If one counterparty to the transaction fails, then the central counterparty absorbs those losses, protecting the system as a whole from collapse. A similar system has worked very well for over 100 years in the exchange- traded futures markets.

Wall Street firms hate this idea because their prodigious profits will dwindle when derivatives are traded in the light of day, letting their counterparties see the true costs.

So Wall Street is pushing hard to exempt as many transactions as possible.

The Senate version of the clearing house requirement, which is currently the base text for the bill, includes a narrow, well-defined exemption that allows commercial end-users a complete exemption from clearing, while denying this exemption to financial players.

The House language, however, would exempt anyone hedging "balance sheet risk." Since every financial player has a balance sheet, it is estimated that more than 50% of the outstanding derivatives would go uncleared under the House plan, compared to just 10% under the Senate version.

The Senate language is superior to the House's simply because it forces far more derivatives into the open.

But there also is a critical policy distinction that must be made between commercial end-users like airlines, and financial entities like hedge funds. For a commercial end-user, risk arises naturally out of the ordinary conduct of business. For a financial entity, pricing and managing risk is their core business.

As an example, an airline cannot fly without incurring the risk of wildly gyrating jet fuel prices. Allowing them to hedge their jet fuel exposure without a clearing requirement would provide stability for the airline, confidence for airline investors and ensure that the broad U.S. economy benefits from reliable airline service.

A hedge fund, however, starts with no inherent risk. Its mission is to evaluate investment options, balancing risk and reward. If a hedge fund enters into a jet fuel derivatives contract on a bet that prices will increase, then it's nonsense to say that they are "hedging" when they subsequently enter into an offsetting deal to reduce the risk they voluntarily took on in the first place.

These semantic charades can easily be carried to such extremes that every transaction a hedge fund enters is "hedging" something. An exemption for hedge funds serves no social purpose and, in fact, it puts our entire financial system at risk.

Congress should reject the efforts by Wall Street to craft any exemption that includes financial entities. Allowing exemptions for commercial end-users is a practical proposition. Congress must adopt the Senate language on mandatory clearing requirements for all derivatives. If it allows exemptions for financial entities, it will have failed to protect the American people from the next financial crisis, which will be sure to follow.

Michael Masters is an equity hedge fund manager. He has been a vocal proponent of strong financial regulatory reform and has testified in front of the U.S. House, Senate and Commodities Futures Trading Commission more than eight times on the topic of derivatives reform.