I have long been concerned about the damage that derivatives did during the global financial crisis and their ability to cause another one. The biggest problem is the lack of transparency. There is no clearing exchange to understand what the market was betting on, and it is important, because it is a $583 TRILLION market.
Very little was done last year in the Dodd-Frank financial regulation bill. One of the things was to require participants to put up more capital. Yesterday, non-financial companies were exempted from that requirement. For example, the airlines routinely and understandably hedge their fuel costs. Derivatives were invented to fill this legitimate need to hedge risk. (Beer companies hedge the cost of aluminum and hops!) However, the new rules might have been construed to require the airlines to take capital away from more protective uses and use it to "collateralize" their derivative purchases. This is costly, and they wanted assurance they would be exempted. Of course, they got it.
But, I see the camel's nose coming under the tent. Next, the commercial banks will ask for such an exemption to hedge interest rates. Then, they will ask to be relieved of their rather limited role in policing the credit quality of the other market participants. And, still, there is almost no transparency to what these trillions of dollars are doing in the market. Despite all the consternation and hysterics surrounding last year's debate on financial regulation, there is virtually nothing to prevent another AIG.
If our slowly recovering economy sustains a "heart attack," it will be here.
