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Since the financial crisis of 2007, Americans have become more interested and reliant on complex financial products than perhaps at any other time in history. The media made quick work lumping together and demonizing all derivatives – something they little understand.

Commodity derivatives are investment tools that allow investors to profit from certain items without possessing them. This type of investing dates back to 1848 when the Chicago Board of Trade was established. Initially, the idea behind commodity derivatives was to provide a means of risk protection for farmers. They could promise to sell crops in the future for a pre-arranged price.

Simply put, a derivative is a contract which allows the holder to purchase a good in the future at a price determined by the market today. The contract holder hopes the price of the good will rise above the agreed contractual purchase amount.

Playing to the fears of the American public, Sen. Chris Dodd (D-CT) and others are jumping at the chance to harness sentiment against derivatives. Dodd’s crusade against derivatives must be stopped as many derivatives actually benefit everyday American life. Derivatives shield the market against enormous price fluctuations in food, energy, steel and countless other items we depend on to live normal, everyday lives.

Now, Sen. Dodd’s “Wall Street Bailout” bill, S. 3217 the Restoring American Financial Stability Act of 2010, seeks to unnecessarily regulate these commodity derivatives which make up 0.6% of the global derivatives market. In fact, derivatives, like those used in end user transactions, help fuel the American economy, incentivize responsible growth and protect consumers.

• Legislating all derivatives together will have severe unintended consequences in the market and will result in increased costs and job losses
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    “According to Exelon’s analysis, it is very possible a requirement that virtually all trading activity occurs on organized exchanges…could increase the power prices…from 5 to 15 percent.” (Exelon testimony on H.R. 3795, 12/2/09)
• Requiring all derivative trades to post cash collateral  removes vital liquid capital from corporate balance sheets where it can be used more effectively
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    FERC Chairman John Wellinghoff mentioned during oral testimony before the House Energy and Commerce committee that not exempting end users from clearing requirements could negatively impact companies’ abilities to invest in renewable energy technology. (FERC testimony on H.R. 3795, 12/2/09)
• During this economic downturn, credit has become difficult to secure. If cash collateral is required for all derivative trades companies will be forced to sell assets to raise necessary collateral
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    “These are very important markets for us to hedge our risk. We don't have the kind of capital at hand to be able to handle a great deal of risk. Anything that would increase those costs I think are going to push our people out of those markets and it increases risk to our members considerably.” (NREC testimony on H.R. 3795, 12/2/09)
• Companies trading derivatives primarily to hedge losses are not large financial institutions with sophisticated trading desk.
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    “Whenever you look at the size of these markets you can’t hardly see us with a magnifying glass.” (NREC testimony on H.R. 3795, 12/2/09)
• If hedging losses is prohibited, traders will be at the mercy of extreme price fluctuations and will pass that cost onto consumers
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    “I would like to mention the critical importance of continuing to allow LSEs and energy end users to use non-cleared, individually negotiated OTC transactions to hedge the price of energy fuels in order to continue to offer the best electric rate possible to our customers.” (American Public Power Association testimony on H.R. 3795, 12/2/09)

The proposed regulating of derivatives in the Dodd bill will harm, not help our economy. Yet another problem plaguing this bill – allowing this bill to pass will cripple our economy and will make permanent the same failed practices of the past.

For more information, contact Brian Johnson at bjohnson@atr.org.