Regulated Derivatives Threaten Insurance Companies and Debt Markets

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Photo Credit: Swift Economics

New regulation attempts on the derivatives market could threaten the earnings of insurance companies and add new strain to the corporate debt markets.  A move by US legislators to de-leverage the derivatives exchange could bring about incredibly expensive margin calls.

The Basis of Regulation

A financial reform bill moving throughout Congress has one simple goal: to reduce the reliance on the derivatives market, as well as reduce the total amount being traded between investment banks, insurers and other institutions.  The new bill would require higher margin requirements for both parties in a derivatives bet, both for bets already made and for future bets between two parties.

Why the Regulation Matters

The derivatives market is perhaps the most leveraged market on the face of the earth, with most bets made with just 1-2% of the stake put up as collateral.  When one bank and another make a wager for $50 million in the future, only one party would put up $1 million as collateral, or a premium, to maintain the bet.  This allows for systematic leveraging throughout the entire exchange that has exploded the total value of all derivatives to an estimated $100-$500 trillion.  This figure is multiples above the total output of the entire world in just one year.

What the Bill Would Do

As mentioned previously, the goal of the bill is to reduce the overall size and scope of the derivatives market by requiring higher margin requirements.  The requirements would rise with the size of the individual banking institution, based on the amount of risk each bank poses to the financial system at large.

However, politicians have yet to consider how much new collateral would be needed should these bills pass.  If we assume that derivatives are worth a total of $100 trillion, and Congress mandates a new 10% margin requirement, $10 trillion will need be raised from the debt markets to continue trading.  This amount is just a fraction of the derivatives market, but some 70% of the total economic production of the United States in just one year.

Thus, should this bill pass and new requirements fall into place, insurers, bankers, and gamblers alike will have to pony up trillions to meet new laws.  Where will this money come from?  No one yet knows.

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