Nov

18

I wanted to share my latest oped with dailyspec, as I thought you might find it interesting, and perhaps worth writing about.

In the piece, I explain why Dodd-Frank, the federal law designed to regulate Wall Street, is actually harming farmers — and could end up raising food prices for ordinary Americans. The law's ham-fisted approach to derivatives is wreaking havoc on the "swaps" that farmers use to guard against swings in the price of their crops.

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The Dodd-Frank Net Might Ensnare the Family Meal

Federal regulators recently roiled America's farmers with the release of new rules for financial instruments. The Commodity Futures Trading Commission, one of the agencies charged with implementing the Dodd-Frank Wall Street Reform Act, officially announced the new requirements and said they would take effect by year's end.

What does Dodd-Frank, passed in response to the 2008 economic crisis and aimed at reforming a vast swathe of the financial sector, have to do with farmers?

A great deal. Among the instruments covered by the Commission's proposals are agricultural commodity "swaps." Basically, swaps empower farmers, ranchers, agribusinesses and other food suppliers to hedge against certain risks common to their trade, like bad weather or a crash in the price of a food item they sell.

Swaps might sound like they serve some distant, exotic purpose far removed from the lives of average Americans. But they play a key role in providing food producers with a basic level of financial security through tough times, which helps to ensure price stability for consumers.

Consequently, the way the Commission imposes Dodd-Frank rules on these instruments will have a profound effect on Americans' pocketbooks. And right now, all signs indicate the Commission's approach to implementing Dodd-Frank is going to inadvertently smother agricultural swaps with over-regulation.

In the rush to prevent another crisis, it has cast its net too wide. As a result, Dodd-Frank could make risk management significantly more costly for America's farmers, driving up volatility in the market and potentially leading to huge price increases for consumers.

The Commission's new rules affect agricultural commodity swaps that aren't sold on exchanges and don't run through third-party intermediaries –so-called "over-the-counter" swaps.

Consider a bread baker in Kansas City. He buys thousands of pounds of flour each year. Because of this year's droughts, though, he's worried that America's wheat supply will shrink, driving up flour prices over the next twelve months.

So, to hedge against a price spike, he buys $10,000 in over-the-counter flour swaps today to guarantee that next year he'll be able to purchase up to 10,000 pounds of flour for $1 per pound. In 12 months, if the price of flour is dramatically higher, he'll have saved himself a huge amount of money. The price could also be lower, of course, but that's the risk he runs in order to guarantee he won't go bankrupt.

Right now, over-the-counter agricultural swaps are mostly unregulated. But that shouldn't be a point of concern — these instruments had nothing to do with the financial meltdown.

Nevertheless, this new round of Dodd-Frank rules would impose a slew of new requirements on these instruments. Buyers and sellers would have to trade them on approved exchanges, and they would need to have a certain level of capital on hand to trade. Reporting rules regarding profits and losses would be ratcheted up.

There would also be mandatory "clearing," meaning swap trades would be required to run through certified middlemen. This is a particularly backwards idea.

The over-the-counter agriculture swap market has been running safely and efficiently for years without mandatory middlemen. No one — not even the regulators charged with implementing Dodd-Frank — claims otherwise.

On the other hand, the traditional futures market operating under mandatory clearing rules has been home to some of the biggest financial meltdowns of the last few years. About a billion dollars evaporated before the brokerage firm MF Global declared bankruptcy in October 2011. And Peregrine Financial had racked up a $200 million shortfall in customer funds before it was forced to shut down in July.

The clearing rules regulators are so eager to foist on over-the-counter agricultural swaps were in full force for both MF Global and Peregrine. And yet, the system still suffered massive losses. This regulatory structure is obviously broken.

So implementing Dodd-Frank as planned means forcing agriculture swaps to move from a regulatory environment that is universally acknowledged to be working well to one that has failed repeatedly to prevent fraud and abuse. That's just senseless.

Overregulation can be just as dangerous and costly as under-regulation. And in this case, these invasive Dodd-Frank rules could dramatically drive up operation costs for farmers, ranchers, and others involved in food production. The rise in expenses would, in turn, be passed along to American consumers in the form of higher food prices.

Some farmers would no doubt be driven out of the swaps market altogether. With no way to manage financial risk, the next hurricane or tornado could put them out of business.

At the very least, regulators need to give themselves more time to study this issue by installing a three-year moratorium on the Dodd-Frank rules governing agricultural commodities. Blindly marching ahead and imposing strict new requirements on these instruments would wind up doing substantially more harm than good.

*Don Coursey is Ameritech Professor of Public Policy Studies at the Harris School of the University of Chicago.


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4 Comments so far

  1. Duncan on November 19, 2012 9:00 am

    I don’t think it unusual that sweeping legislation is often crafted by politicians who leave office almost immediately after. It is either because the law is so bad they do not want to be there as it is implemented, or so enlightened that they would only write such legislation when freed from the burden of reelection.

  2. Phil Pia on November 19, 2012 2:49 pm

    Sounds like the author is making a big leap…putting some transparency and regulation into OTC swaps is going to cause higher food prices! If farmers and ag end-users want to hedge their exposure, they can open a futures account and hedge futures normally. From my experience, most OTC swaps are ultimately more costly than straight futures hedging; the only advantage is that it is sometimes faster to do a swap with a bank as opposed to opening up a futures account. Finally the legislation aims to regulate all types of OTCs, not just swaps, and this include the parasitic violatility structures that are nothing more than the usual “keeping upside gains, and sloughing off the downside risk” onto the public (in this case, the buyer of the OTC who usually does not fully understand the structures).

  3. Ed on November 19, 2012 4:28 pm

    What is the advantage of an OTC swap vs. using futures? I wish I had the expertise to understand.

  4. Russ Sears on November 20, 2012 6:52 pm

    One of the big advantages to OTC is customization. Beyond the grain brands itself, prices are not uniform, season to season quality and quantity of the grain per acre can varies considerably. Customization of course comes at a price to the farmer, but lessen the risk.
    Besides raising the price the regs may also lower the quality and diversity of a crop a farmer is willing to raise.

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