Could the Senate’s financial reform bill hinder some Main Street firms that want to use derivatives to hedge their risk? That’s certainly not the intention of the Senators who drafted the legislation. But in its current form the bill would fail to exempt some smaller companies from a the rule intended for big Wall Street firms. The provision could make it very costly for the little companies to hedge their natural exposures to risk.

The problem is found within the derivatives bill (.pdf) drafted by Senate Agriculture Committee chair Blanche Lincoln (D-AR). It will be incorporated with the larger bill as a slightly revised amendment. The spirit of the legislation seeks to exempt small companies who are considered end-users from clearing. End-users are derivatives buyers who are not speculating, but trying to hedge some risk that their business cannot otherwise avoid. An example might be a company located near Minnesota’s northern border that does a lot of business in Canada and wants to hedge the Canadian dollar. In its current form, the bill fails to exempt some smaller Main Street firms, so it would force them to clear their derivatives.

The custom derivatives that little end-users sometimes require would carry with them additional risk for a clearing house. As a result, in order to get their derivatives cleared, these smaller companies would be forced to maintain high cash collateral balances to offset their default and/or liquidity risk. If they couldn’t afford to put aside that necessary capital, then they wouldn’t be able to hedge their own risk using derivatives.

David Hall has recognized this problem in the legislation for end-users of derivatives. He’s the chief operating officer of Chatham Financial, the largest independent interest rate and foreign exchange risk management advisory. Hall says:

The general concept is right in the Senate bill in that it tries to catch the systemically risky players, without catching the small Main Street firms that are trying to hedge their normal business risks. We just think it doesn’t do a perfect job yet and there needs to be some improvement.

How should it be changed? He explains:

The end user exemption as currently designed does a pretty good job covering people who make stuff, like manufacturers or people associated with certain commodities. But it doesn’t cover people who own stuff, for example commercial real estate firms.

He says the bill would also require companies which are financial in nature to clear their derivatives. While this is fine for big financial institutions on Wall Street, others like community banks and small accounting firms would suffer. They would probably be priced out of the derivatives market, which would provide a competitive advantage to large banks with the ratings and capital to utilize a clearing house without any additional burden.

So really, the fix should be quite easy. The bill would just have to be amended to exempt from clearing small to medium-size financial companies and those which would hedge large assets like real estate. Hall says that an amendment introduced last week by Senator Saxby Chambliss (R-GA) would help to fix this problem. It seeks to exclude these smaller Main Street firms that the original legislation missed.