Financial reform legislation, though long overdue, has the chance to send what has been a robust stock market recovery into bear market.  While the two party system works to discuss new legislation, all parties are ignoring a very important function of the derivatives market.

How Derivatives Work

Think of derivatives like a giant insurance marketplace where one person can bet against another person to hedge their own individual endeavors.  For this example, we’ll use two people, Jim and Joe.  Jim owns a small farm, and should the weather fail to produce enough rain his crop is in danger.  Joe, on the other hand, is a speculator, and thinks (for whatever reason) the amount of rain this year will be adequate for Joe’s farm.  The two agree to make a bet for $100, the amount of money Jim stands to lose if his crop turns out poor.

They work out the agreement, and Jim puts up $10 of collateral.  If the weather isn’t adequate for farming, Jim will receive $100.  If it turns out to be an excellent summer, Jim will have lost his $10 to Joe.  In either case, Jim will make $100 either way.  Either his farm will prove to be resilient and earn him $100, or Jim will pay him $100 if the weather isn’t good enough for his crops to grow.

Why People Hate Derivatives

One of the biggest faults with derivatives is that there is no actual product trading hands.  In fact, nothing but a minute amount of money is every exchanged until expiration, and one party has to make good on its loss.  You see, big banks and financial firms bet huge amounts of money amongst each other on all kinds of speculative investments.  At the same time, they also put up very small amounts of collateral, usually a few percentage points of the total bet.

Why Reform Matters

Current measures to reform the financial markets involve a hefty amount of derivatives regulation.  One of the key pieces of all legislation is to increase the amount of money firms have to put up as collateral when making bets.  So, rather than put up $1 on a $100 wager, firms would have to put up three, four, even as much as ten times that amount.  The reform bills are retroactive, so they’ll have to put up even more money for bets they’ve already made.

Why it REALLY Matters

No one really knows how much the derivatives market is worth but most suggest it is worth anywhere from $50-$600 trillion.  So, should investors have to put up more than just a few percentage points on their outstanding bets, they’re going to need a LOT of money.  Tons, and tons more than they currently have.  So, where are they going to get it?  The companies that make these bets, and there are many, will have to borrow or issue stock to come up with the money.

The problem is that in this post-credit crunch world there is very little available capital, and it would cost significant amounts of money to borrow enough to cover bets both in the past and present.  Should these reform bills pass, corporate debt yields will skyrocket, stocks will tank as they are diluted, and who knows how many firms might go bankrupt trying to keep up with new regulation.  So many variables, so few answers.