In the finance-reform debate, the smart money is fighting over derivatives.
It's easy to see why: Five big U.S. banks made $28 billion in revenues last year trading derivatives, according to Bloomberg News. And the push in Washington to change the way derivatives are traded could eat into the profits banks make off those trades.
So, this morning's WSJ reports, big banks are lobbying hard to dilute the proposed changes.
Derivatives are financial instruments whose value is derived from something else — the weather, or interest rates, or the likelihood that a borrower will default on a loan.
They're largely traded over-the-counter. That's fancy way of saying that one banker picks up the phone and calls another banker, and they make a deal. So nobody really knows what derivative contracts are out there, or how much risk any bank is taking on.
That's how you could have a giant company like AIG collapse all of a sudden — it wrote a lot of derivatives contracts that were supposed to pay off if mortgage-backed bonds failed. But when the housing market crashed, AIG couldn't pay up.
It's likely that any financial-reform bill that Congress passes will require many derivatives to be traded publicly — on an exchange, or through a central clearinghouse. (For the latest details on this, see yesterday's letter from Sen. Blanche Lincoln, who is one of the key players on derivatives reform.)
Some businesses use derivatives to hedge risk; farmers, for example, buy derivatives as insurance against crop failure. The banks argue that requiring more open, standardized trading of derivatives could harm their ability to write customized derivatives contracts that meet the precise needs of businesses.
Of course, more transparency in the derivatives market would also give businesses outside the banking world a better idea of whether they're paying competitive rates for the derivative contracts they're buying. That, in turn, could eat into banks' profits.