There is someone in Washington watching out for the little guy. Idaho Sen. Mike Crapo has gone to bat for small players in the financial markets.
Along with Nebraska Sen. Mike Johanns, Crapo attached an amendment to the 2012 Farm Bill providing an exemption from new margin requirements for users of financial derivatives that are not themselves financial institutions. This change protects Idaho farmers.
Derivative markets are often called nothing more than financial casinos, but gambling is not their function. A financial derivative is any contract where the price depends upon (is derived from) some other asset. The derivative contract itself has no independent value. The price of the transaction is determined by changes in the value of the underlying asset, which can include agricultural commodities, like corn and barley, and financial assets, like currencies or mortgages.
Many Idaho companies use financial derivatives to protect against risk. For example, Micron uses derivatives to hedge its risk of changes in the value of foreign currencies. According to its website, the J.R. Simplot Co. uses agriculture futures to hedge its risk of changes in the price of cattle feed and other products.
Financial institutions that trade derivatives with big firms like Micron and Simplot, as well as small farmers, require a sort of deposit, called margin. A margin is any collateral deposited with the broker or exchange to insure the holders of derivative contracts will make good on their obligations when the time comes.
While derivative markets can be used to speculate, they serve other very important economic functions, such as price discovery. This is the process whereby investors, speculators and hedgers alike determine the most probable, or expected, price and value in the future.
The new margin requirements would lead to fewer users, particularly among small farmers. As the market gets smaller, less information is available. With less information, farmers and agricultural product consumers alike have a harder time managing their business.
As part of the massive Dodd-Frank financial market regulation passed in 2010, new rules were put in place that many believed would reduce the volatility of all financial markets by changing the rules for derivative users. As is often the case, regulations designed to protect us from risk lead to even more risk in the real economy.
Crapo correctly described the benefits of derivative contracts to his Senate colleagues. Nonfinancial end-users from manufacturing to energy to farming rely on financial risk management tools like derivatives to manage the unique business risks associated with their day-to-day operations, he said. Our economy benefits from this type of risk management activity in the form of less-volatile business activities, and in turn, lower prices for consumers.
Consider how financial derivatives protect local farmers. Suppose this summer a local corn farmer sees that the price for a Chicago Board of Trade futures contract on corn delivered later in the year is selling around $7 a bushel. He or she can lock in that price. When the crop is ready for delivery the local co-op, the market price may have fallen to $6 a bushel.
The farmer is unconcerned about this drop in price. The loss on the sale of corn in the local market is made up by the financial hedge. The farmer buys a new futures contract at the lower price to make good on his earlier promise, making up the lost $1.
Even if prices rise over the summer, the farmer is better off because risk is reduced. He or she will have to put up more cash with the exchange (the margin) but will recoup these costs by selling the corn crop at a higher price.
Higher margin requirements make this simple transaction more expensive and divert cash from other needed expenses. Worse yet, the new requirement may cause the farmer to plant less because the risk of price changes is too high. In an effort to do something about the financial crisis, policymakers simply didnt think through how this would affect small farmers.
Some in Washington may think financial derivatives are a gamble. Sen. Crapo and Idaho farmers know better.
PETER CRABB is a professor of finance and economics at Northwest Nazarene University in Nampa. Contact him at email@example.com.