The Side Effects of Financial Reform

Lawmakers and regulators across the globe are scrambling to corral banks and other culprits of the financial crisis. But companies and small investors may find themselves ensnared, too, because proposed and new rules could crimp corporate profits and investment returns.

Reformers aren't oblivious to the potential consequences. They just figure the benefits outweigh any side effects. Even so, says Simon Gleeson, a partner at law firm Clifford Chance, the perceived pitfalls "don't win politicians any gold stars for policymaking." And they won't make it any easier for companies and investors to dig out of the recession.

Consider the proposed rules for derivatives. Both U.S. and European regulators want to clamp down on the use of the complex financial instruments, whose values are tied to the performance of an underlying security or benchmark. The deals got a bad name last fall when an especially esoteric and risky version—credit default swaps—blew up, prompting huge losses at insurer American International Group (AIG) and other companies. The pending reforms are meant to prevent another disaster.

But corporations could end up paying a price. Many companies buy basic types of derivatives to protect their earnings against fluctuations in interest rates, commodity prices, or currencies—a process known as hedging. "Hedging is an important weapon in any company's arsenal," says John Grout, policy and technical director at the Association of Corporate Treasurers, a trade group. American Airlines (AMR), for instance, controls its fuel costs with derivatives. Packaged goods maker Kraft Foods (KFT) uses them to keep grain expenses in check.

Any new rules may pressure companies to move their derivative deals to a regulated exchange, where trading is more transparent and oversight is stricter. (Right now almost all hedging contracts are created in private transactions with investment banks on the over-the-counter market.) Exchange-based derivatives cut into cash reserves. Under current requirements, companies have to fork over 3% of a contract's value as collateral up front in case the transaction goes south. They also have to pony up extra funds should conditions change—say, when commodity prices rise or fall dramatically.

If the proposals go through, companies that use derivatives would have less money to invest in their operations. European manufacturing giant Siemens (SI) reckons it will need an extra $1 billion in cash reserves, and engine maker Rolls Royce (RYCEY) figures its tab would total $4 billion.

The changes could also make derivatives a less effective tool for controlling expenses. Derivatives sold over the counter are tailored to a company's individual needs, while exchange-traded contracts are standardized. With custom contracts, corporations can lock in their prices through any date, say Dec. 12, 2010. A standard exchange contract only has certain dates—typically near the end of the month—leaving businesses vulnerable to price movements in the interim. "Any reduction in the access to nonstandardized derivatives would…add volatility and risk to quarterly earnings," Michael W. Connolly, Tiffany's (TIF) treasurer, told Congress last month. The jeweler uses derivatives to manage the cost of silver and other metals.

Businesses are rethinking their strategies in response to the proposed rules. Some executives have stopped using these sorts of risk-management techniques for now, fearful that rule changes would void existing contracts. Automakers and manufacturers, big users of derivatives, have been hesitant to enter into new deals because making changes to them could be costly. "It's causing treasurers to lose sleep," says Tim Sangston, managing director at consultancy Greenwich Associates.

Already the costs of derivatives are on the rise. As rivals get out of the business amid the tumult, JPMorgan Chase (JPM), Barclays (BCS), and others are hiking their prices. Banks now charge as much as 3% of a contract's value, compared with less than 0.1% before the crisis.

Commodity Funds Shut Down Meanwhile, individual investors are feeling the pinch from new regulations on commodities. The U.S. Commodity Futures Trading Commission and such exchanges as the New York Mercantile Exchange are limiting purchases of oil, grain, and other commodity derivatives known as futures contracts. The changes are designed to curb speculation by hedge funds and other financial players whose trading can affect the markets dramatically. Some experts suspect speculators pushed oil prices past $147 a barrel in 2008.

In light of the changes, financial firms are pulling back on some commodity offerings for small investors. On Sept. 1, Deutsche Bank (DB) announced it would shut down PowerShares DB Crude Oil Double Long (DXO), an exchange-traded product geared toward individuals. The bank figured it would be difficult to manage the fund without running afoul of the limits.

Money managers who keep their commodity funds open may decide to charge more or take bigger risks with exotic derivatives. Earlier this year the U.S. Natural Gas Fund (UNG), an exchange-traded offering, stopped issuing new shares amid worries about the limits. That drove up the value of existing shares, meaning investors who wanted access to the fund had to pay a 10% premium or more for their stakes. The fund recently started selling new shares again. To do so, the managers are buying complex derivatives, which introduces another set of problems. John Hyland, chief investment officer at the U.S. Natural Gas Fund, says the firm is taking steps to mitigate the risks, "but you don't eliminate them completely."

The regulatory environment has prompted some financial advisers to shy away from these types of offerings. Barclays Wealth recently told high-net-worth clients to ditch exchange-traded funds that focus on commodities in favor of hedge funds and other alternatives that invest in this area. "Most ETFs are still O.K.," says Michael Crook, a strategist with Barclays Wealth. "We just don't know what's going to happen."

Retail investors may also take a hit if high-frequency trading is curbed. The Securities & Exchange Commission is investigating whether financial firms that use superfast computers to buy and sell stocks have an unfair advantage. The technique has been controversial of late as big trading firms have booked billions in profits while their clients' portfolios have dwindled.

If the SEC cracks down on the practice, trading costs may rise. High-frequency traders buy and sell stocks in small lots regularly throughout the day. Their activity, roughly 70% of market volume, has helped drive down spreads—the difference between the price at which a stock is bought and the price at which it is sold. A decade ago, the spread for retail investors was roughly 6¢ a share. Now it's around a penny. "With any new technology, there's always the possibility of misuse," says Andrew W. Lo, a professor at Massachusetts Institute of Technology's Sloan School of Management. "But investors are benefiting from it."

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