Imagine if you went to a vendor to purchase something you wanted and needed. The vendor happily sold you what you were looking for but as a condition of that sale, you were also required to buy something you had no interest in whatsoever. To make matters worse, imagine that you had no idea what that extra something should cost or what you would be charged if you purchased it elsewhere because all of the transactions are conducted in private and the prices are never disclosed. Finally, imagine that the extra something was terribly complex and something understood by a tiny fraction of 1% of sophisticated business people.
The vendor on the other hand is well versed in that thing you are being required to buy. In fact, the vendor buys and sells that particular product thousands of times every year and has deep knowledge of the pricing of that product.
Do you think you would be charged a fair price for that extra something? Fat chance.
That something extra is an interest rate swap. If a business borrows a few million or more from a bank today, the bank will require that the loan be a variable rate loan. The bank will also require the borrower to buy something extra; an interest rate swap to convert that variable rate loan into a fixed rate loan. (Yes it would be easier to simply structure the loan as a fixed rate loan but there’s little profit in that for the bank.) There is no up-front charge for the interest rate swap but the bank charges a swap rate that is very favorable to the bank. Once the loan and the swap are finalized, the bank can then resell the swap at a profit. If swaps were publicly traded like stocks the banks wouldn’t be able to get away with this. However, the swaps are not publicly traded but are instead traded in private. As a result, borrowers have no way of knowing if they are getting a good deal or not. Rest assured they are not.
A new rule required by the Dodd-Frank financial reform law is being considered by regulators that would require the vast majority of derivatives trades to be conducted on an open electronic platform. Banks are resisting the change.
It’s important that the new rule be adopted. Financial institutions are a critical and valuable sector of any developed economy and they deserve a profit on their activities like anyone else. However, they don’t deserve to generate a profit by requiring their customers to purchase products they don’t want and which they have no idea how to determine a fair price for. By requiring derivatives trades to be conducted in a transparent market, customers will be able to determine a fair price for the derivatives they are required to purchase.