Companies that use derivatives for hedging have been heavily resisting the Dodd-Frank Act’s move to steer some/most/all private derivatives transactions – swaps, for example – on to regulated markets backed by clearing houses.

The reason? They don’t want to have to post margin (otherwise known as collateral) on their open positions. All existing clearing houses impose this obligation as part of their safety net against default by any participant.

The objections of the ‘end users’ focus on two points:

First, that posting margin will impose an unreasonable burden on their finances, tying up large amounts of money in a broker’s account that could be more profitably applied to other purposes.

Second, the critics argue that if margin must be posted, it should be protected against seizure by the clearing house when some other participant defaults. At present, a clearing house can use margins belonging to any customer to meet a default by any other customer, with the full blessing of regulators.

Reasonable protection

Requiring margin against market liabilities is parallel to a bank taking security in a property as part of a home mortgage. It is simply sound business and a practice that hedgers should support, since they can least afford to be denied fulfilment of their contracts through the default of other traders.

Hedgers generally have to pay smaller deposits than other traders because they have countervailing assets that will gain in value if their market positions sustain losses, reducing the risk that they might default.

Finally, most if not all clearing houses accept interest-bearing securities like US Treasury notes as margin, allowing the depositor to earn money on those funds while they sit with the broker or clearing house.

True, margin deposits tie up funds for a while. Some companies create the impression that their other business operations will be deprived of capital as a result. One might be forgiven for responding: “If you won’t show me the money, show me the math.”

It may exist but I have not seen any reliable tabulation of this “cost”. Remember, too, that applying the same funds to some other purpose may produce losses as likely as profits.

Bottom line: why cannot the Fortune 500 conform with hedge margining rules when the family farmer has quietly done so for 150 years?

The end users’ second objection – that their funds at the clearing house might be swallowed up by the default of a total stranger – requires closer examination because it is true.

Today, clearing houses maintain only two accounts for each clearing member firm, a “house” account containing margin for the firm’s own trading and a single “customer” account holding margins to support the positions of all the firm’s customers, collectively.

If any customer defaults, the clearing house has a legal right to seize all the margin in the customer account to cover those losses. In at least one case, a clearing house has liquidated Treasury securities owned by a non-defaulting customer to meet the losses of another customer.

A shared burden

Is this fair? Facially, no. But one must consider as well that without this system a clearing house might have insufficient funds to meet large defaults.

Since regulators would not tolerate such an outcome, clearing houses would need to raise additional default protection funds. One approach might be to raise margin requirements substantially for each customer, making them more burdensome.

Another possibility is for the clearing house to raise a great deal of additional capital, from either clearing members or outside sources. In either case the cost of clearing would have to rise significantly.

The fundamental policy issue is whether market risk should be mutualised across all customers at relatively low cost or should be funded separately for each customer at higher cost to the system and customers.

End users that express a preference for the latter approach must weigh the resulting far higher transaction costs against the remote, yet real, possibility of underwriting another customer’s liabilities.

Here, the burden of producing the math shifts to the clearing houses. They should quantify the cost impact of funding each customer account separately and, as the debate proceeds, perhaps they will.

The existing clearing system for regulated derivatives is not victim-proof. While no defaults have been left unpaid, the recovery can sometimes be at the expense of innocent fellow customers.

But, after nearly $4 trillion of expenditures by the US government to rescue a financial system that was left largely unregulated, unobserved and uncollateralised, care is needed before tinkering with the one segment that required no dollars in federal support.

Philip McBride Johnson is a past commissioner and chairman of the US Commodity Futures Trading Commission and was a derivatives lawyer at Skadden, Arps, Slate, Meagher & Flom in Washington until 2010.