White House Seeks New Reins on Derivatives

By | August 13, 2009

The Obama administration this week sent Congress legislation seeking to impose broad new oversight on derivatives, the complex financial instruments blamed for hastening the global economic crisis.

The plan is designed to bring transparency to, and prevent manipulation in, a $600 trillion unregulated worldwide market. Credit default swaps, a form of insurance against loan defaults, account for an estimated $60 trillion of that market. The collapse of the swaps brought the downfall of Wall Street banking house Lehman Brothers Holdings Inc. and nearly toppled American International Group Inc. last fall, prompting the government to support the insurance conglomerate with about $180 billion in aid.

The value of derivatives hinges on an underlying investment or commodity — such as currency rates, oil futures or interest rates. The derivative is designed to reduce the risk of loss from the underlying asset.

In a point long awaited by the financial industry, the plan defines types of derivatives broadly in a way it says will be “capable of evolving with the markets.”

The plan sent to Capitol Hill was the final section of the administration’s sweeping legislative proposal for overhauling the U.S. financial rule book to help avert a repeat of the meltdown touched off last year. It capped a series of measures rolled out in recent weeks by the Treasury Department.

Under the proposal, the big investment banks that trade the derivatives would be subject to requirements for holding capital reserves against risk and other rules. A new network of clearinghouses would be established to provide transparency for trades in credit default swaps and other derivatives. All so-called “standardized” derivatives would be required to go through clearinghouses and to be traded on regulated exchanges or electronic trading systems.

Customized derivative products, by contrast, are designed for specific users in a transaction and would remain largely unregulated — a gap that some critics fear could allow abuses.

The plan defines standardized derivatives broadly. An over-the-counter derivative that is accepted by an official clearinghouse would be presumed to be standardized. In addition, the Securities and Exchange Commission and the Commodity Futures Trading Commission would get authority to prevent attempts by market players to falsely portray derivatives as customized to skirt the oversight of clearinghouses and exchanges.

Treasury officials said the goal wasn’t to shut down the business of customized derivatives, which they noted an array of companies rely on to hedge risks, but to encourage the growth of standard derivatives by imposing stricter capital requirements on firms dealing in the customized variety.

CFTC Chairman Gary Gensler recently estimated that about 80 percent of derivatives could be considered standardized under the plan.

Late last month, two influential House lawmakers announced an agreement on guidelines for legislation to regulate derivatives, a proposal that closely resembles the administration’s plan. Democratic Reps. Barney Frank, chairman of the House Financial Services Committee, and Collin Peterson, who heads the House Agriculture Committee, said the House could vote on a bill in September.

Gensler on Tuesday called the administration proposal “a very important step toward much-needed reform to protect the American people.”

SEC Chairman Mary Schapiro, in a statement, said “I believe Treasury’s approach is a step forward in the process of bringing (over-the-counter) derivatives under a comprehensive regulatory framework. We all agree it is absolutely vital for Congress to bring rigorous standards, complete transparency and vigorous enforcement” to the derivatives market.

The Obama plan would split oversight authority for derivatives between the CFTC and the SEC, longtime turf rivals, while federal banking agencies would have power over the Wall Street banks that deal in the instruments.

Cory Strupp, managing director of government affairs at Wall Street’s biggest trade group, the Securities Industry and Financial Markets Association, said the group supports “regulatory reform of these markets, including additional regulatory transparency, while ensuring that derivatives continue to play a vital role in risk management as well as expanding the availability and lowering the cost of credit for borrowers.”

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