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Federal regulators propose derivatives changes

Two key federal regulators are urging Congress to impose broad new rules on the financial instruments blamed for hastening the global crisis.
/ Source: The Associated Press

Two key federal regulators on Wednesday urged Congress to impose broad new rules on the financial instruments blamed for hastening the global crisis while Republican lawmakers chafed at constraints they said could hurt U.S. firms' competitiveness.

Securities and Exchange Commission Chairman Mary Schapiro and Gary Gensler, who heads the Commodity Futures Trading Commission, have agreed on how the agencies — turf antagonists in the past — could share regulation of the so-called over-the-counter derivatives market.

They appeared together at a hearing of the House Financial Services Committee and made the case for expanded authority for their agencies to supervise the $600 trillion market, now largely unbridled.

"One of the gaps exposed by the financial crisis concerns the lack of regulation" of over-the-counter derivatives, Schapiro testified.

The Obama administration has proposed to Congress, as part of a broad financial overhaul plan, a new network of clearinghouses to provide transparency for trades in credit default swaps and other derivatives. Many derivatives, however, would continue to be traded privately in a multitrillion-dollar market worldwide rather than on commodity exchanges regulated by the government.

Key lawmakers are closely considering the plan. Rep. Paul Kanjorski, D-Pa., a senior member of the House panel, said the goal is to "sensibly regulate this dark corner of our financial markets."

But several Republicans questioned a grant of more regulatory power, pointing to recent deficiencies in the runup to the financial crisis of agencies such as the Federal Reserve and the SEC. They pointed most notably to the SEC's failure to detect the massive Bernard Madoff fraud over decades despite red flags raised by whistleblowers.

"Why should the American public ... be sanguine to think we're giving more authority to the SEC?" Rep. Scott Garrett, R-N.J., another senior panel member, asked Schapiro.

All federal regulators, not just the SEC, had failures in regard to stemming causes of the crisis, Schapiro said, and the SEC's past lapses are outweighed by its work that "benefits the American investor and taxpayer on a daily basis."

To effectively regulate the derivatives market, Gensler said, "two complementary regulatory regimes must be implemented: one focused on the dealers that make the markets in derivatives and one focused on the markets themselves — including regulated exchanges, electronic trading systems and clearinghouses."

Under the administration plan, the big investment banks that trade the derivatives would be subject to requirements for holding capital reserves against risk and other rules. The plan is similar to legislation proposed by a small group of major Wall Street banks.

Still unresolved so far by the administration plan is defining what would be considered a "customized" derivative product designed for specific users in a transaction and which would remain largely unregulated. Some critics fear that could create a big loophole. Lawmakers are awaiting specific proposed legislative language from the administration on the issue.

Gensler said the new capital requirements under the plan would cover both customized and "standard" derivatives products, while the latter also would be mandated to be traded on regulated exchanges or electronic trading systems. He estimated that some 80 percent of derivatives could be considered standard.

"Why are we prescribing cures for a nonexistent ailment?" Garrett insisted, saying it was the more exotic credit default swaps — not standard derivatives — that played a role in the financial meltdown. Regulation that isn't "sensible" could bring a flight of capital away from U.S. markets, he said.

Credit default swaps, a form of insurance against loan defaults, are traded in a secretive international market valued at about $60 trillion. 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.

The value of over-the-counter derivatives hinges on an underlying investment or commodity — such as currency rates, oil futures or interest rates. The derivative reduces the risk of loss from the underlying asset. About $600 trillion of those contracts are held worldwide.

Under the accord between the SEC and the CFTC, credit default swaps and other derivatives related to securities — underlying stocks, bonds, options — would fall under SEC supervision. Primary oversight for the others — derivatives tied to interest rates, commodities, currencies, energy and metals — would go to the CFTC. The regulators say the new regulatory system will require close coordination between the two agencies.