Two key regulators on Tuesday urged Congress to go beyond an Obama administration proposal and impose comprehensive oversight on the sprawling, complex market for financial derivatives blamed for worsening the credit crisis last fall.
The administration is seeking to increase the transparency of the $600 trillion global derivatives market and has proposed that big investment banks that trade derivatives be subject to requirements for holding capital reserves against risk. In addition, a new network of clearinghouses would be established to provide transparency for trades in credit default swaps and other derivatives.
The House Agriculture and Financial Services committees recently agreed on guidelines for a measure similar to the administration's proposal. But Commodity Futures Trading Commission Chairman Gary Gensler has urged lawmakers to tighten the legislation in several areas, including eliminating exemptions from new requirements for foreign-currency swaps and small firms dealing in derivatives.
Gensler says excluding foreign-currency swaps from the new restrictions could enable dealers to structure other swaps transactions in a way to skirt regulation.
"The law must cover the entire marketplace, without exception," he told the House Agriculture Committee Tuesday.
Securities and Exchange Commission Chairman Mary Schapiro agreed and said the Treasury Department's proposal "should be strengthened in several ways to further avoid regulatory gaps."
The value of derivatives hinges on an underlying investment or commodity — such as stock prices, currency rates, or oil futures. The derivative is designed to reduce the risk of loss from the underlying asset.
Schapiro said derivatives should be regulated in similar ways as the underlying assets. Otherwise, investors might choose to buy derivatives linked to a company's share price instead of the shares themselves, if the derivatives face lighter regulation.
The Treasury Department's proposal would split the regulation of securities-related derivatives between the SEC and CFTC, which "could result in significant regulatory differences" between the derivatives and the underlying securities, she said. Instead, the SEC should regulate all securities-related products, Schapiro said.
Sen. Jack Reed, chairman of a Senate Banking subcommittee, introduced a bill Tuesday that is similar to the administration's proposals, but it gives the SEC sole jurisdiction over securities-related derivatives.
Many derivative contracts ended up spreading risk instead of mitigating it. "The financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system," Gensler said, referring to American International Group Inc.
AIG's derivative trading group "was not subject to any effective federal regulation," he added. The insurance company later received a government bailout valued at more than $182 billion.
Meanwhile, the SEC — the government's primary securities markets watchdog — and the CFTC, which oversees the trading of oil, gas and other commodities as well as financial instruments, have started coordinating their rules to eliminate differences involving similar types of investments such as derivatives.
Credit default swaps, a form of insurance against loan defaults, account for an estimated $60 trillion of the so-called over-the-counter derivatives market. The collapse of the swaps brought the downfall of Wall Street banking house Lehman Brothers Holdings Inc. a year ago and nearly toppled AIG.