TOPICS > Economy

Treasury Seeks More Regulation of Risky Derivative Trades

BY Admin  May 13, 2009 at 5:20 PM EST

Treasury Secretary Timothy Geithner; file photo

In a draft two-page letter to leaders in Congress released
to media organizations, the Treasury Department said it wants to create a
central electronic-based system that would track the buying and selling of
over-the-counter derivatives, which have been blamed for much of Wall Street’s
troubles in the past year.

It also wants to ensure financial firms selling the
privately traded instruments have enough capital in case they default and
subject them to stringent standards of conduct and new reporting requirements.

The administration’s goal is to bring transparency to the
so-called “dark markets.” Current law largely excludes the privately
traded derivatives from regulation.

Derivatives can take many forms, but trillions of dollars’
worth exchange hands every day around the world, the New York Times reported.

The administration wants to amend securities law so that
most derivatives would have to be traded through central clearinghouses
regulated by the Securities and Exchange Commission and the Commodity Futures
Trading Commission, the Washington Post reported.

The clearinghouses would then require traders to keep enough
capital on hand to cover any investments gone bad, but traders have blasted the
so-called “margin requirements” since they cut into their profits.

While the SEC oversees many kinds of securities and the CFTC
regulates most kinds of commodities, many derivatives have escaped oversight.

“All (over-the-counter) derivatives dealers and all
other firms whose activities in those markets create large exposures to
counterparties should be subject to a robust regime of prudential supervision
and regulation,” Treasury wrote in its draft letter, according to the
Associated Press.

The legislative proposal, to be announced by Treasury
Secretary Timothy Geithner late Wednesday, is the Obama administration’s first
major step in overhauling the U.S. financial regulatory system.

“Key elements of that robust regulatory regime must
include conservative capital requirements, business conduct standards,
reporting requirements and conservative requirements relating to initial
margins on counterparty credit exposures,” the department adds.

If enacted by Congress, the new regulations would deter
financial firms from taking undue risk, prevent fraud and ensure they are
marketed appropriately, Geithner said in the draft letter.

Some members of Congress have introduced legislation to
regulate derivatives, but many also pressed the administration to release its
own plan. Last Friday, at Neal Wolin’s confirmation hearing to be the next
deputy Treasury secretary, Democratic Washington Sen. Maria Cantwell pressed
him to move quickly to get the administration’s views on the regulation of
derivatives.

Geithner said last month that he wants to force these types
of contracts to be cleared through a central system.

“Let me be clear: The days when a major insurance
company could bet the house on credit default swaps with no one watching and no
credible backing to protect the company or taxpayers from losses must
end,” Geithner testified before Congress.

The value of over-the-counter derivatives hinges on an
underlying figure or commodity — ranging from currency rate swaps to oil
futures and inflation bets. The derivative reduces the risk of loss from the
underlying asset. The global business world holds a staggering $600 trillion of
these contracts.

One of the most infamous examples of the derivatives were
credit-default swaps sold by American International Group Inc. AIG sold the swaps
to investors as a kind of insurance to protect against defaults on
mortgage-backed securities. But the company had to accept a hefty federal
bailout after it was unable to support the contracts.

Under the plan, the CFTC would establish an “audit
trail” for the derivatives and have “clear unimpeded authority to
police fraud, market manipulation and other market abuses” involving the
derivatives, according to news agencies. The Securities Exchange Commission
would be given “comparable authority,” including tools to prevent
insider trading.

The new system should enable the regulators to “detect
and deter all such market abuses,” Geithner states.

However, some analysts have warned about loopholes in the
administration’s plan, which has been hinted at in recent months. The proposal
would allow a limited number of highly specialized derivatives to trade without
going through a clearinghouse, but some analysts fear this might lead
derivatives traders to create increasingly complex derivatives to avoid
regulation, according to the Post.