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Treasury Seeks More Regulation of Risky Derivative Trades

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.