US govt seeks crackdown on loosely regulated derivatives

The Federal move is expected to reduce shadow banking system

 
The administration asked Congress to move quickly on legislation that would allow federal oversight of many kinds of exotic instruments, including credit-default swaps, the insurance contracts that caused the near-collapse of the American International Group.

The Treasury secretary, Timothy F Geithner, said the measure should require swaps and other types of derivatives to be traded on exchanges or clearinghouses and backed by capital reserves, much like the capital cushions that banks must set aside in case a borrower defaults on a loan. Taken together, the rules would make it more expensive for issuers, dealers and buyers alike to participate in the derivatives markets.

The proposal will probably force many types of derivatives into the open, reducing the role of the so-called shadow banking system that has arisen around them. Geithner said the proposal was intended to make the trading of derivatives more transparent and give regulators the ability to limit the amount of derivatives.

The administration is seeking the repeal of major portions of the Commodity Futures Modernisation Act, a law adopted in December 2000 that made sure that derivative instruments would remain largely unregulated.

Credit crisis

At the time, the derivatives market was relatively small. But it soon exploded, and the face value of all derivatives contracts across the world outstanding at the end of last year totalled more than $680 trillion, according to the Bank for International Settlements in Switzerland.

As the credit crisis has unfolded, trading in credit-default swaps has cooled, market participants said. The collapse of AIG took a huge player out of the market and banks, hobbled by losses, have curbed their activities in the market. Still, derivatives trading desks have been profit centres at major banks recently.

The biggest banks and brokerage firms, including JPMorgan Chase, Citigroup and Goldman Sachs, as well as major insurers, are all major players in derivatives.

Derivatives are hard to value. They are virtually hidden from investors, analysts and regulators, even though they are one of Wall Street’s biggest profit engines. They do not trade openly on public exchanges, and financial services firms disclose few details about them. The new rules are meant to change most, but not all, of that opacity.

The administration plan would not require that custom-made derivative instruments be traded on exchanges or through clearinghouses, though standardised ones would. The plan would require the development of timely reports of trades, similar to the system for corporate bonds.

While derivatives regulation will be a focus of some market players, of equal concern to many in the financial industry are what the Obama administration and Congress might do to regulate compensation for executives across the board, not just at institutions that have accepted federal bailout money.

In addition to the regulatory changes it is seeking, the administration is also continuing to expand its bailout programs for various industries.