U.S. Pushes Ahead With Derivatives Regulation
First in Broad Overhaul: Rules on 'Dark Markets' That Fueled Meltdown

By David Cho and Zachary A. Goldfarb
Washington Post Staff Writers
Thursday, May 14, 2009

The Obama administration yesterday unveiled a plan to regulate a vast market of exotic financial instruments known as derivatives, which fueled the global economic crisis and wounded some of the biggest names on Wall Street.

As the administration's first step to overhaul financial regulations, the proposal calls on Congress to establish rules that would restrict the banks, hedge funds and other investors that trade derivatives on what have been called "dark markets" for their lack of oversight.

The proposal would for the first time empower regulators to probe more deeply into the inner workings of these markets, and the firms that profit from them, and curb the risks traders can take.

But the proposal doesn't go as far as some analysts and officials want. The administration would allow a set of highly specialized derivatives to trade largely outside government view. Some analysts warn this exception might lead traders to create increasingly complex derivatives to avoid regulation.

In just a few years, trading in derivatives -- which are essentially contracts between two investors betting on whether a stock, bond or other security will go up or down in value -- has mushroomed into the world's largest market, estimated to be in the tens of trillions of dollars. It has allowed unregulated traders around the world to influence and bet on a vast array of sectors, from how much companies pay to borrow money to the value of currencies and critical goods such as oil and cotton.

Losses on a type of derivative known as a credit-default swap helped topple American International Group, prompting a government bailout that has grown to $180 billion. And when Washington Mutual, the country's largest thrift, collapsed last fall, regulators struggled to understand how the losses on its derivatives investments would spread across the financial system.

"The financial crisis was caused by significant gaps in oversight," Treasury Secretary Timothy F. Geithner said yesterday at a briefing with reporters. "One of the reasons crisis can spread so rapidly . . . is the uncertainty people have in judging risk."

For Geithner, regulating derivatives represents a turnaround. He was part of a Clinton administration team that favored the innovation of new financial products and rejected regulation of derivatives as they emerged in the 1990s.

As the president of the Federal Reserve Bank of New York, Geithner began to realize the threat that derivatives posed. He called for new ways to regulate the market with technology and other mechanisms that would make it easier to track the trades. Yet some of those efforts ended up stoking the derivatives market.

The administration's proposal faces a complicated political landscape on Capitol Hill. While the crisis has convinced most lawmakers that regulation is needed, there is intense debate about how far it should go -- and who should be in charge.

The split is not just along party lines. Lawmakers representing agricultural and energy-producing states have a strong interest in ensuring that their committees and the Commodity Futures Trading Commission have authority over these new regulations.

But the Securities and Exchange Commission, which has more experience in enforcement and is favored by lawmakers representing states with heavy financial industry presence, is also angling to regulate derivatives.

Yesterday, SEC chairman Mary L. Schapiro and CFTC acting chairman Michael Dunn pledged to work together to regulate the market, even as Dunn at a briefing at the Treasury acknowledged that many details need to be ironed out.

Geithner, sitting between the two, said details would be worked out later.

The Obama administration's proposal has four goals. First, it proposes that most derivatives must trade through a regulated clearinghouse run by the industry that requires traders to report their activities and hold a minimum level of capital to cover losses.

This would solve a big problem exposed by the crisis, when AIG didn't have enough money to cover the losses incurred by its derivative portfolio, which focused on credit-default swaps. A swap is a type of insurance contract in which one party agrees to cover the losses if an investment goes sour, in exchange for periodic fees.

Under the government's plan, a clearinghouse would have required AIG to put cash in reserve for each credit-default swap it sold.

Second, the proposal would require clearinghouses and firms dealing in derivatives to provide copious information to regulators about their trades, allowing the government to track activity in these markets. An exception was made for certain specialized derivatives often employed by industrial companies, but traders in those instruments would still have to post information about their activity to clearinghouses.

Third, it would empower regulators to force traders to turn over detailed paperwork about their activities and to pursue cases of fraud and manipulation against wrongdoers.

Finally, it would ensure that derivatives are not marketed to groups that may not understand their complexities.

Michael Greenberger, a law professor at the University of Maryland and former director of trading and markets at the CFTC, said the proposal does not bring as much transparency to the derivatives market as there currently is for stocks and bonds.

"There is a reluctance on the part of the administration to go that full distance," he said. "It therefore leaves hanging in the balance customized or individualized derivative products, which can also be toxic in their nature."

Industry officials welcomed the proposals but expressed some caution about whether the measures would shrink the derivatives market.

Robert Pickel, chief executive of the International Swaps and Derivatives Association, said it is important that policymakers "ensure these reforms help preserve the widespread availability of swaps and other important risk-management tools."

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