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Derivatives Proposal Is Too Soft, Regulator Says
Agency Chief Concerned About Rule Exemptions

By Zachary A. Goldfarb
Washington Post Staff Writer
Thursday, August 20, 2009

A top federal regulator has urged Congress to adopt tougher rules to govern betting in exotic financial instruments known as derivatives than the Obama administration has proposed, warning that the administration's new vision of market regulation could contain loopholes.

One of the Obama administration's top priorities in its revamp is to regulate both derivatives and firms that trade them.

But Gary Gensler, chairman of the Commodity Futures Trading Commission, warned key lawmakers in a letter this week that provisions of the administration's proposed legislation could leave significant elements of the derivatives market out of the reach of regulators and undermine efforts to combat fraud.

"The story of market regulation has largely been one of rules being set and then end runs being worked out and ways to avoid the intent of the regulation being discovered," said William F. Hederman, an analyst at Washington Research Group. "Here's an attempt by the regulator to be proactive and an attempt to see those end runs ahead of time and close some of them off."

Trading in derivatives -- securities that derive their value from underlying assets, such as stocks, bonds and commodities -- 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.

One type of derivative called a credit-default swap added fuel to the financial crisis and contributed to the near collapse of American International Group, prompting a massive government bailout.

Gensler helped craft an Obama administration plan to police this market for the first time. The proposal would require that most derivatives be traded on exchanges, like stocks and bonds, making the market much more transparent. It would also subject the banks and other firms that deal in the derivatives trade to robust requirements.

However, the legislation contains several exceptions that are the source of Gensler's concern. For example, the administration has proposed exempting certain types of derivatives used to bet on currencies from regulation by the agency. The CFTC worries that traders could structure derivatives that would otherwise be regulated to fit within this exemption.

"There is also a risk that these exclusions may have the unintended consequence of undermining the CFTC's enforcement authority over retail foreign currency fraud," the agency wrote in a memo to Congress.

A second concern is that minor traders in derivatives would not have to meet the robust trading requirements envisioned by the legislation. "This excludes a significant class of end users," the agency said. "This major exception may undermine the policy objective of lowering risk."

Gensler said Wednesday that he still supports passage of the legislation.

Andrew Williams, a spokesman for the Treasury Department, said the administration appreciates the CFTC's input.

"We've reached consensus with the regulators on all the basic principles -- and the vast majority of the details -- for how to regulate the . . . derivatives market for the first time," he said. The administration looks "forward to continuing discussions with the CFTC and other regulators about how to best regulate our financial markets."

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