By Silla Brush - 07/10/09 06:43 PM EDT
The Obama administration wants to bring clarity to what is effectively a dark market of financial instruments that are intended to hedge risk. Lawmakers and critics say those derivatives exacerbated the financial crisis and were the major factor in bringing insurance firm AIG to its knees.
The administration proposal aims to regulate all over-the-counter derivatives, or those that are traded directly between buyer and seller, rather than through a third party. The administration also wants to see all standardized OTC derivatives pass through a central clearinghouse that could limit risk, as well as see many of them traded on a regulated exchange.
A major battle is brewing, however, over definitions. At root it boils down to how regulators and the market determine the difference between a standardized derivative and a customized derivative.
In his testimony before a joint hearing of the House Financial Services Committee and House Agriculture Committee, Geithner said that the administration would use a “broad definition” of standardized derivatives that would be “difficult to evade.” The administration proposal would raise capital requirements for customized derivatives, “given their higher levels of risk.”
Geithner said that the administration would likely recommend broad principles in statute and then define them further in regulation.
Banks and a range of other non-financial firms are lobbying heavily on derivatives legislation, which is one part of the administration’s plan to revamp regulations for the wider financial system.
Four major Washington lobbying associations -- Business Roundtable, U.S. Chamber of Commerce, National Association of Manufacturers and the Grocery Manufacturers Association -- wrote in a letter on Friday that the proposal would increase the cost of business. “We urge you to prevent an anti-derivatives sentiment from translating into anti-business legislation,” the associations wrote.
A separate letter from 15 associations representing the electric power and natural gas industries raised concern with the mandatory clearing provision and the effort to move OTC derivatives onto public exchanges. The proposals, the associations said, would “significantly increase costs,” and “greatly reduce the ability of companies to find the customized derivative products they need to manage their risks.”
Still, some lawmakers already are signaling frustration with the administration's proposal.
Rep. Spencer Bachus (R-Ala.) said he is concerned that the proposal shifts the risk in the derivatives market to taxpayers. Bachus said that the five largest companies that deal in derivatives, all major banks, will likely be deemed “systemically significant” by federal regulators. In doing so, taxpayers could be on the hook if those companies fail because of poor trades in derivatives.
Rep. Maxine Waters (D-Calif.) introduced legislation on Thursday that would go further than the administration proposal by banning all credit default swaps, one form of derivatives.
“Unless credit default swaps are banned entirely, I am concerned that the industry will find a way to loosen standards and widen exemptions for customized contracts and then we will be right back to where we are today, with capital markets hobbled and the financial system in need of additional government intervention,” said Waters.
Credit defaults swaps were a major factor in the meltdown at insurer AIG, which has since received $182.5 billion in bailout funds from the government.