Derivatives oversight may take a while

The Obama administration has focused closely on setting up a new regulatory system for the highly nuanced and largely unregulated market. Users of derivatives defend them as an essential tool to hedge against risk in a variety of markets, while critics blame them for spreading the crisis throughout the financial system.

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The push to regulate the multitrillion-dollar market is one of the most closely tracked and lobbied parts of the broader effort by the Obama administration to revamp the nation’s financial regulations and prevent future crises. The House Agriculture Committee is holding a hearing on the issue on Thursday as lawmakers in the chamber prepare legislation this fall.

House Financial Services Committee Chairman Barney Frank (D-Mass.) is planning to pass a comprehensive bill by the end of the year.

The face value for derivatives traded between two parties at one point stood in excess of $600 trillion. Largely a dark market, administration officials and members of Congress are debating how best to bring greater oversight and transparency to what is now a major source of profit for Wall Street.

According to the Office of the Comptroller of the Currency, commercial banks posted record revenues of $9.8 billion in the first quarter of 2009 on trades in cash and other derivatives products.

Gary Gensler, the head of the CFTC, said he was confident the chairmen of the House Financial Services Committee, Senate Banking Committee and House and Senate Agriculture committees would reach an agreement on regulating derivatives.

Still, Gensler recognized that it is unlikely to happen quickly. “It may take awhile, and certainly they’re going to be making compromises they ask us to think about,” he said, referring to congressional lawmakers. Gensler spoke at a conference hosted by The New Republic magazine and the International Securities Exchange.

The administration’s plan would increase capital and margin requirements for dealers, require central clearinghouses for derivatives trades and aim to put as many derivatives as possible onto public exchanges.

Lawmakers and the financial industry have been wrestling with how to preserve the market for some highly customized products without opening a loophole for abuse. Gensler emphasized that the administration is intent on regulating dealers in derivatives for all of the products they trade as a way to ensure that certain types of products are not exempted.

“We have to regulate the dealers for all of the products — customized as well as standard,” Gensler said. Capital and margin requirements should apply to dealers in relatively standard interest rate products as well as to more customized derivatives, he said. Higher capital requirements could be mandated for traders in customized products that are not placed onto public exchanges, Gensler said.

While five large banks dominate the dealer market, the administration is looking at ways to beef up regulations of non-bank dealers as well. The Federal Reserve and bank regulators would set capital requirements for bank dealers of derivatives, while Gensler said that the CFTC might play a role in regulating capital requirements for non-bank dealers. “We don’t want the next AIG,” he said, noting that the firm is not a bank.

Gensler also suggested that credit default swaps could face additional scrutiny. “Just as they have rules about short-selling for equities,” he said, “it may well be appropriate to have short-sale rules with regards to credit default swaps.”

Gensler said he thought the plan would benefit small users of derivatives, such as local governments, as well as large institutional players such as hedge funds.