Weaknesses in the US Regulation of Derivatives

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DerivativePresident Obama’s new proposal aimed to regulate derivatives has some major flaws.  The proposal stops short of creating a fully transparent market.

Derivatives are financial products that supposed to help investors manage risks, like the possibility of default or of interest-rate swings.    They are virtually hidden from investors, analysts and regulators. They do not trade openly on public exchanges and have very few other requirements.

As the financial bubble burst progressed, many of these derivatives didn’t work as they were supposed to.  As we have seen in AIG case, rather than reduce risk, they created or increased it to the point that the failure of one party to various derivatives contracts threatened to crash the entire system.  This disaster caught regulators completely off guard and taxpayers have been paying for bailouts ever since.   The regulators argue that transparency is the best way to avoid a repeat of the crisis triggered by these unregulated financial products.

As the result, the Administration is seeking to repeal major portions of the Commodity Futures Modernization Act, enacted in 2000, that ensured derivative instruments would remain largely unregulated.  The recent proposal would subject participants in the derivatives market to capital requirements and to record-keeping and reporting requirements. This would allow regulators to track their activities and intervening as necessary to prevent system-wide problems.  Also, the proposal calls for certain derivative trades to be handled through clearinghouses in order for the regulators to prevent fraud and manipulation.

However, the proposal has some major weaknesses.   It does not call for trading derivatives on fully regulated exchanges, the most reliable way for transparency.   It also makes a distinction between standardized and customized derivatives and proposes a lighter regulatory touch for the custom variety.  That could open the door to gaming the new system, which could be avoided if all derivative contracts were traded on exchanges.  In some important respects, it appears to give regulators the discretion, though not the duty, to police markets more closely.

The proposal also makes it unclear if the Securities and Exchange Commission and the Commodity Futures Trading Commission would oversee derivatives.    Thus, it creates tension between two regulatory agencies.    Another flaw is that Obama’s nominee to lead the Commodity Futures Trading Commission, Gary Gensler, has a credibility problem.  During the Clinton administration, Mr. Gensler – along with Lawrence Summers, Obama’s top economic adviser – championed derivatives’ deregulation.  That caused two senators to place a hold on his confirmation.

If government wants to bring this proposal to life, it needs to provide regulators with protections, resources and clear political support they would need to carry out their new mandate.

Anna Timone (195 Posts)

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