WASHINGTON — The Obama administration on Tuesday sent Congress its proposal to regulate a complex part of the financial world that played a key role in the near-meltdown of the global financial system last year.
The comprehensive plan to regulate so-called derivatives was the final element in the largest proposed overhaul of U.S. financial regulation in generations. Tuesday's plan would subject a largely unregulated financial market whose size is in the trillions of dollars to federal scrutiny.
"It is a comprehensive reform, going right to the very heart of the problems we saw in the last crisis," Assistant Treasury Secretary Michael Barr said.
Derivatives have grown explosively in recent years, developing faster than regulators could keep pace with, especially the market for swaps. These are private deals between two parties on anything from a change in the value of the dollar versus other currencies to a bet that a company will default on its corporate bonds or suffer a downgrade of its credit rating, called a credit-default swap.
Credit-default swaps were instrumental in the near-collapse of the global financial order last September. The Federal Reserve and the Treasury Department saved insurance giant American International Group from collapse, concerned that the lack of transparency in swaps markets would trigger runs on other financial institutions.
Neither markets nor regulators were certain who owed what to whom in the swaps market. There was no central place to settle the bets or to resolve disputes.
That's where Tuesday's proposed legislation comes in. Under the Treasury's plan, most derivatives would become standardized financial products and be traded on a regulated exchange, much as stocks and commodities are. Settling these private bets would take place in a clearinghouse regulated by either the Commodity Futures Trading Commission or the Securities and Exchange Commission.
One especially popular swap product involves energy prices, with two parties betting on the price movements of oil, airliner fuel, natural gas and other products.
Some end users of these products complained that they need a specialized deal, and could be harmed by a standardized approach. For them, the Treasury would allow customized swaps. They'd be subject to tough reporting standards and would require more cash held in reserve than would be required for standardized products.
The lack of sufficient reserves to cover losses was one reason that the government was forced to seize AIG. Tuesday's proposed legislation would require more capital reserves from participants in the swaps market.
For the first time, any firm that deals in derivatives and any large firm that engages in a derivative transaction also would come under direct supervision by regulators. However, the Treasury's proposal would require transactions to be settled in a clearinghouse only if they were between large financial institutions that pose a risk to global finance. One noted analyst finds that insufficient.
"By putting that in there, you sort of eviscerate what you want," said Michael Masters, a hedge-fund manager whose testimony before Congress has highlighted a dangerous lack of transparency in oil swaps. He considers the large-firm stipulation "a large loophole."
A Treasury official, who spoke only on the condition of anonymity in order to talk freely, countered that the exception was necessary to avoid hurting smaller corporations that use swaps to hedge against risk. Every swap dealer, regardless of size, would be regulated for the first time, the official said, as would major participants, whether or not they were financial institutions.
The chairman of the Commodity Futures Trading Commission, Gary Gensler, recently held three hearings on proposed regulatory changes involving derivatives. In a statement Tuesday, he welcomed the new proposals as "a very important step toward much-needed reform to protect the American people by lowering risk, promoting transparency and protecting market integrity."
His fellow commissioner, Bart Chilton, added in a statement that the proposed regulatory overhaul "represents much-needed modifications to the former 'hands-off' attitude toward complex derivatives trading and clearing in the United States."
"These critically important markets that affect the prices American consumers pay for the gasoline in their cars and for the oil that heats their homes are too important to be allowed to fall prey to the types of market catastrophes and sharp dealing we have witnessed in recent years," Chilton said.
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