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Broad Federal Oversight Eyed for Derivatives, Swaps, Hedge Funds

Treasury Secretary Timothy Geithner last Thursday proposed a sweeping expansion of federal regulatory authority over large financial firms and markets that he said pose systemic risks to the economy, including over-the-counter (OTC) derivatives, credit default swaps (CDS) and hedge funds. His plan calls for the broadest reform of federal financial regulatory system since the New Deal, "not modest repairs at the margin, but new rules of the game" that are "simpler and more effectively enforced and produce a more stable system."

Testifying before the House Financial Service Committee, he proposed the creation of a single, independent federal agency that would have responsibility for the "consolidated supervision" of systemically important financial (nonbank) firms and for systemically important payment and settlement systems and activities, such as OTC derivatives, CDS transactions, hedge funds and money market mutal funds.

"We're examining right now the question about what requires legislation and what we can do with existing authority," Geithner told the House committee. "We actually can do quite a lot with existing authority," but that authority is "segmented...and no one's really accountable for looking at the whole thing," he said.

"Weaknesses in the settlement systems for key funding and risk transfer markets, notably overnight and short-term lending markets and OTC derivatives, have been highlighted as a key mechanism that could spread financial distress between institutions and across borders. While some progress was made in the markets for CDS and other OTC derivatives while I was at the New York [Federal Reserve], federal authority over such arrangements is incomplete and fragmented, and we have been forced to rely heavily on moral suasion to encourage market participants to strengthen these markets.

"We need to give a single entity broad and clear authority over systemically important payment and settlement systems and activities. Where such systems or their participants are already federally regulated, the authority of those federal regulators should be preserved and the single entity should consult and coordinate with those regulators," Geithner said. The Commodity Futures Trading Commission currently has limited oversight authority over derivatives.

Geithner's proposal did not recommend eliminating or combining any existing federal regulatory agencies.

The Obama administration's plan calls for the federal government to regulate the markets for CDS transactions and OTC derivatives "for the first time," Geithner said. "The complex [CDS] instruments were poorly understood by counterparties, and the implication that they could threaten the entire financial system or bring down a company of the size and scope of AIG [American International Group] was not identified by regulators, in part because the CDS market lacked transparency."

But "the days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers from losses must end," Geithner said. CDS transactions are insurance-like contracts that cover losses on certain securities (bonds) in the event of a default. They're supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft. However, that hasn't been the case. CDS transactions are traded or swapped from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. They have been blamed for much of the upheaval in the credit markets (see NGI, Dec. 15, 2008).

The Obama administration also proposes to identify "all dealers in OTC derivative markets and any other firms whose activities in those markets pose a systemic threat to a strong regulatory and supervisory regime as systemically important firms," which would subject them to stringent liquidity, counterparty and credit risk management requirements, according to Geithner.

OTC derivatives are contracts that are traded between two parties, without going through an exchange or other intermediary. The OTC derivatives market, which had a notional amount of $684 trillion in June 2008, is the largest market for derivatives and is largely unregulated. Players in the market are often banks and other highly sophisticated parties, such as hedge funds.

"We will force all standardized OTC derivative contracts to be cleared through appropriately designed central counterparties (CCPs)," which will be subject to "comprehensive settlement systems supervision and oversight," he said. And "we will require that all non-standardized derivatives contracts be reported to trade repositories and be subject to robust standards for documentation and confirmation of trades, netting, collateral and margin practices and close-out practices."

Moreover, "we will bring unparalleled transparency to the OTC derivatives markets by requiring CCPs and trade repositories to make aggregate data on trading volumes and positions available to the public and make individual counterparty trade and position data available on a confidential basis to federal regulators, including those with responsibilities for market integrity," Geithner said.

With respect to hedge funds, "we recommend that all advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) with assets under management over a certain threshold be required to register with the SEC [Securities and Exchange Commission]," he told the House panel. All affected funds "should be subject to investor and counterparty disclosure requirements and regulatory reporting requirements" to determine whether "the fund or fund family is so large or highly leveraged that it poses a threat to financial stability."

One notable hedge fund disaster involved Amaranth Advisors LLC, which collapsed in September 2006 after suffering $6 billion in market losses due to ill-advised positions in the natural gas futures area (see NGI, Sept. 25, 2006).

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