6.17.2009 |
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New US Derivative Rules To Address Systemic Risk - Reuters
Obama unveils new proposals to regulate global derivatives markets 
By Karen Brettell New proposals to regulate the $450 trillion privately-traded global derivatives markets, unveiled by the Obama administration on Wednesday, are designed to remove the risks of another global financial crisis.
But heated debate is likely over details on how the proposals can be implemented, especially over what will be deemed a standardized contract and subject to mandatory processing through central clearing house, as well as about how much margin desposit will need to be posted to back derivatives trades.
The collapse of the world's largest insurer, American International Group , in September last year, highlighted the risks that some derivatives posed to global markets.
AIG had sold hundreds of billions of dollars of protection on risky debt using credit default swaps but held little capital to cover its potential obligations to other parties.
The new US government reform proposals are geared toward removing counterparty risks by requiring greater use of central counterparties, imposing stricter capital controls on financial institutions active in the markets, and giving regulators the option to set position limits.
For contracts that are not processed through a central clearing house, the proposed new rules will require higher capital levels be held against contracts, and will mandate recording in trade repositories and monitoring by regulatory agencies.
"It's a pretty sweeping proposal that covers all parts of the market," said Michael Greenberger, law professor at the University of Maryland, who has testified before Congressional committees on the need for derivatives regulation.
"I think the distinction, or the hope, by the financial services industry that there'll be large parts of these markets that will not be regulated is not going to hold up," Greenberger said.
Derivatives are synthetic contracts that derive their value from physical securities in the credit, interest rate, foreign exchange, equity and commodity markets.
The vast majority of the contracts are written on currency and interest rate securities, standing at around $400 trillion in notional volumes.
CDS THE MAIN CONCERN
Derivatives have come under regulatory scrutiny, however, due to the role credit default swaps (CDS), a fast growing market during the credit boom of 2003-2007, played in concentrating debt exposures among large financial companies.
Concerns about the ability of investors to reclaim assets posted against derivatives also helped fuel bank runs that led to the failure of investment banks Bear Stearns in March 2008, and Lehman Brothers last September.
The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) will share market supervision under Wednesday's proposals. The two agencies have been tasked with harmonizing rules by the end of September, to avoid potentially conflicting regulations.
"Whenever you are regulated by two separate and distinct entities, one has to ensure that they are both singing from the same choirbook; otherwise it can become unnecessarily expensive and contradictory," said Jamie Cawley, chief executive of inter-dealer credit default swap broker IDX Capital.
Details on many key issues, however, remain unanswered and are likely to be hotly debated by market participants in coming months.
"We have no more clarity on ultimately how we are going to determine what is a standard trade versus a customized trade," said Joel Telpner, partner at law firm Mayer Brown in New York.
Some banks and investors have said that certain contracts are not conducive to central clearing as they are customized to specific client needs.
Others fear that if a large portion of contracts remain outside of central counterparties, the risk that a party will be unable to make good on their obligations will remain.
Another contentious issue is how much margin investors will need to post against derivative trades, and if more stringent requirements placed on customized trades would drive more trades to central clearinghouses.
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