WASHINGTON (CN) – Treasury Secretary Timothy Geithner on Friday put forward plans giving federal regulators oversight of the $592 trillion derivatives market, which is largely unregulated. The market’s secrecy played a big role in the economic crisis and prevented the government from realizing the extent of the catastrophe, Geithner said.
“Our plan will help prevent the over-the-counter derivative markets from threatening the stability of the overall financial system,” he said.
“The United States entered this crisis without an adequate set of tools to contain the risk of broader damage to the economy and to manage the failure of large, complex financial institutions,” Geithner stated.
He appeared before a House Agriculture and Financial Services joint committee hearing to push for new oversight legislation. The two committees share jurisdiction over derivatives, and comprise 111 representatives.
“Clearly we will be significantly expanding the regulation of derivatives,” said Massachusetts Democrat Frank, chair of the Financial Services Committee, agreeing with the necessity of stricter regulations.
Geithner, who Frank claimed he could not see from across the large chamber, outlined a central clearinghouse to control over-the-counter derivatives. Under the plan, all standardized derivative trades would have to be reported to and cleared by a harmonized Commodity Futures Trading Commission and Securities and Exchange Commission.
A derivative is a financial contract that transfers to another party the risk that an asset’s price will change. In the case of the American International Group, the company had sold protection against investment risks without adequate capital to back up its commitments, resulting in a $180 billion government bailout.
Over-the-counter derivatives are simply privately negotiated derivatives.
The plan comes on top of proposals made last month by the Barack Obama administration to establish a Consumer Financial Protection Agency, require more capital cushion behind investments, and extend regulation beyond the banking sector to cover all firms that play a “critical role” in the market.
The broader goal of all these reforms is to make the market more resilient against periodic crises and price bubbles to prevent the economic crisis that the world has felt since last year.
OTC derivatives “grew explosively,” rising more than six-fold in the last ten years and now play a critical role in financial markets, Geithner said. He reasoned that they should therefore be well regulated.
He also blamed unregulated derivatives in part for the economic downturn. “Under our existing regulatory system, some types of financial institutions were allowed to sell large amounts of protection against certain risks without adequate capital to back those commitments.” This was the case with AIG.
“You need to have capital backing risk where risk is taken,” Geithner said.
Such unregulated agreements also hampered the government from realizing the extent of the economic downturn because it could not see the network of commitments between firms, he stated.
“When the crisis began, regulators, financial firms, and investors had an insufficient basis for judging the degree to which trouble at one firm spelled trouble for another,” Geithner said.
Geithner expects the clearinghouse to weaken this interdependence of companies and stabilize the market against future downturns. “Central clearing of a substantial proportion of OTC derivatives should help to reduce risks arising from the web of bilateral interconnections among our major financial institutions.”
Under the plans Geithner set out, such agreements would be regulated and companies that insure against risk would need appropriate capital cushions.
Some representatives expressed worry over what would happen if the clearinghouse did not clear a transaction.
“That’s something we’ll think through carefully with you,” Geithner replied, but gave no direct answer, although he agreed the clearinghouse would have that power.
Others asked if the stringent capital requirements would eliminate small firms, and create more “too big to fail” firms.
Geithner replied that details still have to be worked out in any proposed legislation, but admitted that such a result would be bad for the market.
“Why not ban credit default swaps?” a California representative asked. Credit default swaps were the type of derivative used with AIG. But Geithner replied that banning them would not be appropriate, and said that derivatives, if properly navigated, can protect the market.
Georgia Democrat David Scott asked about the jurisdiction of the rules, and asked whether nonfinancial dealers would be required to meet capital requirements. Others asked if responsible banks would have to fulfill the capital requirements as well.
To these, Geithner replied that risk will migrate to other parts of the market if there are holes, as it has already done, and said he hopes regulation is broad.
Others expressed concern that the new requirements would send companies overseas to less restrictive nations. But Geithner said the United States and the European Union are working to establish similar regulations, but representatives maintained there would always be other countries that have less stringent regulations.
When Texas Republican Jeb Hensarling stated that the regulations would reduce jobs, Geithner replied, “I am happy to consider any proposals,” and maintained that, in the face of the continuing economic downturn, the government has an obligation to regulate such derivatives.
The committees have yet to consider legislation dealing with such derivatives, but held the hearing with plans to tackle the matter within coming months, likely after August recess.