Over-the-counter derivatives to be regulated

Treasury's OTC plan is broadly welcomed

By Aline van Duyn, Henny Sender and Francesco Guerrera in,New York

Published: May 14 2009 03:00 | Last updated: May 14 2009 03:00

The proposed regulatory overhaul of the multi-trillion dollar derivatives industry is expected to vastly increase the amount of information available to regulators around the world and could increase the cost of trading and taking on positions.

Industry experts said the proposals unveiled by Tim Geithner, Treasury secretary, and other US officials could address some of the shortcomings which left many of the excesses of the credit bubble undetected and allowed huge amounts of leverage to build up, in part through the use of derivatives. "This seems to be going in the right direction," said Joel Telpner, partner at Mayer Brown. "It seems to be addressing one of the biggest concerns about the industry, the lack of transparency and not enough information about who's trading."

In the announcement yesterday, the US Treasury specifically mentioned AIG, the insurance giant which had to be bailed out by the US government due to its credit default swap exposures. The huge exposures to an AIG default by other big derivatives dealers had created such large counterparty risks that the entire financial system was at risk.

"As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by both regulators and market participants. But even if those risks had been better known, regulators lacked the proper authorities to mount an effective policy response," the Treasury said.

But while backing regulators' sentiments, some dealers voiced apprehension that if the measures are not implemented in the right way, the effect might well be to add to counterparty risk.

Dealers usually try to offset their positions with each other. But if some trades go through new clearing houses and others do not, a dealer could actually be magnifying the risks in the system.

Experts are also divided on the extent to which these measures will affect the profitability of the derivatives markets. In the past, precisely because these markets were so opaque, they gave rise to all kinds of lucrative price disparities. But as more derivatives became standardised, they became less profitable in any case.

"As long as dealers are still allowed to do customised derivatives with clients, they can still make money," says Leslie Rahl, president of Capital Markets Risk Advisors.

Mr Telpner said the details of the plan would be closely watched. For example, he said it would be crucial to find out what derivatives would be moved to full exchange trading and exactly which derivatives users would be subject to new rules.