The dark and largely unregulated market of derivatives, which helped trigger the financial crisis, moved closer to federal oversight as a congressional committee voted to impose new rules on the products to try to limit the risk they can pose to the economy.
The 43-26 vote by the House Financial Services Committee was a key step for the Obama administration’s plan to overhaul Washington’s oversight of the financial system while shedding more light on complex investments.
Immediately after the vote Thursday, the committee took up the most contentious issue in the regulatory package: creation of the Consumer Financial Protection Agency. A vote on that provision, though, isn’t expected until next week.
Thursday’s largely partisan vote on derivatives supports bringing regulation for the first time to the private, over-the-counter securities, named derivatives because their value is derived from the price of an underlying asset such as interest rates or oil.
“This is a very important step forward in bringing these complex financial products under the regulatory umbrella and bringing transparency to this unregulated market,” said Mary Schapiro, chairwoman of the Securities and Exchange Commission, which would share oversight of derivatives with another agency, the Commodity Futures Trading Commission.
But some critics said the new rules wouldn’t be strong enough to prevent crises, in part because they would exempt too many derivatives deals from transparency requirements. The legislation still faces changes in the House and Senate, which are under pressure from banks and other businesses to limit the new oversight.
“There is progress on some important issues in this legislation, but it doesn’t begin to fulfill the promise that was made that we’re going to get comprehensive reform in the derivatives market,” said Barbara Roper, director of investor protection for the Consumer Federation of America.
Gary Gensler, chairman of the Commodity Futures Trading Commission, has pushed for tougher regulations. He said Thursday’s vote represented “historic progress” but added that he wanted to work with Congress “to complete legislation that covers the entire marketplace without exception.”
Derivatives were at the heart of the failure of Lehman Bros. and the near-collapse of insurance giant American International Group Inc. The Federal Reserve bailed out AIG last fall when its failure threatened to send shock waves through the financial system because of the numerous companies AIG covered through derivatives known as credit default swaps.
The legislation, which tracks the Obama administration’s proposal, would set rules for standardized derivatives to try to limit their potential to cause market meltdowns.
Dealers, banks and other firms that trade derivatives would have to report and keep records on all transactions, and would be required to have set amounts of money in reserve to cover losses.
All standardized derivative trades between dealers and large market participants also would go through central clearinghouses that would act as middlemen, and the trades would have to take place on exchanges or electronic trading platforms, adding transparency to what has been a murky and mysterious market.
“We are making substantial changes in the atmosphere in which they operated,” said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee. “There will be no more hidden trades. There will be no more hidden prices.”
But an industry official said too much oversight could limit the effectiveness of derivatives, which many firms use to offset risk in deals and investments, such as variations in interest rates and commodity prices.
“Our view is the bill’s requirements would tie people’s hands and reduce their ability to manage risk effectively, and that’s not the best result from our perspective,” said Robert Pickel, executive director of the International Swaps and Derivatives Assn., which represents more than 830 firms that participate in the market. The group is working with lawmakers on the legislation.
Most Republicans opposed the legislation, arguing that it was heavy-handed and would increase costs for businesses that use derivatives -- costs that ultimately would be passed on to consumers.
“If we want people to make capital available in our system for job creation, we shouldn’t be lessening their ability to manage risk with any type of derivative they think is necessary,” said Rep. Jeb Hensarling (R-Texas).
He and other Republicans said the legislation placed new requirements on derivatives that were unrelated to the problems of AIG, whose overexposure to derivatives should have been identified by regulators using existing oversight.
But consumer advocate Roper said AIG’s problems were hard to discover under current laws.
“To say that regulators could have acted against AIG’s exposure, they would have had to know it existed,” she said. “The whole problem with this opaque, unregulated market is you don’t know what kind of exposure is out there.”
Roper said AIG was only the latest example of the problems of unregulated derivatives. She noted that Orange County’s 1994 bankruptcy was triggered by a collapse in investments in derivatives based on interest rates.
Roper said she was disappointed that the bill would exempt many derivatives deals from the requirement to go through clearinghouses and exchanges. Only transactions between dealers and large market participants would be covered.
Frank said he was convinced that some deals should continue outside of clearinghouses and exchanges. Those would involve companies that provide goods or services and use derivatives to limit risk, such as airlines that hedge against fuel increases.
The goal was to reduce speculation in derivatives, so the requirement would apply to dealers and heavy participants in the market, Frank said.
But the bill would add regulation to the derivatives market for the first time, which is important to prevent future crises, he said.