Regulating the Industry: Derivatives spared harsh regulatory overhaul

Derivatives manage to maintain their smoke-and-mirrors appeal for hedge funds as the House Finance Services Committee approves a Derivatives Bill that would finally put derivative transactions under government regulatory control. The derivatives bill forces many of the complex products and negotiated contracts under the auspices of Commodity Futures Trading Commission, and Securities Exchange Commission, according to the Wall Street Journal.

Derivatives have always been a high risk, high return products that, until now, had little regulation and even less transparency. Derivatives are complex products which are privately negotiated agreements structured to hedge interest rate, credit risk, and commodities. These transactions involve private contracts with various institutions and third parties, often consisting of strips of bonds or interest rate swaps that are extremely difficult to track, or audit. So why did it take the near collapse of the financial market to bring the issue to light? Apparently, last year when authorities were trying to unravel the portfolio of derivatives for the faltering insurer AIG, regulators soon realized that it was next to impossible to figure out who owes who, and what the market value was given the circumstances.

Although the derivatives bill is a step in the right direction, there are exceptions written into it that should be cause for concern. Under the new bill, derivative contracts that are made between institutions are deemed standard and required to be processed through a clearing house. These trades will have to be traded on an electronic platform or exchanges, where dealers are required to use their own funds to make trades. The bill makes exceptions, however, for companies that use swaps as a way to hedge. In this instance, companies won't have to trade on exchanges, nor will they be required to go through a clearing house. Needless to say, this will result in untraceable trades, which could undoubtedly lead to abuses. It's these kinds of unregulated complex transactions that got us into trouble to begin with. It should be no surprise to find that corporations aggressively lobbied against this bill, and very possible that he loop hole left open for under-the-radar transactions is a kind of consolation gift.

The chairman of the Commodity Futures Trading Commission, Gary Gensler, was quoted as saying that "substantial challenges remain", although the passing of the bill marked a significant step (WSJ - Oct. 16). The bill will most likely see several revisions before it is signed into law, which should be by the end of the year.

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K. Reilly