Geithner Outlines Derivatives Plan

By SARAH N. LYNCH for The Wall Street Journal, July 10 2009

WASHINGTON -- Treasury Secretary Timothy Geithner took his plan for regulating over-the-counter derivatives to Congress on Friday, but his prepared testimony did not delve into some of the details the industry is clamoring to hear.

Geithner reiterated his call to bring all over-the-counter derivatives under strict federal oversight in an effort to make the financial system more stable and eliminate risks that could threaten the marketplace.

Appearing at a joint hearing of the U.S. House Agriculture and Financial Services committees, he reiterated his call to mandate that "all" standardized over-the-counter products be processed through clearinghouses, which absorb credit risk and help cushion the blow in the event of a default. Such contracts would also be traded on regulated exchanges or electronic execution systems.

Customized products, meanwhile, would not need to be cleared, but they would be subject to reporting requirements as well as much stricter capital standards.

But defining when contracts are considered standardized and when they can be cleared is still a major question among those in the industry.

Mr. Geithner on Friday did not yet offer a definition as some had hoped, although he indicated the administration plans to offer one that will be very broad. The definition, he said, "will be designed to be difficult to evade."

"We will employ a presumption that a derivative contract that is accepted for clearing by any central counterparty is standardized," Mr. Geithner said in prepared testimony. "Further attributes of a standardized contract will include a high volume of transactions in the contract and the absence of economically important differences between the terms of the contract and the terms of other contracts that are centrally cleared."

Another component of the Obama regulatory plan for derivatives will include regulating the dealers as well as "all other major over-the-counter derivatives market participants," Mr. Geithner said.

This means that regulations will likely extend beyond just the big banks that deal in derivatives to other non-banking corporations involved in the swaps business, such as ConocoPhillips or Cargill Inc.

"Conservative capital and margin requirements for OTC derivatives will help ensure that dealers and other major market participants have the capital needed to make good on the protection they have sold," Mr. Geithner said.

The proposal to regulate the trading of over-the-counter derivatives would give much of the authority to the Securities and Exchange Commission and the Commodity Futures Trading Commission. Both the SEC and CFTC would be required to establish reporting requirements that would result in an audit trail on all OTC derivatives, and they have been asked to work together to figure out how to divide their jurisdiction.

Mr. Geithner told lawmakers on Friday that the agencies and Treasury have made "great progress in narrowing the outstanding issues" and intend to issue draft legislation that would clearly delineate the oversight authority of the two agencies.

Friday's joint hearing represents a major step forward in trying to get past a longstanding turf battle over derivatives.

The Agriculture Committee, which has authority over the CFTC, earlier this year approved a bill to require clearing of standard over-the-counter products. The bill then went to the House Financial Services Committee, which oversees the SEC, but the committee has not acted on it. House Financial Services Chairman Barney Frank, D-Mass., said Friday he believes the two committees as well as the agencies have been careful to avoid jurisdictional battles and are successfully working together to enact new regulations.

"There is no fight to cover between these two committees," he said in addressing the media.

Geithner Wouldn't Ban 'Naked' Credit-Default Swaps

Mr. Geithner said he doesn't support banning so-called naked credit-default swaps, but he does want to see them regulated.

His comments came in response to questioning from Rep. Scott Garrett (R., N.J.), during a joint hearing Friday held by the U.S. House Agriculture and Financial Services committees.

"I do not believe it is necessary or appropriate for us to ban them," Mr. Geithner said. "But I want to underscore we do believe there needs to be comprehensive oversight of these markets."

Credit-default swaps became a prime target of criticism last year after some said they contributed to the financial crisis. They are insurance-like contracts that promise payouts to swap buyers in the event of a bankruptcy, default or credit-rating downgrade.

While credit-default swaps can be used by bond owners seeking to hedge their risks, they can also be used to bet against the credit-worthiness of companies by investors who have no ownership in the underlying bonds. These are known as "naked" credit-default swaps.

The U.S. House approved a ban on these naked credit-default swaps recently in the climate change bill, although the measure is not likely to survive.

In addition to the fact it still faces approval by the U.S. Senate, the carbon bill also contains a provision which says the ban would become null and void once Congress enacts separate derivatives reform as part of the regulatory revamp.