Geithner: US will "force all standardised OTC derivatives into central clearing"

Testifying yesterday before the House Committee on Financial Services, Geithner revealed four major initiatives that represent a landmark departure from the current powers and jurisdiction of the existing fragmented US supervisory framework, which is split among the Federal Reserve, the Securities and Exchange Commission (SEC) and four other supervisory agencies.

"We should establish a comprehensive framework of oversight, protections and disclosure for the OTC derivatives market, moving the standardised parts of those markets to central clearing houses (CCPs), and encouraging further use of exchange-traded instruments," Geithner said.

Under the plan, the government will fully regulate the markets for credit default swaps (CDS) and OTC derivatives for the first time, subjecting all dealers in derivatives markets "to a strong regulatory and supervisory regime as systemically important firms", although Geithner did not explicitly define whether all directly negotiated derivatives contracts will be captured under the new rules.

As well as vowing to "force all standardised OTC derivatives contracts to be cleared through CCPs," all non-standardised derivatives contracts will be required to report to trade repositories and be subject to robust standards for documentation and confirmation of trades, netting, collateral and close-out practices. No information on how the Treasury Department shall delineate standardised and non-standardised derivatives was provided in the regulatory reform fact sheet.

Geithner added that the financial crisis had "been amplified by excessive risk-taking" by many banks trading CDSs, and that the "implication that they could threaten the entire financial system or bring down a company of the size and scope of AIG was not identified by regulators, in part because the CDS markets lacked transparency".

A second major shift will reintroduce stipulations requiring hedge funds with assets above a certain threshold to register with the SEC, almost three years after previous efforts to coerce fund managers into registering with the securities regulator were struck down by the Court of Appeals for the District of Columbia in June 2006.

This time around, other capital pools - including private equity funds and venture capital funds - will be obliged to register alongside hedge funds and provide investor and counterparty disclosure on top of regulatory reports to allow supervisors to assess whether the fund is so large or highly leveraged that it poses a threat to financial stability. If such a threat is found to exist, the new systemic risk regulator will then subject the fund to stringent prudential capital and risk management standards.

The establishment of a new single independent regulator with responsibility for systemic stability over major financial institutions, OTC derivatives products and hedge fund registration represents the common thread binding the new proposals together.

The regulator's primary task will be to identify institutions of sufficient size and influence as to have potential to have a systemic impact on the wider economy. The characteristics used in determining systemically important firms will include the financial system's dependence on the firm, its size, leverage - including off-balance sheet exposures, the institution's reliance on short-term funding and the importance of the firm as a source of credit for households and as a source of liquidity for the financial system.

Once these systemically important firms are established, the fourth pillar of the plan will see capital requirements levied on these institutions at levels that "must be more conservative than for other institutions and be sufficiently robust to be effective in a wider range of deeply adverse economic scenarios than is typically required".

"The single systemic regulator will also need to impose liquidity, counterparty, and credit risk management requirements that are more stringent than for other financial firms," said Geithner. "For instance, supervisors should apply more demanding liquidity constraints and require that these firms are able to aggregate counterparty risk exposures on an enterprise basis within a matter of hours."

Congressmen were generally supportive of the plans, although some Republican members questioned the need for a new "super regulator" when existing agencies had failed to prevent the current crisis. Geithner argued that a philosophical shift is needed to move regulation of financial products and institutions to focus on the economic function they provide and the risks they present, not the legal form they take.

"We must end the practice of allowing banks and other financial companies to choose their regulator simply by changing their charters; regulators must choose who to regulate. We must not let turf wars or concerns about the shape of organisational charts prevent us from establishing a substantive system of regulation," concluded Geithner.

See also: Market frustrated by lack of detail on US toxic-asset purchase plan
US stress tests under way
Bernanke: Public-private partnership required to value toxic assets
Questions remain over $1trn toxic asset purchase plan
US reforms mean more bailouts and centralised power

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