U.S. Treasury Secretary Timothy Geithner urged lawmakers on Wednesday to let regulators block companies from customizing derivatives contracts to avoid trading on central clearing houses.
Testifying before the Senate Agriculture Committee, Geithner also said it was imperative that key regulators get powers to proactively require central clearing of any derivative types whether or not they are currently accepted for clearing.
We...should require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing, Geithner said.
Derivatives are financial instruments that derive their value from an underlying asset like a Treasury bond, stock or interest rate.
Some derivative products are traded on exchanges and centrally cleared while other, customized transactions are made over-the-counter or between individual parties, are not centrally cleared and are far less transparent.
Unregulated trading of derivatives was blamed for contributing to the financial crisis that drove the U.S. economy into recession in 2007.
Lack of transparency in OTC (over-the-counter) derivative markets, combined with insufficient regulatory power to police these markets, left our financial system more vulnerable to fraud and manipulation, Geithner said.
He argued that regulators -- specifically the Commodity Futures Trading Commission and Securities and Exchange Commission -- need authority to decide what derivatives must be centrally cleared rather than letting private parties make the call.
Central clearing interposes a regulated clearinghouse between the original counterparties in a derivatives transaction and so creates an opportunity to make dealing more transparent.
With careful supervision and regulation of the margin and risk management practices of clearinghouses, central clearing of a substantial proportion of OTC derivatives should help to reduce the risks arising from the web of bilateral interconnections among our major financial institutions, Geithner said.
That would reduce the prospect of threats to financial stability stemming from derivatives dealing that is measured in the hundreds of trillions of dollars annually, he added.
Subjecting derivatives trade to more scrutiny and supervision is a fundamental element of the Obama administration's bid to overhaul financial regulation but banks and other financial market participants want to keep as much of the market unregulated as possible.
(Reporting by Glenn Somerville and Mark Felsenthal, Editing by Andrea Ricci)