WASHINGTON -- Federal regulators are worried that the rapid growth of sophisticated derivative transactions may pose risks for globally linked financial markets, but they those risks are currently manageable.
Susan Phillips, a Federal Reserve Board governor, and Brandon Becker, deputy director of the Securities and Exchange Commission's division of market regulation, both say federal regulators fear that a disruption in the derivatives market or the failure of a firm involved in derivatives could disrupt the stock markets or hurt large broker-dealers or banks.
However, both officials suggested the risks associated with derivatives appear to be manageable at this point.
Both stressed in remarks made here to the International Swap Dealers Association's North American Regional Conference that more information is needed about how firms manage and account for these products, as well as on the risks they pose. Becker said his views were not necessarily the SEC's.
Phillips' and Becker's remarks come almost a year after Gerald Corrigan, president of the New York Federal Reserve Bank, told bankers involved in derivatives that they should "take a hard look" at these transactions, which do not appear on the balance sheets of firms. These transactions are not subject to the same level of regulation as items that do appear on balance sheets.
Corrigan's remarks, which were somewhat vague, triggered fears about derivatives, Consuela Washington, counsel for the House Energy and Commerce Committee, told the swaps group. She said that some members of Congress and others began to call for derivatives studies, fearing that "regulatory black holes" may exist with respect to over-the-counter instruments.
But Phillips and Becker, in their speeches to the group, were more specific about concerns surrounding derivatives and how regulators are addressing them.
Phillips said regulators are worried about derivatives because, "We're seeing more and more activities by a broader range of financial and non-financial firms." She added that derivatives "have become an important source of profits for banks and other intermediaries."
A key concern, she said, is that the failure of a large firm or dealer may result in a "loss of liquidity," which could have a "domino effect" and cause problems for other firms.
"We used to think in regulatory circles that you could wall off a potential problem and therefore limit the risk," she said. But, she added, "it's not clear anymore that you could wall off one kind of activity."
The market has grown so large, she continued, that "there's a concern that if there were a problem it couldn't necessarily be contained within one domestic regulatory sphere."
Phillips said the biggest concern about derivatives among regulators is "whether the reporting and accounting systems have fully caught up to the practices in the market."
Many of these products are "derived from high-tech trading strategies and often very sophisticated formulas," she said. "This has really brought home and made us focus on the fact that regulatory and financial reporting systems ought to be made high-tech."
The fact that derivative transactions are treated as off-balance sheet activities "makes regulators less confident about the scope and the use of derivatives," she said. Another problem, she said, is that "a lot of senior banking and financial institution executives often profess or feel that they don't fully understand what's going on."
But Phillips said one of the "philosophical approaches" to derivatives emerging at the Fed "is the belief that bank examiners have a very important role in addressing these concerns and issuers."
At this point, she said, "there does appear to be a well-defined reliance on the management of the entities we oversee to put into place adequate information systems and internal controls."
But she said the board wants to heighten the awareness of the risks associated with trading in these markets and encourage market developments that will assist in containing risks.
Becker, meanwhile, said his agency has two principal concerns about derivatives. First, a disruption in the derivatives market could force broker-dealers and their affiliates to take positions in the equities markets that would interfere with those markets. But so far, the SEC "hasn't seen any indication that this is really a major issue," he said.
The second concern is whether effective capital rules are in place to ensure that broker-dealers and their affiliates remain financially stable and strong enough to withstand a potential market disruption if a major firm fails, he said.
He said the SEC adopted rules earlier this year for broker-dealers and their affiliates that are "designed to give us a better picture of the scope and nature of the risks that are outstanding in the affiliates of the broker-dealer firms." These rules call for the firms to report information to the SEC early next year.
But he said the SEC has already started to informally gather such information through conversations with firms. "The good news, as a result of those conversations, is that we generally concur in the view at this point that the risks are being managed," he noted. One ongoing question, however, is whether "many of these products are being done outside the broker dealer" and through newly established affiliate companies because commission rules affect the economics of derivatives products. He said some broker-dealers appear concerned that "The net capital rules administered by the commission would impose such [so-called] haircuts on the contractual arrangements entered into that it becomes uneconomic to do the product."
A haircut is a deduction a firm must take in valuing its capital.
Becker told the group that it "does not strike me as a particularly good result to have a capital rule that draws the product outside of the regulated entity.
He said the SEC staff, therefore, has "been actively working with the broken-dealer community to identify whether there might be alternative approaches to a capital standard that would be more in tune with the way in which the products are carried ... on the books of firms and the kinds of capital they use."
