GAO report says derivatives are risky and need regulating.

WASHINGTON -- The General Accounting Office issued a hard-hitting report on over-the-counter derivatives yesterday that concluded that these complex financial instruments pose significant risks and should be federally regulated.

The long-awaited report, which was the result of a two-year study, says all major U.S. over-the-counter derivatives dealers should be regulated under comprehensive and consistent federal standards and that legislative proposals pending in Congress would accomplish this goal.

The report calls on ConFess to enact legislation immediately to bring the derivatives activities of securities firms and insurance company affiliates under the purview of one or more federal agencies.

It also calls on the Securities and Exchange Commission to ensure that registered corporate end users of derivatives establish internal controls and public reporting requirements for their derivatives activities.

In a surprising leap beyond derivatives, the report also recommends that Congress "address the need to revamp and modernize the entire U.S. financial regulatory system" to better reflect the rapidly evolving global markets. "Banking, securities, futures, and insurance are no longer separate and distinct industries that can be well regulated by the existing patchwork quilt of federal and state agencies," the report said.

Meanwhile, in what appeared to be an unprecedented show of unity, six financial industry groups issued a joint statement strongly opposing the GAO's call for more federal regulation of over-the-counter derivatives.

"If implemented, the GAO recommendations would increase the cost and reduce the availability of these transactions," said the groups, which comprised the Public Securities Association, the Securities Industry Association, the International Swaps and Derivatives Association, and banking and futures organizations. "We are convinced that any legislation having these effects will harm the American economy."

The Securities Industry Association has been urging the SEC to allow the industry to self-regulate its derivatives activities.

In their statement, the six groups noted that federal regulators have repeatedly said that they have the tools they need to oversee derivatives.

In fact, both SEC Chairman Arthur Levitt and SEC Commissioner J. Carter Beese Jr. said yesterday that they are not convinced by the GAO report that legislation to increase oversight of derivatives is needed.

"At the present time, I'm hesitant to reach for a legislation solution in such a dynamic and rapidly evolving industry when the market participants seem more than willing to address the issues at hand," said Beese.

Beese also said he is concerned that the report calls for the SEC to regulate corporate end users of derivatives. "I think we have to guard against a situation where the SEC ends up being a de facto member of every company's board of directors," he said.

The GAO report and opposition to it will form the backdrop for congressional hearings and pending legislation on derivatives.

The House Energy and Commerce subcommittee on telecommunications and finance and the Senate Banking Committee have both scheduled hearings for today to discuss the GAO report. The Energy and Commerce subcommittee has asked federal officials to respond to the report at a hearing on May 25. Other congressional panels can also be expected to hold hearings.

The GAO's call for legislation comes as at least three derivatives bills are pending in Congress, including a measure introduced Tuesday by Sen. Byron Dorgan, D-N.D., and Sen. Barbara Mikulski, D-Md., that would bar banks and credit unions from engaging in proprietary trading activities involving derivatives.

Rep. Henry Gonzalez, D-Tex. and Rep. Jim Leach, R-Iowa, the top lawmakers on the House Banking Committee, have each introduced derivatives bills and are working on a compromise measure that will call for increased regulation of banks' derivatives activities.

Rep. Edward Markey, D-Mass., chairman of the Energy and Commerce sucbommittee, suggested yesterday that derivatives legislation may be needed for securities firms when he issued a statement calling the report "a road map for regulatory and legislative reforms."

In its report, the GAO said derivatives "serve an important function in the global financial marketplace" by helping firms better manage the financial risks associated with their business activities.

But because derivatives affect global markets and are concentrated in the United States among 15 major dealers that are extensively linked to one another, to end users, and to the exchanged-traded markets, "the sudden failure or abrupt withdrawal from trading of any of these large dealers could cause liquidity problems in the markets and could pose risks to others, including federally insured banks and the financial system as a whole," the agency said.

As the derivatives markets continue to grow, more inexperienced firms may try to become players and "may take on unwarranted risk in an attempt to gain market share or increase profits," further increasing the risk that a derivatives crisis could affect the whole financial system, the report said. The federal government would probably have to intervene to keep the system functioning if any such crisis occurred, it said.

The GAO noted that both derivatives market participants and federal regulators have begun to address derivatives concerns, but said there is "no regulatory mechanism" to force firms to comply with industry standards and there are "significant gaps and weaknesses" in the regulation of many major over-the-counter derivatives dealers.

"Federal regulatory authority over the derivatives-dealing affiliates of major securities firms and insurance companies is limited or nonexistent," in contrast to regulated banks, the report said.

The GAO noted that while securities firms and insurance companies represented only about a third of the total U.S. derivatives dealers' total volume at the end of fiscal year 1992, their derivatives business grew faster, at rates of 77% and 100% from 1990 to 1992, compared to 41% growth for banks.

As part of its study, the GAO surveyed more than 4,600 state and local governments and 156 of the largest private pension plans to gauge the extent of their use of derivatives. Only 288 of 3,727 respondents reported using derivatives, including 4% of 3,400 localities.

The survey found that only 4% of the respondents indicated they had experienced "unintended consequences as a result of using any derivative products" and only two said they had filed a complaint or entered into arbitration or litigation to resolve a derivatives dispute.

"On the municipal side, I think that's terrific," said Fenn Putman, chairman of the PSA and a managing director at Lehman Brothers, one of the major derivatives dealers in the municipal market.

"I would say there was a much higher percentage of unintended consequences of buying a bond or a stock," Putman said, adding that the survey seems to indicate there is little evidence of abuse or bad track records with derivatives in the municipal market.

But Putman quarreled with the GAO's conclusion that derivatives products subsidiaries are unregulated, saying they are subject to tough market-imposed standards as well as federal reporting requirements.

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