Washington - Federal Reserve Board Governor Susan Phillips yesterday, called for federal regulation of derivatives to remain flexible, so derivatives can continue to be used for risk management and U.S. dealers can remain competitive with their foreign counterparts.

At the same time, Phillips said at an industry conference here that federal reporting requirements may need to be expanded for banks with significant derivatives activities.

She also called on industry officials to consider creating a clearinghouse through which obligations could be offset and credit risks reduced for over-the-counter derivatives.

Phillips made the remarks at a conference sponsored by the International Swaps and Derivatives Association.

She called on the many federal regulatory agencies that share jurisdiction over derivatives to "help accommodate our regulatory regime to these evolving products, rather than accommodating the products to regulation, as has too often been the case in the past."

The agencies, she said, should avoid restrictions that would deter banks, corporations, and other so-called end users from employing derivative products to manage interest rates and other risks.

"A flexible regulatory regime is crucial if we are to let market forces allocate the [risk management services provided by derivatives] in a manner similar to the way that the market allocates credit," Phillips said.

In addition, the international scope of the derivatives business "raises the risk that regulatory actions in the United States could place U.S. firms and markets at a competitive disadvantage," she said. U.S. firms make up only one-sixth of ISDA's membership and are not among the top firms for most derivatives products, according to ISDA and a recent industry survey.

It comes as no surprise that derivatives fall into the regulatory bailiwick of several agencies, Phillips said.

"Derivatives products are constantly evolving. No matter how you slice and dice regulation in such an environment, you face jurisdictional problems," she said. Many of these products simply "do not fit neatly into regulatory pigeonholes," she said.

Phillips said she supports federal agencies' cooperating both with each other and international officials in regulating these products.

She said the current regulatory regime can address the concerns that have been raised about derivatives. While legislative changes "might ultimately be necessary," the case for them has not yet been made, she said.

Phillips lauded the recent derivatives study by the Group of Thirty, a private organization of international financial experts, but said the study "leaves much work to be done" by industry and regulatory officials.

The report makes 24 recommendations, the bulk of which are aimed at helping financial institutions ensure that adequate systems exist to manage the risks associated with derivatives. Phillips and ISDA officials at the conference urged firms to implement the study's recommendations.

One of the challenges for the Federal Reserve System, Phillips said, is how to incorporate the Group of Thirty recommendations into supervisory standards for banks. The Federal Reserve System, she said, has incorporated the study's risk management principles into a new trading activities manual for its examiners that is being "field tested" at federal reserve banks.

But while major dealers in derivatives should adopt the Group of Thirty's recommendations, firms with limited derivatives activities will have to weigh the costs with the benefits of adopting them, Phillips said.

The Federal Reserve has issued for public comment a proposal to incorporate interest rate risks into riskbased capital guidelines for the banks it oversees.

Phillips said also that while U.S. banks already report more information that most other market participants, "expanded reporting requirements may be appropriate for banks whose derivatives activities are a significant element in their overall risk profile."

Phillips praised the report's recognition that end users of derivatives must also adopt sound risk management systems for their derivatives activities. While an end user with a derivatives problem would probably not endanger financial markets, it "could have legislative and regulatory repercussions for the markets as a whole," Phillips said.

Phillips emphasized that firms must be able to net, or offset, their derivatives obligations and credit risk. Recent legislation and a rule proposed in May by the Federal Reserve Board would treat netting contracts between and among depository institutions, broker-dealers, banks, futures commission merchants, and other large-scale dealers in the over-the-counter derivatives market as valid and legally enforceable, she said.

At the same time, Phillips said, "I hope market participants will carefully explore the benefits of a clearing-house" resembling those that exist for exchange-traded derivatives to reduce counterparty credit exposures, Phillips said.

Meanwhile, ISDA officials at a press briefing said their organization is not considering creating a clearing house, in part because of the risks and costs involved in such an effort. ISDA instead has focused on developing netting agreements that could be used by firms to reduce credit risk, they said.

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