A broad study of the U.S. derivatives market under way at the General Accounting Office could become the basis for future federal regulation of the industry for the highly volatile products.

Lawmakers in key congressional committees called for the study after hearing reports that individual and institutional investors have suffered huge losses due to drops in the mortgage securities market.

The study also was prompted by warnings from Federal Reserve Board officials about the lack of supervision in derivatives trading and the risk this poses to the international markets.

While institutions use these highly volatile products mainly as part of their hedging strategies, there is fear that investors could be exposed to higher losses should a catastrophe hit the fledgling market.

The lack of uniform accounting rules for these products also contributes to the problem, because the derivatives are subject to a variety of on- and off-balance sheet treatments.

Study leader James Bothwell, GAO's director of financial institutions and market issues, said researchers are going deep into the industry for more detailed information about the market and the products. Depository and nondepository institutions also are being asked about their derivatives trading practices, accounting methods and risk management systems.

Besides evaluating the positive uses of derivative products, the study also will look at potentially fraudulent uses of these instruments and the types of regulations in place to prevent such fraud.

In addition, the study will look at the extent and effectiveness of existing federal regulations and their impact on the derivatives market. Lawmakers fear that gaps in federal oversight could lead to a disaster like the one that struck the U.S. thrift industry, particularly with a number of broker-dealer subsidiaries out of the federal regulatory loop.

Bothwell said the survey phase of the GAO study is expected be completed in January. The entire report is slated for publication early next year.

"We tend to be more concerned about studies done by regulatory agencies, like the SEC, because they can take immediate action." said Andrew S. Carron, director of fixed-income research at the First Boston Corp. and immediate past chairman of the Mortgage Securities Division of the Public Securities Association.

Carron said PSA staff has cooperated with the GAO on the current study.

A recent Securities and Exchange Commission study found that securities firms did not suffer severe losses on interest-only strips, despite record prepayments last summer. But SEC Chairman Richard C. Breeden said this is no reason to refrain from giving the National Association of Securities Dealers the authority to make suitability and sales practice for all government securities, including the IO strips issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage: Corporation.

"The volatility of those instruments underscores the absurdity of the exemption, in current law, of all government securities, including interest-only strips issued by government-sponsored enterprises, from NASD's suitability and other sales practice rules.'" Breeden wrote to Rep. Edward J. Markey, D-Mass., chairman of the Telecommunications and Finance Subcommittee of the House Energy and Commerce Committee. (See The Mortgage Marketplace, Oct. 19, page 3.)

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