WASHINGTON -- Federal Reserve Board governor John LaWare reiterated his long-standing position yesterday that new legislation to regulate derivatives is not needed.
"Further legislation is unnecessary and might even be counterproductive," the Fed governor said at a conference on derivatives usage by mutual funds hosted by the Strategic Research Institute.
"The markets are already making adjustments," he said.
While conceding that many losses from derivatives investments have been reported, LaWare said the problems with funds are "manageable."
"It goes without saying that interest in this area has intensified," he said. "To my knowledge no public institution has failed because of its derivatives uses."
LaWare called for continued coordination among regulators and emphasized that derivatives, on the whole, are valuable investment tools.
"What has not received publicity is the large number of investors that have used the instruments to reduce risks," he said. "The derivatives market encourages the redistribution of risk [and] permits end-users to identify fundamental financial risks."
LaWare said the recent losses reflected the substantial changes in interest rates and involved investments primarily in government issued structured notes.
"It is not surprising that some violent actions have ensued," he said, adding that he was surprised it wasn't worse.
LaWare said the stress tests used to measure market risk a couple of years ago when making investment decisions didn't go far enough to measure possible market changes.
He said a large number of the investment decisions were made in a time of market stability.
"Relative stability probably obscured some of the risks," he said. "It is inherent that the degree of stress tests used did not contemplate the amount of movements in interest rates.",
In addition, LaWare said the lack of knowledge about some of the derivative products made it difficult to predict the risks in some cases.
LaWare said the move to the largely unregulated over-the-counter market reflects a "natural evolution of financial markets."
However, he also noted that dealers in the over-the-counter market commonly use exchange-traded instruments.
He expressed concern about possible overregulation of the over-the-counter derivatives market. He also said care had to be taken to make sure that the rules are fair for futures exchanges that want to do more derivatives business but currently fall under more government regulation.
LaWare said the Federal Reserve plans to conduct a survey next spring to determine the size of the over-the-counter market in addition to the replacement value of derivatives contracts.
"While the market for derivatives is large, documenting the size is difficult," he said, adding that there is confusion over the notional size of the derivatives as opposed to the replacement cost.
LaWare expressed concerns about bank mutual fund customers' understanding of potential investment risks, given that the funds are not federally insured.
"We remain concerned about public misconception," he said. "They must be advised that their principal is at risk."
LaWare said the Fed is also concerned about the expertise bank employees have in derivatives and is spending a lot of time on this issue.
"We have been concerned about bank advisers being fully aware of products," he said. "You have to be able to ask the right questions."
"That is a skilled job," he said. "If you're just there to earn a commission, you may very well end up giving the wrong advice."
LaWare applauded current efforts by the Securities and Exchange Commission and top industry representatives to devise voluntary guidelines for derivatives affiliates.
He said that if certain aspects of the SEC guidelines enhance current Federal Reserve guidelines they would be used.
"We would want to incorporate those enhancements," he said. ordination is really important on this issue."