Regulators and lawmakers are moving into high gear to scrutinize the derivatives activities of commercial banks.

American Banker asked Joseph P. Bauman, Citibank's head of business development for Global Derivatives and chairman of the International Swaps and Derivatives Association, or ISDA, about regulating the derivatives markets:

Q.: How should derivatives activity be regulated?

BAUMAN: Derivatives dealers are currently regulated through their institutional regulators. This makes sense since the activities themselves do not exist in a vacuum within the firms.

Derivatives are offered alongside many of our other activities with our clients, such as corporate finance lending in the case of commercial banks or underwriting for investment banks.

Q.: Do the regulators know what they're looking at?

BAUMAN: Absolutely. The regulators understand the risks being taken and the business environment. But as in all regulatory environments, you probably have the situation in an activity characterized by innovation that the person who's doing the business is one step ahead of you in product knowledge.

Q.: Has that slowed you down at all?

BAUMAN: We have not found it slowing us down. Perhaps a couple of years ago, when the products were expanding beyond interest rates and currency swaps, this might have occurred. But we have not found it to be so now.

Q.: How much of derivatives use is just plain gambling?

BAUMAN: I think very little of the activity is speculative in nature. These are not instruments that lend themselves to that kind of use. The activity has developed out of, and continues to be driven by, end users who are looking to hedge or manage real financial risk.

Q.: How risky are derivatives?

BAUMAN: It's important to realize the risks in the derivatives business -- credit, market, legal, and operational -- are no different than the risks that financial intermediaries take in all their other lines of business. So we view the risks as being very consistent with the role of financial intermediaries in general.

Keep in mind some specifics. On the credit side, our customers are the highest-credit-quality institutions, and industry data confirm this. Less than one-half of one percent of the market value of all swaps has been lost due to credit defaults.

On the market-risk side, a variety of studies have already pointed out that dealers can manage these risks.

As far as legal and operational risk is concerned, ISDA has developed documentation that eliminates legal uncertainty on enforceability of derivatives contracts in all jurisdictions around the world.

Q.: What kind of additional regulation do you think you'll get?

BAUMAN: We think that the education efforts directed at congressional staff and with the regulators will lead to recognition that the current environment is one that should be continued, one that encourages firms to act efficiently and responsibly.

As several regulators have said, there 's no need for wholesale change in the way the businesses are managed or regulated.

Q.: What do you think is going to come out of the House Banking Committee hearing?

BAUMAN: We hope it gives a forum for the airing of a variety of points: that derivatives are a product that has developed because of the needs of firms to manage risk, that there are facilities in place within dealer institutions that can manage these risks,... and that the regulatory and supervisory activities are adequate and appropriate to monitor both the progress of the market in general [and] individual firms.

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