WASHINGTON — The Treasury Department set its sights on tough regulation for over-the-counter derivatives with the release Tuesday of legislative language that is stricter than other recent proposals.
The Treasury's bill would let bank regulators set margin and capital requirements for banks entering into derivatives contracts. All firms using derivatives, whether they were trading them as major market participants or forging swap agreements as end users to hedge risk, would have to have their standardized contracts centrally cleared and traded over regulated exchanges.
The Treasury also outlined separate requirements for dealers of derivatives to not only clear standardized contracts, but trade them on exchanges. Dealers will no longer be able to directly trade standardized contracts among themselves; they will have to use an exchange or an equivalent trading platform.
"There will be significant incentives for financial institutions both large and small to use more standardized products in the future," Michael Barr, the Treasury's assistant secretary for financial stability, said during a conference call with reporters.
Barr denied that lack of any exemption for end users from clearing requirements would put a squeeze on small banks trying to hedge their risks.
"I think that they'll find the new system much less subject to the concerns that we saw in the last financial crisis and for which they and all of us are currently paying."
In these respects and others, the bill is tougher than one authored by House Financial Services Chairman Barney Frank, D-Mass., and House Agriculture Committee Chairman Collin Peterson, D-Minn.
"It's a very strong piece of legislation. It carries forth what the administration had been promising," said Michael Greenberger, a professor at the University of Maryland School of Law.
Also differing from the Frank-Peterson proposal, the Treasury's bill would divide jurisdiction between the Securities and Exchange Commission and the Commodity Futures Trading Commission based on the distinction between contracts derived from a narrow index or single security, such as a stock, and contracts based on broad indexes.
Frank and Peterson wanted to divide jurisdiction along the lines of the underlying asset, giving credit-based derivatives to the SEC and commodity-based derivatives to the CFTC.
The Treasury's approach would effectively divvy up regulation of the most infamous of credit derivatives — credit default swaps — which have been the target of scrutiny by lawmakers and the public since the credit crisis began last year. Unlike the Frank-Peterson proposal, the Treasury would not place specific limits on trading CDS.
The Treasury's proposal would, however, "fundamentally change the nature of the CDS market by requiring for the first time meaningful, full transparency," said Barr.
The Treasury envisions a central repository for information on all derivatives trades, both standardized and customized. The SEC and the CFTC would jointly determine the definition of standardization within six months after enactment.
"Standardized products are presumed to be standardized if they are centrally cleared," Barr explained, but the two regulators will have a final say on the level of standardization of a contract.