It is commonly acknowledged in the nation's capital that the way to kill something is to set up a commission and study it to death.

But that maxim does not apply to the fast-growing, sophisticated derivatives market, which most observers say has not been studied enough.

During the past few months, federal regulators, a congressional subcommittee, and industry groups have all begun studying derivatives. Their goal is to gauge the scope of the market and to determine whether it poses risks for other globally linked financial markets.

What are the potential risks?

Federal regulators say they are worried that a disruption in the derivatives market, or the failure of a firm heavily involved in derivatives, could have a domino effect and hurt other financial institutions or cause disruptions in other financial markets, like the stock markets.

"We used to think in regulatory circles that you could wall off a potential problem and therefore limit the risk," Susan Phillips, a Federal Reserve Board governor, told swaps market participants meeting in Washington, D.C., last month.

However, she added, "It's not clear anymore that you could wall off one kind of activity." The derivatives market has grown so large, she said, "there's a concern that if there were a problem, it couldn't necessarily be contained within one domestic regulatory sphere."

Concerns about derivatives have arisen because the products have become an important source of profit for banks and other financial institutions, Phillips told the swaps group. "We're seeing more and more activities by a broader range of financial and nonfinancial firms," she said.

Federal regulators and lawmakers have had trouble getting a handle on the use of these products and the scope of the market because most financial institutions treat derivatives as off-balance sheet items and do not report them as assets or liabilities.

A number of broker-dealers have begun doing derivatives transactions through recently established, highly rated affiliates that have not been subject to Securities and Exchange Commission reporting or capital requirements.

During the past year, the Federal Reserve System, through the Bank for International Settlements, and the SEC have begun trying to obtain information about the scope of derivatives activities by financial institutions and the risks associated with these activities. In July, the SEC approved a rule requiring broker-dealers and their affiliates to submit certain information.

Along with these efforts, the House Energy and Commerce Committee's subcommittee on telecommunications and finance; the Group of Thirty, a group of international financial leaders; and the Public Securities Association have also begun trying to identify and put in perspective the risks associated with these products.

~Regulatory Takeover'

At least one Bush administration official is worried some of these studies could ultimately hurt the derivatives market.

Wendy L. Gramm, the chairwoman of the Commodity Futures Trading Commission, warned swaps market participants last month that the studies may be setting the stage for an unwarranted "regulatory takeover" of the derivatives market. Some of them, she said, may produce "alarmist and incorrect" findings that could be used as "ammunition" by any member of Congress who wants to subject derivatives to futures regulations when the Commodity Exchange Act is reauthorized. The act is due to expire at the end of fiscal year 1994, which starts Oct. 1.

But interviews with officials involved in most of these studies suggest the opposite. So far, they say, they are finding that the derivatives market consists mostly of large, sophisticated players who have evaluated and taken steps to control the risks associated with such products.

The Bank for International Settlements in Basle, Switzerland, a bank made up of central bank officials from 10 countries, issued a report last month concluding that market participants have devoted considerable resources to evaluating and managing the risks of derivative transactions.

This "should reduce the likelihood of problems at individual institutions and of financial market disruptions more generally," the bank said.

The report also finds that most derivative transactions are concentrated among a smaller number of highly rated, well-capitalized firms.

The report shows that derivatives activities have expanded significantly since 1986. It shows the notional principal amounts of over the-counter instruments such as interest-rate and currency swaps increased nearly ninefold during a recent five-year period, growing from $500 billion in U.S. dollars in 1986 to $4.45 trillion in 1991. The notional principal amounts of exchange-traded instruments like futures and options jumped sixfold, from $583 billion in 1986 to $3.52 trillion in 1991, the report says.

But the working group that wrote the report said more information is needed on netting arrangements and accounting and reporting practices. The report advises firms "to develop contingency plans which take into account the potential problems to arise ..."

Larry J. Promisel, the senior associate director for the Federal Reserve System's division of international finance who chaired the working group, summarized the panel's work in a recent interview. "The derivatives markets perform valuable functions," he said, noting that most firms use derivatives for hedging purposes. "We want to make sure that the risks are known and that they are dealt with."

Brandon Becker, deputy director of the Securities and Exchange Commission's division of market regulation, said the information collected to date by the commission has not uncovered major problems in the managing of these risks by broker-dealers and their affiliates.

So far, he said, the SEC "hasn't seen any indication" that derivatives activities could lead to a disruption in the stock markets. He said also that, based on informal discussions with broker-dealers and their affiliates, the SEC "generally concurs ... that the risks are being managed" at this point.

Meanwhile, the General Accounting Office is expected to complete a report on the derivatives market next year for the telecommunications and finance subcommittee, which asked the GAO last June to start the study.

Since then, the congressional watchdog agency has been surveying a representative group of large, medium, and small firms that are involved in derivatives, as well as federal regulatory officials and others. The GAO is trying to determine who are the large players in the derivatives market, the market makers, and the end users of derivatives products, a GAO official said.

~A Big-Player Market'

The agency's report will try to assess the risks associated with derivatives and how they are being managed. It will also look at what the federal regulators know about the derivatives market and what they need to know, he said.

"So far it looks like this market is a very big-player market that is very credit-sensitive," the GAO official said, adding, "The question is, is this always going to be the case."

Industry groups are also studying derivatives products, with the aim of providing guidance to those that want to participate in them.

The Public Securities Association's credit research committee, an eight-member group that is chaired by Al Medioli, a vice president at AIG Financial Products Group Corp., is trying to develop a booklet designed to explain municipal derivatives and the potential credit risks associated with them.

The booklet, which is expected next year, will focus on interest rate swaps and secondary market custodial receipts such as strips, tender option bonds, and inverse floaters, committee sources said.

The risks to be addressed include a counterparty failing, interest rates turning against the investor, and state laws and documents not adequately covering a transaction.

The Group of Thirty is also considering developing a guide for managing derivatives' risks.

The group recently set up a steering committee and working group to study the derivatives market. Dennis Weatherstone, chairman of J.P. Morgan & Co., was named to head the steering committee. David Bruner, a director at Paribas Capital Markets in London, and Patrick de Saint-Aignan, a managing director of Morgan Stanley & Co., are chairing the working group.

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