Lawmaker Looks to Regulate Derivatives

A prominent lawmaker says financial derivatives like credit default swaps need to be regulated.  Sen. Tom Harkin (D-Iowa) said yesterday that he plans on introducing new legislation that would force such derivatives onto futures exchanges.

The unregulated derivatives market has shouldered much of the blame for the current global financial crisis.  Derivatives are financial instruments whose value is based on an underlying assets, such as commodities, stocks, residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indices (such as a stock market index or the consumer price index ).

One type of derivative that has been the subject of much scorn recently is the credit default swap.  A credit default swap consists of an insurance-like contract that promises to cover losses on certain securities in the event of a third-party default. Swaps hold many risks, especially in a bad economy.

In 2008, volatility in the credit default swap market led American International Group Inc. (AIG) to report the largest loss in its history, due to an $11-billion write-down of its credit default swap holdings. This prompted the federal government to prop AIG up with an $85 billion loan. The unregulated credit default swap market also played a major role in the abrupt demise of Bear Stearns and the dramatic bankruptcy of Lehman Brothers.

Dow Jones Newswire is reporting that under Harkins proposed law  – the Derivatives Trading Integrity Act -  such financial instruments would be defined and traded as futures contracts. Thus, the U.S. Commodity Futures Trading Commission (CFTC) would have sole regulatory jurisdiction over the market.  It would also mean that they could be subject to CFTC-imposed speculative position limits and federal reporting requirements, Dow Jones reported.

“The economic downturn in this country is forcing us to examine all contributing factors on our markets,” Harkin said. “With the value of swaps at a high of some $531 trillion for the middle of this year – 8 1/2 times the world GDP [gross domestic product] of $62 trillion – it is long past time for accountability in the markets.”

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