Treasury Wants To Track Derivatives

The Obama administration is proposing its first major step in overhauling the financial regulatory system. The plan would extend oversight to the buying and selling of derivatives. Those are the financial instruments that have been largely unregulated because they are traded privately. They were also a key factor in the recent financial meltdown.

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RENEE MONTAGNE, host:

And I'm Renee Montagne.

President Obama has made clear he wants to change the way Wall Street does business, and yesterday his administration announced it's going after one of the most profitable corners of the industry, the shadowy world of financial derivatives - which got us getting NPR's Jim Zarroli on the line.

Good morning.

JIM ZARROLI: Good morning.

MONTAGNE: Help us out here, Jim. What is a derivative, and how have they affected the economy?

ZARROLI: Well, I think one of the few things that people really understand about derivatives markets is that they're huge, and they've really just exploded in the past decade or so. There's one pretty reliable estimate that says that the value of all of the outstanding derivatives contracts is something like $680 trillion.

And it's pretty clear that derivatives played at least some part in the financial meltdown. One of the most frequently cited examples, of course, is credit default swaps. They're a kind of bet that investors place on whether a company is going to default on its debts.

AIG, for example, lost a large amount of money in credit default swaps, and that's why it had to be rescued by the federal government. So the administration is saying, you know, when you have that much exposure by that many big firms, it is a big systemic risk to the economy, and it's really time to begin regulating it.

MONTAGNE: What, precisely, then is the administration proposing to do about these derivatives?

ZARROLI: Well, the proposals that they put out yesterday are really just a kind of blueprint. The ideas will have to be fleshed out by Congress, by regulators. One of the ideas, for instance, would be the creation of a kind of central clearinghouse that would keep track of the buying and selling of certain kinds of derivatives - not all, but some of them.

So if you're, you know, if you're planning on doing business with a firm, you will have a way of determining what kind of exposure it has. This is, of course, one of the reasons why the credit markets got into such a tailspin last September. Now, everybody knew investors were in trouble, but there was no -there's no transparency. Nobody knew who owed what to whom. So lending really just ground to a halt, and it really hasn't recovered fully.

MONTAGNE: Well, essentially, derivatives were such, you know, big profit centers. How might these new regulations affect the financial firms that have traded in derivatives?

ZARROLI: Well, this is going to change their lives a lot. I mean, you know, one of the ideas put forward yesterday is to impose capital requirements on firms that deal in derivatives. They'd have to have a certain amount of money on hand essentially to cover their losses if the derivatives started to tank, just like banks have to have capital when they lend money. And that would almost certainly mean that a lot fewer derivatives would get sold.

The administration's also talking about, you know, sort of a - kind of a code of conduct for derivatives dealers. For instance, you know, they couldn't sell to unsophisticated investors. There've been a lot of cases of, you know, municipal governments, for instance, that were talked into investing money in derivatives. And later, after they lost money, they came back and said, you know, we didn't know what we were getting into.

So the administration has its way that these dealers are going to have to be more careful about how they market these products.

MONTAGNE: So far, how have those Wall Street firms reacted to the new plan to regulate them?

ZARROLI: Well, there is a trade group, the International Swaps and Derivatives Association, for the industry that put out a statement basically saying, you know, it looks forward to working with the administration. I think there clearly is going to be a lobbying battle over what kinds of rules get passed.

I also think that these firms sort of recognize that this is, you know, inevitable. The Democratic Congress wants to do this. It's politically popular. So I think a lot of derivatives firms are just kind of figuring, well, you know, at this point it's better to cut our losses and just try to have as much input into the process as we can.

MONTAGNE: Jim, thanks very much.

ZARROLI: You're welcome.

MONTAGNE: NPR's Jim Zarroli.

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