SEC Chief Testifies About Changes She Wants in Derivatives Reform Proposal

Mary Schapiro, chairwoman of the U.S. Securities and Exchange Commission, testified before a U.S. House of Representatives hearing on the over-the-counter derivatives market, suggesting Obama administration reform proposals might not go far enough in some areas and could need work.

"The recent financial crisis has revealed serious weaknesses in U.S. financial regulation," she said in testimony to the Agriculture Committee. "Fixing these weaknesses is vital, particularly in the current market environment, and it is a goal to which the SEC is absolutely committed. ... It is critical that we work together to enact legislation that will bring greater transparency and oversight to the OTC derivatives market."

One category of derivatives -- credit default swaps -- paved the risky path toward the near-collapse of American International Group Inc.

Credit default swaps built up "enormous risks" in the financial system and "these risks contributed to the collapse of major financial firms in the past year and severe stress throughout the financial system," according to the U.S. Department of the Treasury announcement of its recent proposal to regulate the markets. Its legislative suggestions would regulate trading, tighten trading eligibility and provide market transparency for derivatives ? entities more commonly associated with investment banks than insurance companies (BestWire, Aug. 12, 2009).

Schapiro thinks Treasury's proposal should be pushed farther. "I believe it should be strengthened in several ways to further avoid regulatory gaps," Schapiro argued. She thinks the legislative ideas should be "enhanced" to eliminate regulator shopping, prevent exclusions for foreign currency swaps and forwards being used to avoid regulation and to increase protections against insolvency risk. "In addition, Congress should consider revising the qualification standards for participation in the OTC derivatives markets."

She pointed out the importance of this regulatory reform effort to the overall economy: "The derivatives market has grown enormously since the late 1990s to approximately $450 trillion of outstanding notional amount in June 2009."

"The financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system," said Gary Gensler, chairman of the Commodity Futures Trading Commission, which would share oversight duties of the derivatives markets with the SEC under the administration's proposal. He was the other witness at the hearing. "Every single taxpayer in this room -- both the members of this committee and the audience -- put money into a company that most Americans had never even heard of. Approximately $180 billion of the tax dollars that you and I paid went into AIG to keep its collapse from further harming the economy...The AIG subsidiary that dealt in derivatives -- AIG Financial Products -- was not subject to any effective federal regulation of its trading."

Schapiro generally argued that the proposal from Treasury is "a significant step toward addressing current problems" and should be adopted by Congress. "I strongly encourage Congress to build off this proposal and enact legislation that will bring even more vital transparency and oversight to this market."

The derivatives markets represent just one of several areas of the U.S. financial system the Obama administration is attempting to reform this year, though the effort's momentum has been slowed by Congress' focus on health care reform.

Most AIG insurance companies currently have a Best's Financial Strength Rating of A (Excellent) with a negative outlook.