Regulating the derivative market

NY Times:

In its first detailed effort to overhaul financial regulation, the Obama administration on Wednesday sought new authority over the complex financial instruments, known as derivatives, that were a major cause of the financial crisis and have gone largely unregulated for decades.

The administration asked Congress to move quickly on legislation that would allow federal oversight of many kinds of exotic instruments, including credit default swaps, the insurance contracts that caused the near-collapse of the American International Group.

The Treasury secretary, Timothy F. Geithner, said the measure should require swaps and other types of derivatives to be traded on exchanges and backed by capital reserves, much like the capital cushions that banks must set aside in case a borrower defaults on a loan. Taken together, the rules would likely make it more expensive for issuers, dealers and buyers alike to participate in the derivatives markets.

The proposal will probably force many types of derivatives into the open, reducing the role of the so-called shadow banking system that has arisen around them.

...

This is not at all unexpected and is probably needed. Because of the profound failure of risk analysis by the firms trading these products, their losses were more than they could bare and the government had to step in to save the credit markets. There was also a failure of the underlying assumptions that normally exempted these securities from regulation of the issuers and those trading in them. These failed assumptions also led to huge losses in the market and the need for a massive response from the government that we are still dealing with.

Regulating the issuance and sale of these securities makes more sense than some of the control freak responses the Obama administration has attempted to enforce on salaries and other expenditures of companies that borrowed money from the government. It should be a regulation that forces disclosure of the risks of the instruments and controls the exposure of firms dealing in the instruments.