In a draft two-page letter to congressional leaders, the Treasury Department says it wants to create a central electronic-based system that would track the buying and selling of derivatives. It also wants to ensure that financial firms selling the instruments have enough capital on hand in case they default and subject them to stringent standards of conduct and new reporting requirements.
The legislative proposal, to be announced later Wednesday by Treasury Secretary Timothy Geithner, is the administration's first major step in overhauling the nation's financial regulatory system.
"All (over-the-counter) derivatives dealers and all other firms whose activities in those markets create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation," Treasury wrote in its draft letter.
"Key elements of that robust regulatory regime must include conservative capital requirements, business conduct standards, reporting requirements and conservative requirements relating to initial margins on counterparty credit exposures," the department adds.
Current law largely excludes regulation of instruments, which are referred to as "over-the-counter" derivatives because they are privately traded.
New rules would deter financial firms from taking undue risk, prevent fraud and ensure they are marketed appropriately, Geithner said in the draft letter.
Geithner, who was expected to brief reporters on Wednesday, said in congressional testimony last month that he wants to force these types of contracts to be cleared through a central system.
"Let me be clear: The days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers from losses must end," Geithner told Congress.
The value of over-the-counter derivatives hinges on an underlying figure or commodity â€" ranging from currency rate swaps to oil futures and inflation bets. The derivative reduces the risk of loss from the underlying asset. The global business world holds a staggering $600 trillion of these contracts.
One of the most infamous examples of the derivatives were credit-default swaps sold by American International Group Inc. AIG sold the swaps to investors as a kind of insurance to protect against defaults on mortgage-backed securities. But the company had to accept a hefty federal bailout after it was unable to support the contracts.
Under Treasury's new plan, companies like AIG would have to prove they have enough reserve capital to support its sale of the derivatives.
Also under the plan, the Commodity Futures Trading Commission would establish an "audit trail" for the derivatives and have "clear unimpeded authority to police fraud, market manipulation and other market abuses" involving the derivatives. The Securities Exchange Commission would be given "comparable authority," including tools to prevent insider trading.
The new system should enable the regulators to "detect and deter all such market abuses," Geithner states.