The long-awaited report by the General Accounting Office says all unregulated players should either be brought under the supervision of the US Securities and Exchange Commission or be regulated by three or four agencies, as the US government securities market is.
The report 'recommends that Congress require federal regulation of the safety and soundness of all major US over-the-counter derivatives dealers' - including insurance companies and the seven trading subsidiaries established by big Wall Street firms to avoid the SEC's rules on disclosure and capital reserves.
The report, commissioned by Democrats in the House of Representatives two years ago, concedes that derivatives - the umbrella term for abstract financial instruments such as futures, options and swaps - serve an important hedging function, helping companies to predict prices despite swings in interest rates, currencies and commodity values. But it said risks were posed by the fact that US derivatives trading is concentrated among 15 key dealers that operate globally and are extensively linked to one another.
'The sudden failure or abrupt withdrawal from trading of any of these large dealers could cause liquidity problems in the markets and could also pose risks to others,' the report says. While it is unlikely that Washington would act to prevent any one trader from failing, it would intervene to 'keep the financial system functioning in cases of severe financial stress.'
The report, which will almost certainly encourage calls by the House banking committee's chairman, Henry Gonzalez, for new legislation, drew a sharp rebuke from the leading trade associations whose members deal in derivatives, including the Public Securities Association, the American Bankers Association, and the International Swaps and Derivatives Association.
The recommendations would sharply increase the cost of derivatives and reduce their availability, they said. Legislation 'will harm the American economy' and could drive the dollars 12,000bn business offshore, the groups said.
They said many regulators who once worried about internal controls and risk management - notably the former Federal Reserve governor Gerald Corrigan - have come to agree that the system is well equipped to monitor the market.
But the report by the Accounting Office - whose director, Charles Bowsher, is to testify before Congress today - said the weaknesses and gaps in derivatives regulation demonstrate the need to 'revamp and modernise the entire US financial regulatory system.'
In the meantime, the report's recommendations include:
Disclosure by firms of the identities of the counter-parties to their derivatives deals, as well as information on their profits;
The establishment of minimum capital standards for dealers;
The creation of independent audits and internal reporting of derivatives trading to company directors and external auditors;
New accounting standards for firms that invest in derivatives requiring them to disclose their holdings to shareholders, and possibly requiring them to make their value known to the market;
Pressing regulators in other countries to harmonise disclosure, capital, examination and accounting standards for derivatives.
Mr Gonzalez has promised to have a bill regulating the market ready for debate before Congress's summer recess begins in July.
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