NU Online News Service, Oct. 7, 3:15 p.m. EDT

The chairman of the Commodities Futures Trading Commission today cited American International Group as the poster child for the need for strong regulation of the over-the-counter derivatives market.

Gary Gensler made his comments at a hearing before the House Financial Services Committee on draft legislation, designed to impose strong regulation on the swaps. The draft was prepared by the staff of the FSC and released for discussion early this week by Rep. Barney Frank, D-Mass., who chairs the committee.

Mr. Gensler also testified that AIG's problems highlight all four of the reasons the swaps markets, that led to AIG's failure, must be brought under control.

First, those financial institutions that deal in derivatives should be required to have sufficient capital, Mr. Gensler said.

Second, swap dealers should be required to post and collect margins for individual transactions.

Third, regulators should be able to mandate robust business conduct standards to protect market integrity and lower risk, Mr. Gensler said.

"Fourth, where possible, OTC transactions should be required to be cleared by robustly regulated central counterparties," Mr. Gensler said.

While Mr. Gensler opened the hearing by saying that through AIG, the financial system and federal regulators "failed the American public," the reaction to Rep. Frank's legislation to deal with the issue, was criticism for being too weak from regulators and members of Congress.

For example, Mr. Gensler said the legislation should be amended so that hedge funds or financial firms could not evade requirements that their derivative contracts go through central clearinghouses.

Mr. Gensler also said the proposal does not clearly state whether regulators would have to determine on a case-by-case basis whether swaps would be subject to clearing.

Henry T.C. Hu, director of the SEC's new division of risk, strategy and financial innovation, added that "certain aspects of the discussion draft could unintentionally preserve existing regulatory gaps."

That forced Rep. Frank to say he will "tighten up" his legislation to reduce loopholes in the rules cited by the critics. "There are some areas here where there are gaps that shouldn't have been there," Rep. Frank acknowledged.

The Obama administration's proposed legislation to deal with the issue would mandate that all standardized derivative transactions be executed on an exchange or processed through a regulated clearinghouse. This would impose collateral and margin requirements on trades.

The legislation proposed by Rep. Frank's bill would reduce the number of trades that would be forced to move to exchanges.

But Mr. Gensler's comments about AIG were the most dramatic part of the hearing on the draft legislation.

He called AIG "Exhibit A" of the failures of the financial system and the financial regulatory system last fall.

He said "AIG highlights the need for each of these four priorities. AIG was not required to meet capital standards or post margins for individual transactions."

Moreover, "It was not subject to business conduct standards for its back office functions," he said. "AIG's failure was essentially a failure of a central counterparty in the sense that it internalized the credit risks of its trades," he added.

"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," he said in prepared remarks.

He noted that "approximately $180 billion of our tax dollars went into AIG–that is nearly $414 million per each of your congressional districts," although AIG last week said that the amount it now owes the American people is $83 billion.

"While a year has passed and the system appears to have stabilized, we cannot relent in our mission to vigorously address weaknesses and gaps in our regulatory structure," Mr. Gensler said.

By moving bilateral trades into regulated clearinghouses, he said, "we will reduce the risk that a failure of one firm will cause other firms to fail as well."

He added, "Ineffective regulation allowed the failure of AIG Financial Products and the derivative dealers affiliated with Lehman Brothers, Bear Stearns and investment banks to affect the entire financial system.

"We must ensure that this never happens again. We cannot afford any more multi-billion-dollar bailouts," he concluded.

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AIG Cited As Basis For Strong Swaps Market Oversight

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