UPDATE 2-Derivative reforms key for US recovery-Gensler

Fri Jan 29, 2010 4:45pm EST

(Recasts, adds details, context)

NAPLES, Florida Jan 29 (Reuters) - Reforming the $450 trillion derivatives market is key to removing the risks of financial markets, and greater central clearing of privately traded derivatives is a vital part of that, the head of the Commodities Futures Trading Commission said on Friday.

Central clearing, in which a counterparty stands between two trading partners and guarantees the trade, is needed to remove risks from banks, Gary Gensler, chairman of the CFTC, said at a conference hosted by the American Bar Association in Naples, Florida. He also called for greater transparency.

Banks are at greater risk of failure than exchanges because they also have large lending and trading operations.

Derivatives, which are based on underlying assets including bonds and commodities or can be tied to currency and interest rate moves, have been blamed for exacerbating the credit crisis and contributing to a run on assets that helped fell banks including Lehman Brothers.

And insurer American International Group's (AIG.N) outsized exposure to risky assets using credit default swaps, which are used to insure against a debt default, led to its need for a massive government bailout.

Lawmakers internationally are developing rules to regulate the markets, move standardized contracts to central counterparties, and limit positions taken on by large market participants.

Gensler said that proposals to exempt from central clearing certain end users of derivatives must be very narrowly defined to ensure the majority of the risk does not remain with large banks. End users include industrial companies that use derivatives contracts to protect against interest rate, currency, commodity and other risks.

Data from the Bank for International Settlements shows that only around 40 percent of derivatives volumes are made between the largest dealers, indicating that 60 percent of the market could potentially be exempted from clearing requirements, Gensler said.

Financial companies including insurers and hedge funds, also should not be exempt from central clearing, as they should be sufficiently liquid to meet the margin requirements of central counterparties, Gensler said.

Some industrial companies have said that mandating central clearing of their positions would add significant costs to their business due to the requirement to post margin against the trades, which bank counterparties do not always require.

TRANSPARENCY

Transparency of derivatives contracts is also key to reforming derivatives markets, Gensler said.

"I believe that financial reform would be incomplete if we do not bring public transparency to the over-the-counter derivative marketplace," he said.

Transparency, in which trade prices can be seen through exchanges or other electronic trading platforms, enhances market liquidity and creates a more competitive marketplace by bringing in new players, which in turn reduces trading costs, he said.

The move would shift the advantage of price and trading information from the large dealers to the end users, Gensler said.

Transparency should be also be required for contracts that are not centrally cleared, he said, adding, "Commercial end users are concerned about the cost of clearing, but there is not a cost to transparency."

Technology exists that would allow derivatives users to use electronic platforms to receive quotes form numerous counterparties, and choose the best price to execute on, he said. (Reporting by Karen Brettell; Editing by Leslie Adler)