Tim Geithner's latest headache
The treasury secretary's bid to rein in derivatives meets skepticism.
NEW YORK (Fortune) -- The Obama Administration has given itself two months to tell Congress what new legislation is needed to control over-the-counter derivatives, and testimony by Secretary of the Treasury Timothy Geithner late last week indicated how incredibly difficult the job of writing a law is going to be.
Scores of House members turned up to express their special concerns: Will grain elevator operators be required to register as users of derivatives? Can utilities continue to enter into the customized OTC contracts they regard as essential to their business? How, Secretary Geithner, are you going to prevent the derivatives business from migrating to Dubai?
Answering his critics, Geithner said repeatedly the government needed "to find the right balance" between conflicting arguments and conceded that regulation will be "an enormously complex process." But failure is not an option, he said, because the economic crisis has demonstrated how destructive derivatives can be and how urgent the need is to subject them to new oversight.
Testifying on another day at a different hearing, derivatives expert Henry Hu, a University of Texas law professor who will soon take a leave of absence to work for the Securities & Exchange Commission, concurred that this is "a seminal time" for OTC regulation. Hu also underscored the complexity of the problem and its myriad parts by drawing on the humor of Woody Allen, who once said: "I took a speed reading course and read War and Peace in twenty minutes. It's about Russia."
The Administration wants all derivatives to be regulated. What are called standardized contracts -- for example, a 5-year, $10 million credit default swap on a well-known company -- would move into regulated clearing houses that guarantee payment on all contracts. Derivatives that are customized and not suitable for clearing must, in the Administration's opinion, be backed by large amounts of capital -- which AIG's credit default swaps, for example, horrendously weren't. Traders of these customized derivatives must also report details about them to some central authority, not yet specified, so that at least some degree of transparency would be imparted to a market up to now opaque.
Unfortunately, at this point no criteria exist for saying which contracts belong in a clearing house, and the big derivatives dealers -- most of them big banks -- will be resisting any attempt to define "standardized" broadly. Don't forget, said Representative Collin Peterson (D-Minn.), head of the House agricultural committee, "The banks make a lot more money on customized derivatives than they do on standardized." The differential prevails because customized products, as is typical in most markets, escape tough price competition.
As for who will have jurisdiction over the market, more agreement exists. Peterson opened the hearing by saying flatly that he and House Financial Services Committee chairman Barney Frank have concluded that the SEC and the Commodity Futures Trading Commission will not be merged, despite what some regulatory reformers have urged.
Jointly spared, these two agencies have come up with a plan to share the work. The SEC is asking for authority over equity derivatives and credit default swaps, two kinds of instruments that the commission considers "securities-related." The CFTC, long the regulator of exchange-traded commodity derivatives, wants authority over interest-rate and all other derivatives.
The two agencies have said they will work closely together to make sure that no "gaps" in oversight develop. Coming from the SEC, it must be said, that claim seems ludicrous considering that the commission may hold the record for being oblivious to gaps, having allowed Bernie Madoff to steal from investors for decades.
In the world of derivatives, the danger of flawed oversight is further increased by the speed with which "financial innovation" whips out new products that exploit even the tiniest regulatory crack. Tim Geithner himself acknowledged that credit default swaps took that kind of exploitation to an extreme, permitting most visibly the AIG (AIG, Fortune 500) disaster. "We did not keep abreast of that innovation," he said. "We were behind the curve." Which is where Washington stands now as it tries to rewrite the rules for everything that goes by the name of derivatives. 
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