Derivatives Reform Would Be Huge

It looks like banks are losing the battle over so-called "over the counter" derivatives, the clearest sign yet that we may see meaningful reform of our financial system.
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NEW YORK (

TheStreet

) -- It looks like banks are losing the battle over so-called "over-the-counter" derivatives, the clearest sign yet that we may see meaningful reform of our financial system.

The latest indication that U.S. legislators are committed to spoiling the party for the banks came Tuesday when Senate Agriculture Committee chairwoman Blanche Lincoln (D., Ark.) said she plans to propose legislation that would force virtually all companies trading such derivatives to do so on centralized exchanges, according to a

report

in

The New York Times

.

The goal of such reforms is not, as the banks' less subtle advocates would surely argue, to keep Wall Street from making money. Instead, it is about enormous hidden risks lying on bank balance sheets. As

The Wall Street Journal

's Peter Eavis succinctly put it Wednesday, "a bank may have a large derivatives position but avoid posting cash up front with its trading partner as others do." When banks don't put up collateral, it means the government is on the hook if these trades fall apart.

Over-the-counter (OTC) derivatives are privately negotiated contracts that occur off exchanges and are largely free from regulation. The OTC market currently stands at more than $600 trillion, according to

a report this month from the International Monetary Fund

.

Such transactions were at the heart of the financial crisis, as institutions like

American International Group

(AIG) - Get Report

wrote more than $1 trillion worth of contracts, mostly to protect investors from a range of real-estate related exposures. AIG, of course, was eventually laid low by the credit crisis and has had to accept $182 billion in bailout money from the U.S. government in order to survive.

Goldman Sachs

(GS) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

and

Morgan Stanley

(MS) - Get Report

have been lobbying to keep large portions of the OTC derivatives market off exchanges, as it will make it harder to see what the prices are on many securities.

The lack of transparency leaves big room for profits for the giant banks, which control an outsized portion of the market. A

Fitch Ratings report last year

looked at the derivatives exposures of 100 U.S. companies and found that 80% of the outstanding assets and liabilities were held by the three banks mentioned above, along with

Citigroup

(C) - Get Report

and

Bank of America

(BAC) - Get Report

.

Keep in mind, however, that putting derivatives on exchanges, and requiring central clearing (which essentially just means more cash up front) won't necessarily be the panacea many seem to think it will be. Exchanges are limited liability corporations these days, and don't offer as strong protections against the collapse of one trading party as they used to. Still, it will be a big improvement from where we are today.

--

Written by Dan Freed in New York

.