On Wednesday, Treasury Secretary Timothy Geithner wrote a brief letter outlining proposed regulation of the enormous $600 trillion derivatives market.  In it, he calls “for federal regulators to be given comprehensive authority, for the first time, to police all derivative markets and derivative dealers; for the establishment of clearing, margin, and capital requirements to reduce risk; and for authority to impose position limits on over-the-counter derivatives to prevent market manipulation and excessive speculation. The letter also proposed important derivative reporting and recordkeeping requirements that could be satisfied in part by clearinghouse or regulated trade repository records.”

While most market observers agree that regulation of this market is essential for reducing systemic risk to our economy, many disagree as to the forms these reforms should take and fear that the Geithner proposal will leave dangerous loopholes that will leave us exposed to further danger.

The New York Times reports:

Mr. Geithner suggested that derivatives should be split between standardized instruments, which would be traded on regulated exchanges, and privately negotiated contracts, customized deals (often called “swaps”) that are made between two financial organizations and would not be publicly traded or regulated. Rather, such transactions would be reported privately to a “trade repository,” which apparently would make only limited aggregate data available to the public.

The problem with this, according to critics, is the danger that “today’s exception could become tomorrow’s rule.”  Derivatives have proved an extremely useful tool to investment banks and counterparties seeking shelter in the opacity of lax or non-existing oversight and disclosure requirements.  Should new regulations leave a gaping loophole that would allow these banks to continue pushing risks off their balance sheets or into offshore jurisdictions, the fear is that the banks will exploit it.

This criticism certainly has merit, and we hope that it will find a receptive audience with legislators and the Treasury Department alike.   Still, we are encouraged with this first step down the road to greater accountability and transparency for banks in the operation of this enormous market.  Here is a chance for Timothy Geithner to put his stamp on the future of US financial regulation.  Properly executed, these reforms have the potential of going a long way towards re-establishing trust in our badly shaken banking system.