http://www.bloomberg.com/apps/news?pid=20601068&sid=adyRr4PP035U&refer=economy By Matthew Leising May 6 (Bloomberg) -- The Federal Reserve is planning for the first time to break Wall Streetâs hammerlock on so-called over-the-counter derivatives and bring more regulation to the $684 trillion market. The central bank will require more transparency after the unregulated market contributed to the demise of Bear Stearns Cos. and Lehman Brothers Holdings Inc. and forced the government to use $182.5 billion to bail out American International Group Inc. The worldâs biggest financial companies reported more than $1.3 trillion in losses and writedowns since the start of 2007, in part from derivatives, according to data compiled by Bloomberg. The biggest sign of the Fedâs intentions came when Theo Lubke, the Federal Reserve Bank of New York official responsible for oversight of the market, said the biggest banks shouldnât be allowed to dominate trading of the financial contracts, which let investors hedge against losses or speculate on everything from changes in interest rates to corporate defaults. âIt is simply unacceptable in todayâs environment that the design and structure of the OTC derivatives market can be controlled by a handful of large dealers,â Lubke, a senior vice president at the New York Fed, said at an International Swaps and Derivatives Association conference in Beijing on April 22. Clearinghouse Effort Lubke, 42, was appointed to police OTC derivatives in 2007 by Timothy Geithner, now Treasury Secretary, when he was president of the New York Fed. The central bank has pushed banks to speed up confirmation of trades and use clearinghouses for credit-default swaps to reduce the risk of failed transactions. Capitalized by its members, a clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the default risk between parties to a trade. It also allows regulators to assess market positions and prices. The New York Fed got dealers to share power with investment firms by encouraging ISDA to appoint five buy-side firms including Newport Beach, California-based Pacific Investment Management Co. and Elliott Management Corp. of New York to its committee that makes binding decisions on how credit-default swap contracts are settled. Previously only banks made those decisions. ISDA is also located in New York. âWake-Upâ Statement The comments were âa wake-up type of statement,â said Bruce Weber, a professor of finance at the London Business School. Banks have resisted changes to the OTC market because they want to limit competition, he said. Lubkeâs views underscore a shift in Washington toward more regulation of markets. In March, Geithner laid out a broad effort in four areas where he said increased oversight is needed: systemic risk, consumer and investor protection, eliminating gaps in the regulatory structure and promoting international cooperation. He highlighted the interconnected nature of bank trading in unregulated markets and said a more conservative oversight regime was needed. President Barack Obama said April 14 he wants Congress to pass âtough new rulesâ for Wall Street so they can be enacted before year-end. The Fed regulates bank holding companies, giving it oversight for some of the largest over-the-counter derivatives dealers. Lubkeâs remarks at the derivatives industryâs annual meeting were made as a representative of the New York Fed. Lubke declined to elaborate on his comments. OTC âOpacityâ âThere is opacity in the OTC market that doesnât have commensurate public policy benefits,â Lubke said at the conference. âThis is not something that can continue.â Robert Pickel, chief executive officer of ISDA, which represents dealers, hedge funds and other investors in the privately negotiated derivatives industry, said all types of financial companies deserve representation in the over-the- counter market. âIn order to ensure participants have confidence in the operation of these markets, itâs important that they have a say in market developments,â Pickel said in an e-mailed statement. Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather. The U.S. government and the Fed have spent, lent or committed $12.8 trillion to stem the longest recession since the 1930s, which was triggered when credit markets froze in August 2007 after banks found they couldnât determine the value of derivatives tied to subprime mortgages. Complicating Efforts Over-the-counter derivatives, such as the $28 trillion credit-default swaps market, complicated U.S. and European efforts to unravel trades between banks. Bear Stearns was acquired by JPMorgan Chase & Co. last year, Lehman Brothers Holdings Inc. collapsed in the worldâs biggest bankruptcy and AIG is selling assets after losses from derivatives. All are based in New York. Credit-default swaps are contracts that pay the buyer the face value of a bond or a loan in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. They are used to hedge against risks and to speculate on a companyâs ability to repay debt. âIf this market is going to see its maturation into something that works for the benefit of the financial markets and participants as a whole, the arrangements of decision-making over key design elements need to be done in a more transparent manner,â Lubke told ISDA attendees. âThat includes a broader range of market participants being involved in that process.â Largest User JPMorgan is the largest user of over-the-counter derivatives, with $87.4 trillion in notional value last year, more than the next two largest, Bank of America Corp. and Citigroup Inc., combined, according to the Office for the Comptroller of the Currency. JPMorgan made $5 billion in profit from fixed-income over-the-counter trades last year, according to people familiar with the matter, who declined to be identified because the results arenât public. JPMorgan spokesman Brian Marchiony declined to discuss Lubkeâs comments. The New York Fed pushed last month for the worldâs largest banks to offer hedge funds and other clients access to clearinghouses that back trades in credit-default swaps. Intercontinental Exchange Inc. was first to back trades with its credit-default swap clearinghouse, ahead of rivals CME Group Inc. and NYSE Euronext. ICE Trust has guaranteed $257 billion of the contracts since March. No Link The New York Fed is concerned that credit-default swap clearinghouses lack a common feature of their counterparts for futures, allowing customers to segregate their trading from bank accounts. âBanks and buy-side firms still need to make considerable improvements to both risk management and the design of the OTC derivatives markets,â New York Fed President William Dudley said April 1 in a statement. Geithner said in March that the U.S. would for the first time regulate the market, and that clearinghouses for standardized products such as interest-rate swaps were needed to improve transparency. The trading data will be made public so prices are more visible and the Fed will âencourage greater use of exchange- traded instruments,â Geithner said March 26 in Congressional testimony. Dealer Framework Dealers such as JPMorgan, Goldman Sachs Group Inc. and UBS AG are working with ICE Trust on a framework in which client funds would be granted protections against counterparty default, such as segregated collateral accounts. The lack of segregated accounts led to losses for funds that posted excess collateral with Lehman Brothers last year after the securities firm filed for bankruptcy protection. This âstructural flawâ in the over-the-counter market was evident in the weeks leading to the collapse of Lehman Brothers and Bear Stearns last year, Lubke said. âWe saw a tremendous outflow of liquidity from each bank,â he said. âTheir buy-side counterparties didnât want to lose their initial margin if there was a bankruptcy proceeding.â Lubke, who began his career at the New York Fed in 1995, said there were benefits to the over-the-counter market and that not all derivatives should be made to trade on regulated exchanges. âThe challenge is to design policy solutions that can protect the positive aspects of the OTC market while bringing in the important benefits from an exchange environment,â he said. To contact the reporter on this story: Matthew Leising in New York at mleising@bloomberg.net I DO NOT LIKE DERIVATIVES. THEY ARE TRUE WMD