But a turf war is brewing among three leading federal agencies that have contrasting visions for how the $55 trillion market for speculative financial instruments known as credit-default swaps should be regulated.
While the credit crisis has upended global financial markets and given a lift to advocates of heightened regulation, it has not resolved traditional disputes in Washington over how deeply the government should be involved in free markets.
Some regulators say the market can operate largely on its own but simply needs more transparency. Others say that the credit crisis has exposed wide gaps in oversight that require a much more direct role by the government.
The battle has mobilized the financial industry and lawmakers who are holding a hearing today on market regulation. Some industry players are lobbying sympathetic members of Congress for light oversight. Powerful financial firms, eyeing new fees, are campaigning to play a major role in running the market for swaps, which originated as a form of insurance against bond defaults but grew into a wildly popular vehicle for speculation.
Last month, insurance giant American International Group nearly collapsed partly because it had issued $440 billion in swaps to traders around the world and was not going to be able to cover many of the promises it had made to cover defaults on debt. Government officials realized that swaps could pose a threat to the global financial system.
AIG was kept alive by a $85 billion loan from the Federal Reserve, which grew a few weeks later to about $123 billion, the Fed's largest bailout ever for a single firm.
"If there's a sense that another AIG could happen and a whole swath of financial institutions could be jeopardized, then the efforts to restore confidence are really undermined," said Henry Hu, a law professor at the University of Texas. "Without that confidence, there's no free flow of credit, and without the free flow of credit, there's a risk to the real economy."
Regulators have much at stake as well. The focus in Washington on swaps presents an opportunity for the Securities and Exchange Commission to restore its reputation as an active supervisor of the markets after being criticized as lax during the early stages of the financial crisis, analysts said. The agency is considering regulating swaps with some of the same scrutiny it does for stocks and bonds.
That could put it at odds with the Commodity Futures Trading Commission, which could inherit some oversight responsibilities under one industry proposal for establishing a new means of settling swap contracts. The commission's acting chairman told lawmakers at a hearing last week that current law exempts swaps from regulation and that "wholesale regulatory reform will require careful consideration."
Meanwhile, the Federal Reserve Bank of New York is proceeding with its own plans to set up a private-sector process under its jurisdiction for settling swap contracts. The goal is to bring some transparency and stability to the market.
The fate of the credit-default swap market will largely rest on how Congress defines these contracts in law.
The credit crisis has revealed how risky these swaps are without government oversight, said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, which is holding a hearing on financial regulation today.
"I understand why my Republican colleagues do not want to examine our failure to regulate credit default swaps [and other derivatives] and the other fruits of their deregulatory push," Frank said in a recent statement. "The results of that effort are now in -- a crisis that is sweeping the global economy and threatening tens of millions of working families."
Originally, swaps acted like insurance policies for bond investors in case a company collapsed and could not pay back buyers of its bonds. To protect themselves against such defaults, bond investors could agree to pay a periodic fee to have another party cover the losses.
Unlike stocks and bonds, credit-default swaps fell outside the government's purview largely because they are private contracts. A law backed by leading Republicans and passed by Congress in 2000 specifically exempted swaps from oversight by the SEC and CFTC, which oversees commodity trading.
Since then, big hedge funds and other traders discovered that swaps could be traded and used to speculate on how close a company was to collapse. The market mushroomed. Its total value outgrew that of all publicly traded stocks combined. The swaps market began to affect the financial system in once unimagined ways.
The SEC grew concerned that traders were using swaps to manipulate stock prices. In recent weeks, dramatic surges in swap contract prices to protect against a default by Morgan Stanley and other banks helped drive down their stocks.
Industry officials, however, warned of the dangers of over-regulation and said swaps were not to blame for the crisis.
"I think the clear effect is if further regulatory burdens are put on these instruments, people would look to trade them elsewhere around the world," said Robert Pickel, chief executive of the International Swaps and Derivatives Association. He said lawmakers were blaming swaps for the financial crisis just because they're complex. "But when you probe and further understand what's going on in the markets, especially in regard to imprudent lending, you'll see that those dots cannot be connected," he said.
Lawmakers are divided on what should be done. Some want traders to meet strict capital requirements, referring to how much money an investor can borrow to buy a swaps contract. Others want to put all derivatives -- even those invented in the future -- under the oversight of the SEC, which could force traders to disclose detailed information to regulators on their activities. Still others are opposed to any additional regulation at all.
In a hearing last week, Sen. Michael D. Crapo (R-Idaho), who sits on the Senate Agriculture Committee, said that it was important to make "sure that we allow capital to move freely and efficiently in a market system," but also that the government must protect against "inappropriate manipulation of markets." The House and Senate agriculture committees have oversight of the CTFC because of its history regulating farming commodities.
There is also disagreement over who should be in charge. Members of the House Agriculture Committee said they would like the CFTC to watch the market.
But Sen. Maria Cantwell (D-Wash.) said the CFTC is too close to private industry players. The CFTC "is just looking over the cliff that the American economy is falling into and saying: 'Let's just have self-policing.' It's absurd," she said, adding that she would prefer the SEC to have the job. "We are in this mess because the oversight agencies didn't do this job."
Meanwhile, the New York Fed has been meeting with private companies to set up a private clearinghouse for swap trades that could be in operation by the end of the year.
The clearinghouse, for a fee, would act as an intermediary that would guarantee transactions between swaps traders. In order to make those guarantees, the clearinghouse would require traders to maintain a sufficient amount of capital in their accounts. That would make it difficult to trade swaps without having the resources to cover a contract should a default happen.
One of the firms working closely with the New York Fed is the IntercontinentalExchange, or ICE, which plans to set up a clearinghouse in New York under the Fed's authority. ICE was established by some of the country's biggest banks, including Goldman Sachs and Morgan Stanley.
Another firm, CME Group, is vying to set up a clearinghouse, which would be part of the operation the company now runs for trading commodities with CFTC oversight. The Fed could back one or both of the plans, according to industry and government officials familiar with them.
If, instead, the SEC were granted new powers by Congress to oversee swaps, the agency could set up several exchanges, similar to the way stocks are traded on the New York Stock Exchange and Nasdaq.
"I do think the SEC needs to work vigorously to work to reclaim some of its lost ground. Moving forward on credit derivatives and credit-default swaps is a legitimate area for them to start rattling their sabers a little bit," said James D. Cox, a law professor at Duke University.