The whys and hows of regulations on derivatives

A House bill would impose new restrictions on a series of complicated financial transactions that had traded in private markets around the world without regulations. One type of these specialized derivative instruments, called credit default swaps, was blamed for the crisis that hit Wall Street last year.

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What are derivatives:

—A contract between two or more parties, the value of which is determined by fluctuations in an underlying asset. The assets typically used are stocks, bonds, commodities, currencies, and interest rates. Companies use derivatives to hedge against risks — airlines, for instance, use them to ensure against spikes in fuel prices.

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What was the problem:

—The derivatives known as credit default swaps, a form of insurance against loan defaults, account for an estimated $60 trillion of the over-the-counter derivatives market. When the housing bubble burst, the swaps collapsed and led to the downfall of Lehman Brothers Holdings Inc. a year ago and nearly toppled insurance conglomerate American International Group.

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What the bill does:

—Forces companies to conduct what had been private over-the-counter transactions on regulated exchanges under the oversight of the Securities and Exchange Commission or the Commodity Futures Trading Commission. Companies would have to meet certain liquidity requirements, meaning they would have to have enough money in hand to protect themselves against the risk of the transactions.

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Exemptions:

—The bill would grant exemptions to companies that use derivatives for commercial reasons to protect against risk. Those that use it for financial reasons — that is, only to make money — would fall under the regulations. The SEC and CFTC could also decide to exempt some transactions on their own. All companies, however, would have to report prices and trading.