June 18 (Bloomberg) -- U.S. Securities and Exchange Commission Chairman Mary Schapiro said regulators will have to be “vigilant” about the $592 trillion over-the-counter derivatives market so firms don’t evade reporting requirements.

President Barack Obama’s administration released a plan for overhauling financial regulation yesterday that would require standardized over-the-counter derivatives to be guaranteed by clearinghouses. Customized products would face less-stringent oversight. The Treasury Department’s plan didn’t spell out how the government would distinguish between the two.

“The hard question is what is standardized,” Schapiro said in a phone interview yesterday from Washington. “The regulators are going to have to be very thoughtful and very vigilant on that.”

Lax regulation of derivatives contributed to failure last year of Lehman Brothers Holdings Inc. and the near-collapse of American International Group Inc., leading to the seizure of credit markets and billions of dollars of losses at banks and securities firms. In its proposal, the administration said the contracts “became a major source of contagion through the financial sector.”

Derivatives are financial instruments used to make bets on or hedge against changes in interest rates, a company’s creditworthiness, currencies and commodities. Transactions in such products are typically conducted over the phone between banks and customers. Investment banks fought regulation of derivatives for more than a decade.

Driving Profit

As much as 40 percent of profit at securities firms including Goldman Sachs Group Inc. and Morgan Stanley comes from trading in the contracts, according to fixed-income research firm CreditSights Inc.

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. Among standardized contracts likely to go through clearinghouses are interest-rate swaps.

The White House proposal also urged the use of exchanges and electronic trading platforms for standardized derivatives.

‘Conservative’ Capital Cushions

Under Obama’s plan, customized transactions would only have to be registered with regulated trade repositories. Market participants who trade customized swaps would have to hold “conservative” capital cushions to cover bets that go bad.

Commodity Futures Trading Commission Chairman Gary Gensler told lawmakers this month that determining whether a contract is standardized or customized can be determined by the volume of the contract, the similarity of terms to other contracts and whether prices are disclosed to third parties.

Obama’s plan didn’t say how oversight of derivatives should be divided between the SEC and CFTC. The proposal urged Congress to give both agencies power to impose recordkeeping and reporting requirements on derivative transactions.

It also sought authority for the CFTC to set position limits on swaps that “perform” a “significant price discovery function with respect to regulated markets.”

U.S. Senate Agriculture Committee Chairman Tom Harkin, whose panel oversees the CFTC, said in a May 4 interview that he expects regulation of customized swaps to trigger a fight in Congress. The Iowa Democrat has proposed legislation that goes further than Obama’s plan by moving all trades in the over-the- counter market to regulated exchanges.

Derivatives legislation may also face jurisdictional battles in Congress because the SEC is overseen by banking and finance committees while agriculture panels have authority over the CFTC.

“It is my hope that various constituencies can see beyond their individual, narrow agendas and work toward the greater good to get legislation passed,” CFTC Commissioner Bart Chilton said in a statement today. “My concern is that by a thousand tiny cuts this important reform will languish in committees and backroom debates.”

To contact the reporters on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net; Matthew Leising in New York at mleising@bloomberg.net.

Last Updated: June 18, 2009 12:20 EDT