Regulation - What kind?

The word "regulation" tends to make me feel uneasy most of the time.  However, over the last week - with the new regulatory measures that was under works by the Obama camp was something I was eagerly waiting for.  The fact that there needed to be more regulation in the financial sector is no longer a debatable point. Very few disagree.  The question is - as they say the devil lies in the details - and in this case what they are. As we got some details I am not convinced that the administration is doing enough. In that sense I echo many others not to mention the editorial in NYTimes  .  The big question boils down to the Over-the-counter derivatives and how we regulate those. They are customized bilateral contracts and except for interest rate swaps and few others that follow ISDA Master agreement -- are customized.  As such pricing and valuing and enough hedge is set by mutual consent of two parties.  The real question comes in what happens in the world of absolutely customized contracts.  It is hard to write a code for them so that they can regulated and standardized.  Also, what is a fair value for a one of a kind contract? It is like pricing a painting that I am selling to an art dealer. As econs would call - it is a classic case of "bilateral bargaining problem" in which one cannot set a fair market value price.  Now say we somehow manage to strike a deal - if one of the counterparties defaults, it is hard to set up an auction in the lines of Markit and Creditex since how do we set a price for a one of a kind contract.  If the instrument is in scarcity or bad news has already reached the market, the price will already include the information and we will not get a fair value.  In sum, regulating these contracts is a pipe dream if not plain "nuts".  Of course, if OTC is banned with all customizable options taken off, standardization can happen but why go back.  

A better solution in my mind is to take a leaf out of the page of other regulation.  For instance, systemic failures are not uncommon in complex nuclear power plants or electric grid.  To avoid those, the regulators ask utilities to identify systems, assets, and functional components that are critical to avoid systemic failures.  Why can't we do the same with banks?  Ask the banks to self report on the contracts that have embedded systemic risks.  And then back up with a program to closely monitor and control these puppies and in tandem build a strategy to isolate and island problems and issues to a small local area or department much before they cascade into causing a meltdown of the financial market itself.