June 26 (Bloomberg) -- The fight over regulating the $592 trillion over-the-counter derivatives market spilled over into climate-change legislation being debated in the U.S. House of Representatives today.

A derivatives provision tucked inside the 1,201-page measure to limit greenhouse gases is intended to spur Congress to enact new laws reining in a largely unregulated swath of U.S. financial markets, according to Representative Bart Stupak of Michigan. He added to the bill a measure that would regulate over-the-counter derivatives, accepting a stipulation sought by other Democrats that those rules would be repealed if Congress adopts broader market regulations.

“Assuming this stays in the climate change bill, this will be law until broader regulatory reform is passed,” said Nick Choate, a spokesman for Stupak.

Stupak’s proposal sets clearing and capital requirements and bans “naked” credit-default swaps. The rules would subject end users “to onerous terms, primarily the provision mandating the use of collateral to secure the majority of over-the-counter derivative trades,” said Ted McCullough, a managing director at Chatham Financial Corp. in Kennett Square, Pennsylvania.

“If no other legislation gets put in place to override the Stupak provision, it puts a lot of pressure on responsible businesses,” said McCullough, whose company specializes in currency and interest rate derivatives, in a telephone interview yesterday. Chatham advises clients with about $350 billion in contracts.

“It’s definitely more onerous than what’s on the table” from President Barack Obama and Treasury Secretary Timothy Geithner, McCullough said.

Naked Swaps

Obama is pushing Congress to move most derivatives trading to regulated exchanges and impose oversight over all dealers as part of an overhaul of the U.S. financial regulatory system. The plan would require standardized contracts to trade on an exchange or “other transparent trading venues,” subjecting them to collateral and margin requirements. It would impose capital rules on all customized over-the-counter contracts, which are privately negotiated deals.

Stupak’s measure would expand the Commodity Futures Trading Commission’s power to regulate all energy commodities, including coal, crude oil, gasoline, diesel and jet fuel, heating oil, propane, electricity and natural gas. It would also repeal the 2000 regulatory exemption for energy swaps and other derivatives that let energy traders such as Enron Corp. operate outside federal supervision. It would ban so-called naked credit-default swaps, where the investor doesn’t actually own the underlying debt on the contracts being purchased.

Opposed Fundamentally

“That’s something we oppose fundamentally,” Representative Michael McMahon of New York said yesterday in an interview, referring to Stupak’s provision. McMahon was one of 18 Democrats who opposed the derivatives measure in a June 17 letter to House Energy and Commerce Committee Chairman Henry Waxman and Representative Edward Markey, a Massachusetts Democrat, the primary sponsors of the climate change legislation.

Democratic leaders are still working today to win enough support to pass the climate bill, House Majority Whip Jim Clyburn of South Carolina said before the debate began. “We’re not there yet,” he said.

The International Swaps and Derivatives Association and three other trade groups that would be affected said in a letter to House leaders yesterday that Stupak’s proposal “would disrupt the risk management capabilities of businesses and strip liquidity from important price discovery markets.”

Measure ‘Superseded’

House Agriculture Committee Chairman Collin Peterson, a Minnesota Democrat, said Stupak’s measure will be “superseded” by derivatives legislation he is drafting with House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, as part of the broader regulatory overhaul.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather. Credit- default swaps were created initially as a way for banks to hedge their risk from loans. They became a popular vehicle for hedge funds, insurance companies and other asset managers to speculate on the quality of debt or on the creditworthiness of companies because they were often easier and cheaper to trade than bonds.

Securities and Exchange Commission Chairman Mary Schapiro and CFTC Chairman Gary Gensler are seeking a dual regulatory structure for derivatives. Primary responsibility for derivatives tied to securities, such as credit-default swaps, should go to the SEC, Schapiro told a Senate subcommittee in Washington on June 22. Other derivatives, including those related to interest rates and commodities, should be regulated by the CFTC, Gensler told the same panel.

Harkin’s Proposal

In the Senate, Agriculture Committee Chairman Tom Harkin, an Iowa Democrat, is pushing legislation that would require all over-the-counter derivatives trades be traded on a regulated exchange, not just standardized ones as the Obama administration is seeking.

“Obama’s proposal is still fairly vague, there’s still a lot up in the air,” McCullough said. “We know what his principles are. But how that gets accomplished, we still don’t know.”

To contact the reporter on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net.

Last Updated: June 26, 2009 14:22 EDT